Despite all the advantages highlighted in earlier posts relating to using an entity with less corporate formalities (LLC’s) and/or pass-through tax treatment (LLC’s or S corporations), there is one obvious situation where you are better off using a C Corporation (“C Corp”): venture capital deals. Below are some of the primary reasons this is true:
- Settled Law: Laws governing fiduciary duties, stock preferences, tax treatment and creditor protections are well-settled with C corporations.
- Familiarity: Venture Capital Groups (“VC’s”) are familiar with C Corps. They know what to expect and they often have “canned” forms for dealing with them. They don’t like investing in the unknown.
- Income Taxes: This one will surprise you because of the abhorred “double tax” on C Corps, but for VC’s, C Corps are much easier to deal with from a tax perspective. LLC’s and S Corps provide their owners with K-1’s which pass through the entities’ profit and loss to their owners’ individual tax returns. Investing in hundreds of pass through entities would be a nightmare logistically because they’d be waiting to collect all of the K-1’s and also potentially subject to state income tax filings in states where the pass through entities conduct business.
- Employment Taxes: Similar to S Corps, C corps can minimize payroll taxes (as compared to LLC’s) by only allocating a portion of the company’s income to its owners’ wages.
- Simplicity: Other aspects of accounting are also simpler with C Corps. There are no cumbersome capital accounts to keep track of. Economic benefits are easy to anticipate. If you own 200 shares and there are 1,000 shares outstanding, you know you will get 20% of any common dividend. If you are entitled to a preferred dividend equal to 5% of your original purchase price of $1M for your 200 shares, you know you will get a $50,000 preferred dividend every year plus 20% of the common dividend. The formulas contained in LLC Operating Agreements are not always this simple!
- Preferred Stock: VC’s don’t buy common stock. They typically demand preferred dividends, liquidation preferences, protective voting provisions, rights of first refusal and co-sale and countless other protections. Always remember that S Corps are only permitted to have one class of stock so none of these preferences are permissible! Although LLC Operating Agreements can be structured to accommodate these concepts, there are no form transaction documents for these structures.
- Equity Compensation: The law is well-settled on restricted stock plans and incentive stock options with shares of C Corps.
- IPO: Generally speaking, only C Corps can do an IPO. Only a miniscule percentage of startup companies will ever go public, but VC’s like to have an exit strategy in place if their investment hits!
One caveat to this advice is that most startup companies will never do a venture capital deal either because they are not exciting enough or they don’t want to make the necessary concessions to attract VC’s. It would be foolish to form a C Corp if you do not have a realistic chance of doing a venture capital deal. Keep in mind that even if you begin your business as an LLC or S Corp and then decide to do a venture capital deal, all is not lost. You still have the option to either convert or merge your entity into a C Corp or change your tax elections (in the case of an S Corp).