One of the most important decisions a person starting a new business will make is choosing the form of business entity. Most startup owners choose a limited liability company (LLC) or they form a corporation and then elect S corporation status. (An S corporation, so named because it is taxed under Subchapter S of the Internal Revenue Code, is a business corporation that does not pay income taxes. Its income passes through to its shareholders.) However, if the business’ founders intend to look for funding from venture capitalists (VCs), they may want to incorporate and not select S corporation status. Instead, they may want to own a C Corporation. (A C corporation, so named because it is taxed under Subchapter C of the Internal Revenue Code. It does pay taxes on its income.)
Legal advisers often recommend the C corporation to clients who will seek venture capital funding because many VC firms will not invest in LLCs or S corporations. In fact, many VC firms are not eligible to own shares in S corporations. And the organic documents of many VC firms prohibit them from investing in LLCs.
Why do VC firms prefer C corporations?
There are a number of reasons why VCs prefer dealing with a C corporation. Among those frequently cited are the following:
1. VCs want to avoid pass-through taxation. Many VCs do not want the business’ income to pass through to them. They would rather the entity pay the tax. In addition, VC firms often have tax-exempt investors who could have tax problems if business income passes through to the owners.
2. VCs like preferred shares. VC firms often want preferred shares in exchange for their investment. These provide a preference over other shareholders in receiving dividends and distributions. S corporations are not allowed, by the tax laws, to issue a class of preferred shares. LLCs do not issue shares. They can provide a class of interests with preferences but this is more complex to do and increases the legal fees and startup costs.
3. VCs like companies to issue stock options. VC firms may want the business to be able to offer stock options to management and employees as an inducement to get the most qualified men and women to work for the company. Shares in S corporations come with restrictions that shares in C corporations are not saddled with. LLCs cannot offer stock options. They can offer a “profits interest” but again this adds to the complexity and cost.
4. C corporations offer a better exit strategy. VC firms eventually want to get out of the business either by selling their interest to someone or having an initial public offering. Both options are easier with a C corporation. Generally speaking, C corporation shares are freely transferable while there are restrictions on the sale of LLC interests and S corporation shares.
5. Corporations have been around for much longer than LLCs, therefore, VCs are more familiar and comfortable with corporations. Because of their long history dealing with corporations (particularly Delaware corporations, which many VCs prefer) and because there is such a large body of case law precedents to guide them, these transactions are more predictable.
It is important for small business owners to remember that the best entity choice depends upon many factors – not just whether venture capital funding may be sought. And choosing something other than a C corporation does not absolutely eliminate the possibility of finding a venture capitalist willing to invest. But it is something to discuss with legal and tax advisors at the formation stage.