Everything a Founder Needs to Know About Corporate Structure
Disclaimer: I dropped out of law school. I am not a lawyer. This is not legal advice. I’m not an accountant, and this is not tax advice, either. I’m a startup founder. This is startup common sense.
A surprisingly large number of early-stage startups I see pitching for investment are LLCs instead of C-Corps. Since common sense is the collection of all the things that everyone knows except you, I’ve put together this mini-overview of what a startup founder needs to know about choosing a corporate structure.
The only thing you have to know is that if you want investors, your startup needs to be a C-Corp incorporated in Delaware. Here are the reasons why.
When you start your business, your options for corporate structure are:
- LLC & S-Corp
Proprietorship & Partnership
If you’re building a small business like my consulting services, a sole proprietorship or a partnership is the simplest corporate structure. There’s very little overhead and no separate business income taxes. (Income from the business gets put on your personal taxes.)
But a sole proprietorship or partnership has no liability shield. Your personal assets of all owners are at stake if company loses money or is sued. There’s no way an investor is personally guaranteeing all your company losses, so for a startup looking for investors, we can cross off this option.
LLC & S-Corp
An LLC is a separate legal business entity with a liability shield for “shareholders.” (Technically, an LLC doesn’t have shares, it has “units” and the owners are Unit holders. For this article, I will call them shares and shareholders. If that makes you want to report me to the accounting police, stop reading now because you’re really going to hate the rest of this article.)
The time and cost of setting up an LLC is reasonably low. The personal assets of you and your shareholders other than what you invested in the company is not at risk (ignoring the rare edge conditions like fraud that the lawyers will gladly charge you a thousand dollars an hour to tell you all about.) And there is no Federal income tax. (In most states, there is still a state income tax, AND it applies no matter where the Corp/LLC is registered. Sorry, registering as a Nevada LLC does NOT get you out of paying California corporate taxes no matter what the scammy sites say.)
Your share of the income from an LLC is added to your personal taxes. For example, if the company makes $100,000 income and you own 50%, it’s the same as if you received a dividend of $50,000. It doesn’t matter if you actually received the cash or not, which leads to an entire set of problems we won’t get into here. The details are reported on a tax form called the K-1.
If you’re building a business for profitability, an LLC is a great choice. Yes on liability shield, no on corporate taxes. Sounds perfect. But there’s downsides for investors that we’ll get to.
An S-Corp is basically the same thing as an LLC. (Lawyers and accountants: breathe deep, relax…)
However, it can only have 1 class of shares, so we can cross it off for a venture business that needs, to start, separate preferred and common stock.
That brings us to the granddaddy of corporate structures, the standard C Corporation. With few exceptions, all big companies are C-Corps.
The C-corp has 1 drawback: the corporate income tax. The current Federal corporate tax is 21% and is likely to be increased. The California state rate is close to 9%. That means 30% of the company’s income goes straight to the guvment. The remainder can then be paid in dividends to the owners, who then pay income taxes on what they receive.
Some people call this double taxation of corporate income. Big companies have teams of accountants and consultants to exploit loopholes to reduce or eliminate those taxes. Your startup doesn’t. So why would you possibly want to be a C-corp and pay a big chunk of your earnings in taxes instead of an LLC with no corporate taxes?
If you’re building a small business like a bakery, your goal is to make profits. And nobody wants to pay taxes on those profits, so an LLC or S-Corp is ideal.
If you’re building a venture startup, you won’t have any profits. Despite every startup’s 5-year projections showing huge profitability, no startup in history has ever made a profit. Your goal is acquisition or IPO, not profits. Since valuation depends on revenues and growth, not profits, any money trickling down to the bottom line should be invested back into growth. If you’re showing a significant profit, you’re doing something wrong.
So, now that we’ve eliminated profits, there’s no need to worry about taxes. The C-corp is looking better. And there’s lots of advantages:
C-Corp benefit #1: No K-1.
An LLC or S-corp has to provide a K-1 to each investor to add to their personal taxes. It’s supposed to be distributed by March 15, in time for personal tax deadline of April 15. It rarely is. Most file extensions. K-1s show up in July. Or October.
