Why the Corporation is King for Getting Venture Capital
Choosing a startup’s legal entity can be a frustrating experience for the entrepreneur. Who has time to deal with the LLC, S-Corp, C-Corp, LP, GP, LLP & LLLP when you’re already buried with things like CSS, RoR, AJAX, PYTHON, PHP & ASP? Thankfully, if your startup is absolutely determined to raise venture capital, there’s only one viable legal entity decision your startup can make–the Corporation.
Does this include S Corporations?
No. While the S Corporation structure is a popular choice for entrepreneurs and other small businesses, it comes with regulatory limitations that do not make it a feasible vehicle for raising venture capital. The three main regulatory limitations are:
- S Corporations may only have one class of stock;
- S Corporation stockholders must be natural persons (except for some extremely limited circumstances); and
- S Corporations can not have more than 100 stockholders.
The one class of stock requirement is fatal to a venture capital investment since venture capital firms will demand preferred stock in return for their investment. Also, most venture capital firms are organized as limited partnerships and less frequently as LLCs–but both legal entity types aren’t “natural persons.” And finally, as your startup grows, the 100 stockholder maximum comes into play once your startup begins issuing stock and stock options to employees.
Thus, the C Corporation will be the only type of corporation viable for a venture capital investment.
Why not an LLC?
While the LLC is also a common startup vehicle, the C Corporation wins hands down when it comes to raising venture capital. The following 4 reasons explain why:
1. Pass Through Entity
While the pass through feature (income/losses are passed down to the shareholders rather than dealt with at the entity level) of LLCs are desirable to most entrepreneurs, venture capital funds do not find pass through taxation to be a similarly desirable feature. The venture capital firm does not want the accounting and tax matters of a funded venture to be passed down to the firm, and thereby be attributed to the venture capital firm’s tax exempt and foreign limited partners. Such a scenario could create unrelated business taxable income (UBTI) issues or have their foreign investors be deemed “doing business” in the United States and thus have to file a U.S. tax return.
2. Transferability
The membership interests of an LLC are typically not freely transferable by state statute. This makes the LLC a lousy entity for one of venture capital’s exit strategies: the IPO. (Not that IPOs for venture backed companies are hot at the moment.)
3. Predictability
Started in the late 1980s and only made more popular in the last decade or so, LLCs are a relatively new type of legal entity. Thus, there just isn’t a well developed set of laws and regulations for LLCs. Corporations, on the other hand, provide a larger degree of predictability with regards to corporate governance and stockholder rights.
4. The Venture Capital Firm’s Organizational Documents
Primarily due to the reasons outlined above, many venture capital funds will have specific provisions in their own organizational documents that prohibit them from making a venture capital investment in an LLC, or any other legal structure than a C Corporation. Thus, if your startup is absolutely against being a C Corporation, you could be declined by the venture capital firm regardless of how spectacular your startup is.
The Conclusion
The C Corporation is a venture capital firm’s clear-cut choice for the type of entity in which to place their investment. When the to-be-venture-funded startup is a C Corporation, various administrative and other burdens are minimized for the venture capital firm, which allows them (and their capital) to focus on developing the startup company’s business.
About the Author
Ryan Roberts is a startup lawyer and represents technology companies through all phases of the startup process, including incorporation, seed & venture financings, and exit transactions. Click here to learn more about his practice.
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Please consider subscribing to The Startup Lawyer, following @startuplawyer on Twitter, or contact Ryan directly.25 Responses
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BillB says:
The S-corp isn't really a "structure", but a tax status. More specifically, an S-corp is really just a C-corp that has elected to be taxed under Subchapter S of the IRC.
Why not advise entrepreneurs to form their C-corp and file for S-corp status? Subchapter S does not PROHIBIT an entrepreneur from issuing preferred stock; rather, it states that if you do so, your entity's tax status REVERTS to the traditional C-corp treatment.
If this is indeed the case, why not save a few tax dollars with the S-corp status, until you need preferred stock, entity shareholders, etc.?
Your thoughts?
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BillB- I agree completely with your clarification on the S Corporation.
Like most legal advice, it depends on the situation. The S Corp will make sense for some entrepreneurs pre-funding, but a C corp will be necessary to actually obtain the venture capital funds.
