Launching the Company – Entity Selection
You’ve had your epiphany moment, and now you’re ready to form your company and build the next white hot technology startup. But which type of entity should you choose? When it comes to forming your technology startup, for practical reasons, your choices are three: C-corporation; S-corporation; and limited liability company (“LLC”). Despite what some may try to tell you, there is no “one size fits all” solution to entity selection. When choosing your entity you need to consider the type of business you are starting, the industry you are entering, the financial prospects of your company and its income sources, and your company’s goals and anticipated growth trajectory.
The primary differences among these three types of entities have to do with taxation, ownership, suitability for outside fundraising, and equity incentive issues.
C-corporation. C-corporations are separate taxable entities that are taxed independent of their owners (stockholders). Thus, a C-corporation’s earnings are generally taxed twice: once at the corporate level on the corporation’s taxable income; and again at the stockholder level when earnings are distributed to the stockholders either as distributions or dividends.
S-corporation. S-corporations are, for all intents and purposes, identical to C-corporations with respect to everything except taxation. If you make an election under Subchapter S of the Internal Revenue Code (hence the name S-corporation), you are electing to forego the double taxation experienced by C-corporations, and have the earnings of the corporation flow through to the stockholders. This means that S-corporations are “pass-through” entities, and rather than being taxed at two levels like C-corporations, S-corporations are only taxed at the stockholder level on distributions to stockholders. As will be discussed below, in order to qualify for election under Subchapter S, certain requirements must be met, many of which are untenable for emerging technology companies.
LLC. Unless an election to be taxed as a corporation is made, LLCs are pass-through entities for tax purposes, meaning that, similar to S-corporations, the taxable income earned by the entity is passed through to the individual members of the LLC. LLCs have great flexibility in how they choose to allocate items of income or loss among their members (flexibility that cannot be achieved with a C-corporation or an S-corporation), however, such flexibility is met with increased administrative costs due to the application of complex partnership tax rules that apply to LLCs.
C-corporation. C-corporations have vast flexibility with regard to their ownership. They may have an unlimited number of stockholders, their stockholders may be active or passive, they may have an unlimited number of classes of stock with varying rights with respect to economics and control, their shares may be owned by any other type of entity (e.g., a C-corporation may have stockholders who are other corporations, LLCs, partnerships, trusts, etc.), and their shares may be freely transferred without affecting the continuing existence of the corporation.
S-corporation. S-corporations, unlike C-corporations, are significantly restricted with regard to the types of shares they may have and who may own them. S-corporations may have only one class of stock, they may have a maximum of only 100 stockholders, and none of their stockholders may be non-resident aliens. Additionally, shares of S-corporation stock must be held by individual stockholders with certain limited exemptions for certain types of trusts and other exempt organizations. However, similar to C-corporations, shares may be freely transferred without affecting the continuing existence of the corporation.
LLC. LLCs, like C-corporations, provide for great flexibility with regard to ownership. LLCs may have an unlimited number of equity holders (commonly called “members”), and they may have any number of classes of equity securities (commonly called “units”) with varying rights with respect to economics and control. However, the units of an LLC cannot typically be transferred as freely as shares of a corporation. Whereas corporations are strictly creatures of statute, LLCs are hybrid creatures of statute and contract. Most states have an LLC statute that provides certain default rules for LLCs, but all or most of these rules can be contracted around via an operating agreement among the company and the members. Most LLC statutes provide that if a member transfers its units to a third party, the transfer must be unanimously approved by the other members of the LLC, and if such approval is not obtained, the third party receiving the units can have the economic rights associated with those units, but none of the rights to participate in the business as a full member. As mentioned above, this restriction can usually be contracted around, but it requires thoughtful drafting in the company’s operating agreement.
C-corporation. By and large, sophisticated angel and institutional investors prefer making equity investments in C-corporations because of the flexibility they have with respect to being able to offer various classes of stock with different levels of liquidation preference and voting rights. Additionally, unlike LLCs, corporations are creatures of statute, and by and large, all corporations incorporated in a particular jurisdiction must be operated in substantially the same way. This provides investors predictability and standardization with regard to governance issues.
S-corporation. Because of all of the restrictions that are placed upon them, S-corporations are typically disfavored by investors. Not only that, but by taking investment from most institutional investors, the company’s S-election would be terminated because most institutional investors are structured as entities that are prohibited from holding S-corporation stock. Additionally, most investors prefer to make their investments in technology startups via the purchase of preferred stock, and because S-corporations can only have one class of stock, this objective cannot be achieved in an S-corporation investment. That being said, it is not uncommon for a technology company to form as an S-corporation initially, and then kill the S-election (which happens automatically upon a violation of the S-election requirements) and “convert” to a C-corporation at the moment they take their first preferred stock investment. The only word of caution with respect to this practice is that once the S-election is terminated, the company’s tax year as an S-corporation ends on that date, and depending on the company’s particular situation, a tax bill could come due at that point.