I can’t file my personal taxes until I receive all my K-1s, including the one from the annoying company in which I made a tiny investment through a crowd funding site that doesn’t send out their K-1s until December. And when they find a mistake and need to revise their taxes, they send me a revised K-1 and I have to submit an amended tax return, too.
For tax reporting, investing in a C-corp startup is no different from buying shares of Apple on the stock market. I don’t have to put anything on my taxes unless the company pays a dividend (never), I sell the stock (the start is acquired), or the company goes out of business. And even in those cases, it’s 1 line on the tax form of gain or loss, not the entire accounting of every company I’ve invested in. This makes my taxes a whole lot simpler, especially when I have a large number of individual investments.
For this reason alone, many VC funds are expressly prohibited from investing in anything but C-Corps. If they invested in an LLC, that income (or almost always a loss) would need to be reported by the fund to every one of their investors. The hassle just isn’t worth it.
C-Corp Benefit #2: Tax Breaks!
To encourage investment in startups, the Federal government offers some amazing tax benefits known by the titles that could only excite an accountant as Sections 1202 and 1244.
Section 1202 basically says investors pay NO income taxes on gains in a startup. NONE. As in zero. It’s insane. But it only applies to purchase of stock in C-corps.
Section 1244 says if the company goes out of business, the loss can be taken off our taxes against income instead of against capital gains. I won’t go into details, but trust me, for me that’s a huge benefit.
Due to these tax benefits, I generally limit my investments to companies inside the U.S.
C-Corp Benefit #3: Employee Stock Options
The C-corp has the ability to offer stock options to employees and advisors. And there’s tax benefits for C-corp employee stock options that meet specific requirements.
While it’s possible to create something similar to a stock option in an LLC, it’s more complicated, doesn’t have the same tax benefits, and it’s hard for investors to understand. Which brings us to the next benefit:
C-Corp Benefit #4: Familiarity
Investors are used to investing in C-corps. Everything is familiar. The stock purchase agreements are mostly boilerplate and we (or our lawyers) can review them quickly and understand what we’re buying.
A simple LLC or S-corp is similarly easy to understand, but to build a venture business, the LLC needs multiple classes of shares and options. The legal documents become a hairy mess that makes it difficult to understand who owns what, how much voting rights each shareholder has, and how much payout each shareholder is entitled to.
The impression investors get from these complex constructs is that the structure is designed to obfuscate things from investors and prevent us from having voting rights and board representation. The LLC looks fishy, a big red flag that takes a lot more diligence to become comfortable with.
The LLC to C-Corp Conversion
For all the reasons above, investors require or at least strongly prefer to invest in a C-corp. When you’re ready to begin pitching to outside investors, you need to be a C-corp.
However, it may be a few years from the time you start working on your project until you’re ready for significant investment. And setting up a C-corp can be complicated and expensive. So it’s not unusual for a startup to be initially formed as an LLC for expediency.
While you’re building the tech, applying for grants, and hiring your first employees, an LLC is fine and you can do the setup yourself without having to hire lawyers. However, before you go to raise capital from angels and VCs, you’ll need to convert the company to a C-corp.
It’s easier to be a C-corp from the start without going through a conversion, so if you expect to raise money in a year, start as a C-corp. If you expect years of research and testing funded by grants or partners rather than investors, an LLC can be an expedient way to get started.
The Delaware Corporation
You’re in California. The company is in California. Your co-founders and employees and initial customers are in California. So why should you incorporate in Delaware?
it won’t save any money — in fact, you’ll have to register as an out-of-state corporation in California, anyway, and pay the same California taxes. It would be easier to register as a California corporation.
Delaware has a long history of a business-friendly court system and corporate regulations. California, to avoid expletives, does not. Looking forward, if your business is successful, it will have customers, offices, and employees all over the country, if not worldwide. You still have to follow all local laws and can be sued anywhere by employees or customers. But an investor suing the company would have to do so in Delaware under Delaware law. If there’s a bankruptcy, it’ll be handled in Delaware. A merger or IPO would be handled under Delaware regulations.
As an investor dealing with many companies around the country, it’s simplest to have one set of well-understood, consistent, business-friendly rules to play by. And Delaware has become that standard. Some investors will only invest in Delaware corporations.
But even when it isn’t a requirement, incorporating in Delaware gives the impression that you know how to build a startup to scale and exit. And more than anything else, that’s what investors want to see.
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