Whether or not the entrepreneur decides to make the Subchapter S election pre-funding will depend heavily on the entrepreneur's anticipated early losses. Some startups are truly bootstrapped and the tax dollars saved won't be enough incentive to make the S election. Of course, getting any amount of tax relief today, whether $10 or $10,000, is helpful for the entrepreneur.
Another issue is see more frequently is that startups are bringing on non-US founders & employees to help develop the startup. This would also make the S Corporation status unfeasible pre-funding, assuming such are being issued stock.
Also, I would not advocate making the Subchapter S election as a 'default' for the entrepreneur. Since if the S corporation revokes its S status, it can't re-apply for Subchapter S recognition for 5 years (unless it can convince the IRS to make an exception and consent to the election). Not a major potential deal, but something to think about.
Thanks for your comment. There are so many related issues.
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BillB- I agree completely with your clarification on the S Corporation.
Like most legal advice, it depends on the situation. The S Corp will make sense for some entrepreneurs pre-funding, but a C corp will be necessary to actually obtain the venture capital funds.
Whether or not the entrepreneur decides to make the Subchapter S election pre-funding will depend heavily on the entrepreneur's anticipated early losses. Some startups are truly bootstrapped and the tax dollars saved won't be enough incentive to make the S election. Of course, getting any amount of tax relief today, whether $10 or $10,000, is helpful for the entrepreneur.
Another issue is see more frequently is that startups are bringing on non-US founders & employees to help develop the startup. This would also make the S Corporation status unfeasible pre-funding, assuming such are being issued stock.
Also, I would not advocate making the Subchapter S election as a 'default' for the entrepreneur. Since if the S corporation revokes its S status, it can't re-apply for Subchapter S recognition for 5 years (unless it can convince the IRS to make an exception and consent to the election). Not a major potential deal, but something to think about.
Thanks for your comment. There are so many related issues.
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Hi,
Great article! We are starting a web site but really do not plan to go after VC for at least 6-8 months, and probably not for a year. In this first year we will mainly be dealing with angels. We are pretty much set to start the LLC working under the assumption that we can convert it to a C Corp when we decide to go after VC. Does this make sense?
Thanks again!
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Hi,
Great article! We are starting a web site but really do not plan to go after VC for at least 6-8 months, and probably not for a year. In this first year we will mainly be dealing with angels. We are pretty much set to start the LLC working under the assumption that we can convert it to a C Corp when we decide to go after VC. Does this make sense?
Thanks again!
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Dave,
Your main issues will likely be tax related: making sure the conversion is tax-free, capital account issues, and other debt-related issues. Thus, it would be wise to get a good CPA from start and let him or her know your plans to eventually convert and raise capital.
Of course, there could be an issue with getting the necessary consent from the llc members for the conversion. For example, Texas requires that a conversion by approved "as required by (1) the laws of the jurisdiction of formation and (2) the governing documents of the converting entity." Thus, sometimes llc agreements (governing docs) or the statutes require unanimous approval for a conversion.
Additionally, if you are going to convert a non-Delaware LLC to a Delaware C Corp, you will also have to comply with Delaware's requirements (Section 264 of Delaware's General Corporation Law for LLCs wanting to convert to Corporations) in addition to your current state's requirements.
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Dave,
Your main issues will likely be tax related: making sure the conversion is tax-free, capital account issues, and other debt-related issues. Thus, it would be wise to get a good CPA from start and let him or her know your plans to eventually convert and raise capital.
Of course, there could be an issue with getting the necessary consent from the llc members for the conversion. For example, Texas requires that a conversion by approved "as required by (1) the laws of the jurisdiction of formation and (2) the governing documents of the converting entity." Thus, sometimes llc agreements (governing docs) or the statutes require unanimous approval for a conversion.
Additionally, if you are going to convert a non-Delaware LLC to a Delaware C Corp, you will also have to comply with Delaware's requirements (Section 264 of Delaware's General Corporation Law for LLCs wanting to convert to Corporations) in addition to your current state's requirements.
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If it helps to clarify, we plan to incorporate in Florida. Although we are not based in Florida, I from Florida and have many "agents" there. Would you generally not recommend this approach?
Thanks again!
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If it helps to clarify, we plan to incorporate in Florida. Although we are not based in Florida, I from Florida and have many "agents" there. Would you generally not recommend this approach?
