One of the earliest legal decisions you’ll need to make as the owner of a startup is deciding what type of entity your new company is going to be. Will you choose a C-Corp? An LLC? Something a bit more eccentric, like a B-Corp? There are a number of options out there, and picking the wrong one can spell disaster for someone hoping for a high growth rate fueled by venture funding.
For most startups, there are three different corporate structures to consider: the C-Corp, the S-Corp, and the LLC. The three are primarily differentiated by their tax treatment, but that’s a story for another article, and I have posted an introduction to LLCs and a primer on Corporations before, so check them out if you want to learn more about those entities, how the differ, and what they’re best suited for. Spoiler: the C-Corp is the best entity for a startup.
Now onto the matter at hand. Why are LLCs are terrible for tech startups? There are tons of reasons, but I’ve distilled them down into three.
- Investors Don’t Like LLCs. Venture capitalists can be a funny bunch. On the one hand, they’re always trying to discover the next great thing that’s going to turn into a huge success. On the other hand, they’re ultra-conservative (as much as possible, anyway) with their investments. And they have good reason to be—especially those who are investing other peoples’ money. As a result, investors don’t like LLCs because they’re different than the standard C-Corps they’re used to investing in, which means more money must be spent on due diligence, including evaluating each LLC’s unique operating agreement and drafting the often complex LLC documents; the partnership style taxation of most LLCs means some tax-exempt investors can’t invest in LLCs and all investors can still be taxed on the LLC’s income even if they’re not getting a cut of it in any given year (due to reinvestment, etc.); and investors living in other states may have to declare income, and subsequently be taxed on it, in not only the state where they live, but they state where they’ve invested in the LLC. The upshot of this is that because most investors have issues with LLCs, it makes it much more difficult to find investors for your new startup.
- Unlike Corporations, LLCs Are Difficult to Manage the Larger They Get. With a C-Corp, where stocks are issued instead of membership interest when someone acquires an equity stake in the business, a corporation can easily manage how its stocks are being distributed. Stocks are simple and easy to manage no matter how many shares are being issued. Instead, with an LLC, the company is left trying to cut the pie into smaller and smaller parts with each new investor, leading to all kinds of tax complications. Also, LLCs are predominantly governed by their individual contracts, and as more investors get on board, the contracts will become longer and more complex, leading to higher legal fees with each new transaction (except for those lawyers who help startups for flat fees).
- Taxes, Taxes, Taxes. I’ve already touched on some of the major tax issues, including taxation in states where passive investors reside and where the LLC is located, but tax problems can also arise each and every time a new investor comes in, depending on how they want their preferential treatment structured (liquidation preference, etc.). The tax code also doesn’t recognize LLC membership interest for reduction in capital gains taxes under Section 1202. And to top it all off, when it comes time to sell your company, you’re going to be stuck with taxes and, unlike with a corporation where you can swap the stock of your company for that of the acquirer in certain circumstances in order to help defray those taxes, with an LLC, you’re left hanging out to dry by the tax code with no option but to pony up the cash to pay the tax bill.
So, as the founder of a new startup, what are you to do? The common solution to the problem with LLCs is to just not use them for startups. While ease of operation and need to not follow any of the traditional corporate formalities may seem like a boon for founders in the early stages, the problems with LLCs escalate as they grow. As a result, if you’re bootstrapping your company, you can freely choose any entity you like (though I recommend doing so at the suggestion of your startup attorney and your accountant). But, if you have any desire to raise funding on a large scale down the road, you’re going to want to consider an alternative structure.
For some reason, those who have navigated away from an LLC tend to be drawn towards the S-Corp. Maybe it’s because someone told them they were a great way to protect themselves from taxes and “all the rich people use them” as tax shields, or something like that. And while an S-Corp is certainly better than an LLC in terms of running a startup driven by investor financing, there are still some problems you can run into. Namely, foreign investors and corporations cannot invest in the S-Corp, and as far as growth goes, you’re stuck at a maximum of 75 investors—so much for rapid growth with lots of investors. As a result, if you’re starting out and planning to bootstrap your operation entirely, an S-Corp is a solid choice for your business structure. But if you’re hoping to build the next great startup with a shower of VC money coming your way, think again.
Which leaves us with the C-Corp. The ideal structure upon which your startup should be based. Investors (and their lawyers) are used to them, they’re easy to deal with, there’s a ton of law about how they work, and it just makes sense.
Now, which state should you incorporate in? Delaware? California? Nevada? Your home state?