In the very early stages of your company, you need to make a key decision: What type of business entity to form. Will you be an LLC (a limited liability company), an S Corporation, or a C Corporation? Your choice will have an immediate impact on your company, as well as lasting implications for your ability to raise funds, especially if you decide to pursue venture capital.
If there’s any possibility you’d try to raise VC money at some point, the choice is rather easy: It’s wise to set yourself up as a C-Corp from the outset. Most venture capitalists are unwilling—or unable—to invest in any other business entity.
Why VCs don’t like LLCs
Last month, we featured an article by guest blogger and startup lawyer Joe Wallin on four reasons your startup shouldn’t be an LLC. One of the main problems with LLCs is the tax implications, which deter—and in some cases even prevent—venture capitalists from investing.
LLCs are especially problematic because venture capitalists have a strong focus on liquidity events. To convert equity investment into profits for VCs, startups typically need to IPO or be bought be another company. The problem is, it’s rather complicated—and sometimes even impossible—to transfer or sell partial ownership in an LLC.
Why VCs prefer C-Corps over S-Corps
Not all corporations are created equally. If you’re torn between setting your company up as an S-Corp or a C-Corp, it’s worth noting that VCs vastly prefer C-Corps to S-Corps. Here’s why:
1. S-Corps present the same tax problems for VCs as LLCs do.
Like LLCs, S-Corps are “pass-through” entities, meaning that the S-corp doesn’t pay federal income tax. Rather, the S-Corp’s shareholders pay federal income tax on the company’s taxable income, based on their pro-rated stock ownership. VCs simply don’t want to deal with this sort of complexity.
2. Most VC firms can’t legally be shareholders in an S-Corp.
To legally invest in an S-Corp, shareholders must be U.S. citizens or residents and “natural persons.” Not only does this rule out foreign investors, it also rules out most domestic VC money, which typically comes from VC firms that are set up as partnerships or LLCs. In other words, they are not “natural persons.”
Also, VC firms with tax-exempt partners legally can’t invest in S-Corps because they’re pass-through entities.
3. Only C-Corps can offer preferred stock.
Even if you could find American-based individual venture capitalists who legally could invest in your company, they would likely avoid your S-Corp. Here’s why: S-Corps can only offer common stock, not preferred stock. And preferred stock—which pays higher dividends and puts stockholders first in line to get paid out in a liquidity event—is exactly what VCs expect when they take a significant risk on your company.
4. C-Corps don’t have limitations on growth.
Unlike a C-Corp, an S-Corp is limited to only 100 shareholders. Although this may sound like a lot for a startup that has yet to issue a single stock, this upper limit can be reached rather quickly, especially if a cash-strapped startup offers extra perks in the form of employee stock. VCs are likely to worry about a startup’s inability to grow once the 100 shareholder threshold has been reached. What if you’ve maxed out on shareholders and still need to raise more money to truly scale your company?
Making the switch
If you’re not currently a C-Corp but want to pursue venture capital, you need to be ready to make the switch. The process is not simple; it will cost you time and money, and you’ll need a savvy lawyer to guide you through. And be forewarned: if your company is already generating revenue, there may be significant tax implications as well.
This is where you need to step back and weigh your options. Just how much will it cost you, in terms of time and money, to make the switch? And what, exactly will the tax implications be? And is all of this worthwhile for a shot at a significant influx of venture capital?
Lenders don’t care about your entity
Debt is a different ball game. Lenders have a very different investment goal compared to venture capital firms. They care about predictable payments and downside protection. The tax implications of your entity don’t bother lenders because they’re not looking for exits to make their money back. At Lighter Capital, we’ve funded C-corps, S-corps, and LLCs, and your choice of entity has no effect on our underwriting process. If you’re generating revenue at over $15K a month, consider getting a revenue-based loan from us.
If haven’t yet made a decision on what kind of entity to create for your startup and you plan to eventually seek VC money, it’s wise to start out as a C-Corp. Changing course mid-stream is tough, and without C-Corp status, you’re unlikely to lure in the VC money you’re hoping for.