Thanks again!
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I always believe one should have a compelling reason to incorporate (rather than qualify as a foreign entity) in a different state than the home state. I'm not quite sure those reasons are compelling. But then again I'm not familiar with the pros/cons of a FL incorporation.
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I always believe one should have a compelling reason to incorporate (rather than qualify as a foreign entity) in a different state than the home state. I'm not quite sure those reasons are compelling. But then again I'm not familiar with the pros/cons of a FL incorporation.
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[...] capital. I have written a few posts about “Why Incorporate in Delaware?” and “Why a Corporation for Venture Capital?” explaining the subject. Of course, the Series AA documents aren’t for venture capital [...]
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Vance says:
I have a new LLC without any owners except myself, not Articles, etc.. Is there an easy way (Florida) to convert it to a C-Corp, or is it easier to just set up a new C-Corp?? I didn't think I would need shares, but now I do.
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I have a new LLC without any owners except myself, not Articles, etc.. Is there an easy way (Florida) to convert it to a C-Corp, or is it easier to just set up a new C-Corp?? I didn't think I would need shares, but now I do.
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Timothy says:
hi,
Concerns, if I need capital, from share sales, but in my c-corporation I don't want a board, I need 5000-10000 shares. How can start a c-corporation, sale shares, and not have to worry about a board. Is it possible to open a c-corporaton have 5000-10000 shares, wout a board. Please reply
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hi,
Concerns, if I need capital, from share sales, but in my c-corporation I don't want a board, I need 5000-10000 shares. How can start a c-corporation, sale shares, and not have to worry about a board. Is it possible to open a c-corporaton have 5000-10000 shares, wout a board. Please reply
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How come no one talks about the tax issues on a pre-funding buyout? Or even post funding buy-out with no substantial profit (loss carryover in c-corp is not significant compare to the buyout value) which won't get passed to the investors in a LLC or S-Corp status?
Seems like most of the focus were put on the funding campaign rather than exit?
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How come no one talks about the tax issues on a pre-funding buyout? Or even post funding buy-out with no substantial profit (loss carryover in c-corp is not significant compare to the buyout value) which won't get passed to the investors in a LLC or S-Corp status?
Seems like most of the focus were put on the funding campaign rather than exit?
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Shelby Clark says:
Hi there- This is a great article! I'm an entrepreneur, planning to raise VC for a venture based in San Francisco. Should I register my company in DE or CA?
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Hi there- This is a great article! I'm an entrepreneur, planning to raise VC for a venture based in San Francisco. Should I register my company in DE or CA?
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Adam says:
I am planning to start an entity with one other person. The plan is to self-fund it (~$100K for marketing, external consulting costs, operating expenses), and with this, we think we can develop a product that should produce reasonable recurring revenue. The hope is not to have to raise additional money, but of course, we may need to at some point. If successful in the market, we may also become an acquisition target for larger companies in a similar space. Questions: Corporation for our self-funded entity, or LLC? If we sell in 2 years, we’d like to be able to receive long-term capital gains treatment (83b election), but I don’t think we can do this with an LLC? But we like the flexibility and simplicity of an LLC and are worried about “double tax” of a C-Corp. Thoughts?
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[...] Here’s what I’d do in the beginning:Incorporation(1) Entity Choice: Corporation or Corporation(2) State of Incorporation: Delaware(3) Authorized Shares in Charter: 10,000,000 Shares(4) Type of [...]
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[...] Here’s what I’d do in the beginning: Incorporation 1. Entity Choice: Corporation or Corporation 2. State of Incorporation: Delaware 3. Authorized Shares in Charter: 10,000,000 Shares 4. Type of [...]
The S-corp isn't really a "structure", but a tax status. More specifically, an S-corp is really just a C-corp that has elected to be taxed under Subchapter S of the IRC.
Why not advise entrepreneurs to form their C-corp and file for S-corp status? Subchapter S does not PROHIBIT an entrepreneur from issuing preferred stock; rather, it states that if you do so, your entity's tax status REVERTS to the traditional C-corp treatment.
If this is indeed the case, why not save a few tax dollars with the S-corp status, until you need preferred stock, entity shareholders, etc.?
Your thoughts?