LLC. It was once the conventional wisdom that venture capitalists do not invest in limited liability companies. This stance has changed some, and there are venture investors who are willing to make investments in LLCs. As they have become more familiar with the entity structure, some venture investors have become more comfortable with the idea of making LLC investments, and it is possible to structure an LLC so that, except with respect to its pass-through tax treatment, it looks almost identical to a C-corporation. However, with this comes complexity and cost. Because a venture investor (or more likely their lawyers) would have to wade through the operating agreement to understand every term and how it compares to a C-corporation before making an investment in an LLC, this entity structure can be a non-starter for many investors. Additionally, depending on the way the institutional venture investor is structured, holding equity of a pass-through entity could lead to adverse tax consequences for the investment entity, which can also dissuade an investor from a deal it would otherwise invest in.
Corporations. The difference between C-corporation and S-corporation status is only recognized by the Internal Revenue Service with respect to taxation. Other than that, the two entities are governed by the same corporate statutes (e.g., Delaware C-corporations and Delaware S-corporations are both governed by the Delaware General Corporation Law with respect to corporate governance matters), and thus there is no difference between the two with respect to fiduciary duties and other corporate governance issues. Corporate statutes are generally very rigid and predictable, and provide for a course of dealing that all corporations formed in a given jurisdiction must follow (e.g., the holding of board and stockholder meetings, maintenance of corporate minute books, fiduciary duties of officers and directors owed to the company and its stockholders).
LLC. As mentioned above, unlike corporations, which are creatures of statute, LLCs are hybrid creatures of statute and contract. Each state has a limited liability company statute that provides default rules where the LLC’s operating agreement is silent, but virtually all of these defaults can be contracted around in the company’s operating agreement. As a result, LLCs have much more flexibility with regard to their structure (e.g., they may or may not have a board of directors, they may or may not have the concept of shares or units). Because of this flexibility, there is much less uniformity with respect to the structure and governance of one LLC compared to another than when comparing corporations to other corporations.
C-corporation. C-corporations are ideal for companies that plan to offer equity incentives (such as stock options) to employees and service providers. Because of the availability of a bifurcated capital structure (i.e., the ability to have common stock and preferred stock), a C-corporation may offer preferred stock to investors at an elevated valuation, and common stock equity incentives to employees and service providers at a much lower valuation (thus giving those employees and service providers much more upside potential). Additionally, corporations are able to offer Incentive Stock Options (“ISOs”), which provide better tax treatment for their recipients (which we will discuss in a separate article).
S-corporation. S-corporations can grant Incentive Stock Options just as C-corporations can, but because they are not permitted to have a bifurcated capital structure, if the S-corporation raises capital through equity investments, the fair market value of the equity incentives an S-corporation grants to its employees and service providers will be tied to the price paid by the outside investors for their shares. This is problematic because ISOs must be granted at the fair market value on the date of grant, and in the case of what are called Non-Statutory Stock Options (“NSOs”) (i.e., any type of stock option that is not an ISO) the recipient will be required to pay tax on the difference between the exercise price and the fair market value on the date of grant of such NSO.
LLC. The process for LLCs to award equity incentives to employees and service providers is much less straightforward than it is for corporations. The creation of an equity incentive plan for an LLC will often require the addition of complex provisions to the operating agreement concerning the treatment of options to purchase equity and automatic admittance to membership upon exercise, and could also require the creation of a separate class of equity. Another feature that LLCs can offer is an award called a “profits interest” which gives the recipient upside potential, but very little downside protection. Further complicating matters, LLCs cannot offer ISOs, so recipients of equity incentives from LLCs will be in a much less tax advantageous footing than their corporate counterparts.
By and large, most emerging technology companies that plan to raise capital from venture investors and to offer equity incentives to their employees and service providers will find that forming a C-corporation is the best choice to meet these objectives. Because there is predictability in the corporate structure, because the company may offer preferred stock that may be freely transferred, and because it may offer equity incentives to its employees and service providers in a straightforward way, the C-corporation is the most common entity choice for emerging technology companies. Many startup founders put far too much concern into the dreaded “double taxation” feature of C-corporations, but the reality is that for most emerging technology companies, this never becomes a material concern. Because most technology startups are plowing all of their earnings back into growth (rather than making distributions and dividends to their shareholders), the second level of taxation isn’t triggered until there has been a liquidation event and it’s time to cash out your chips.