Forming Your Tech Startup – C Corp, S Corp or LLC?
WHAT TYPE OF ENTITY SHOULD I CHOOSE FOR MY NEW BUSINESS?
You’ve been working for a long time on this brilliant startup…the one that’s going to change the world forever. You just recruited your genius friend as CTO and your neighbor as a rock star designer. You dream every night about the media that will cover your story, the investors who will be chasing after you, the prestigious Venture Capital (VC) firm that will invest in you, and, of course, the 10 figure number you’ll get for your big exit. But, before your dream is going to come true, you find yourself preparing to form a legal entity for your startup and facing the one million dollar question: what type of entity should I chose for my new business??
Not yet quite the glitz and glamour that you’re dreaming about…but one of the first steps in creating a successful company is choosing the legal structure that will best suit the needs of the business and its shareholders. There are many options to choose from: LLC, C Corporation (C Corp), S Corporation (S Corp), and others, each with their own sets of pros and cons. But rest assured. If you’re planning to seek VC funding, the choice for you is easy. Choose a C Corp. And here’s why:
- No Pass-Through Tax. In contrast to LLCs and S Corps, C Corps are not pass-through tax entities, which means that taxable profits/losses do not pass through to the shareholders, who record these as part of their personal tax filings. VCs prefer dealing with C Corps because pass-through taxation creates significant tax complications for their foreign and tax-exempt entities limited partners.
- Preferred Stock Class. C Corps allow for two or more classes of stock such as Common and Preferred Stock. S Corps, on the other hand,are limited to only one class of stock. VCs will demand Preferred Stock in return for their investment, so C Corps are the way to go.
- General Structure. The structure of C Corps includes Directors and Officers who are in charge of daily operations, leaving VCs to focus on influencing and guiding higher-level strategies and planning. In addition, in the case of an exit (acquisition or IPO), the C Corp equity structure allows for more seamless transfers compared to an LLC.
- Stock Options. As a tech startup, you’re likely going to want to issue stock options to your employees, which is a great incentive. VCs like this because it allows the company to lure high-quality employees and unite them around the company’s long-term success. C Corps allow for such stock options. Alternatively, LLCs cannot provide them and offer only “profit interest,” which has extensive tax complications.
- No Limitations on Numbers of Shareholders. C Corps have no limitations on the number of shareholders allowed. With S Corps, however, there are notable limitations on numbers of shareholders (namely, no more than 100 shareholders are allowed). VCs prefer C Corps because they pose no limits on the company’s growth and ability to acquire high-quality employees.
- No Limitations on Nature of Shareholders. To qualify for an S Corp, shareholders must not be “partnerships, corporations or non-resident aliens.” This is a problem! VCs are often organized as partnerships or LLCs, so if your company is an S Corp, VCs won’t be able to hold shares in your company. Not the case if you’re an S Corp.
In summary, most tech startups tend toward the C Corp path for the reasons noted above. If you’re interested in raising money from VCs, then this is likely the right choice for your tech company too. But think carefully about your decision. There are many factors to consider, given your business plan and unique set of circumstances.
Have more questions? Need more legal assistance? We would love to help you form your new, world-changing company! Just shoot as a note here or visit our Business Formation Page.
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