Mythbusters – Do VCs only invest in C-Corporations?
WHY INVESTORS LIVE IN A C-CORP WORLD
In our series of entity formation blogs, we continue with a discussion of C-Corps and raising capital. You’re ready to start your company and need to make an important decision…what type of business entity to form. This choice will have long-term implications for your company and, if you are seeking future funding, could have an impact on your fundraising ability.
Playing by the rules
Among many startup and Venture Capital communities there is a common myth that you must set up as a C-Corporation or you never have any chance at getting funding. At Briefcase we suspect that this is a myth concocted by non-lawyers who just have a basic understanding regarding the differences between the entity types. Traditionally, there has been merit to this argument. The investment landscape has changed, resulting in less traditional “exit plans,” which in the past have been to go public with an initial public offering. A trend has been towards venture capital funds and private equity funds that scale and grow companies while maintaining private ownership. Understanding the key differences between the entity types will you determine whether the myth holds any water.
Understanding the tax rules of the game
Unlike an S Corporation, or an LLC that’s treated as a partnership, C-Corporations are subject to state and federal income tax on net income after the deduction of expenses. Shareholders are not subject to tax unless the corporation pays them in the form of dividends, distributions, or salary. However, since dividends are paid from net income, the C-Corporation and its shareholders are collectively taxed twice. Once when the corporation pays tax on its net income, and again when the shareholder gets the dividend.
Double taxation is clearly the major disadvantage of the C-Corporation. However, there are a number of features of the other entity types that can overcome this disadvantage such as:
- An LLC and S-Corporation are pass through entities meaning the investor, not the company, have to pay tax on the company’s taxable income.
- Shareholders in an S-Corporation must be U.S. citizens or residents and “natural persons.”
- An S-Corporation is limited to 100 shareholders.
- S-Corporations can only offer common stock.
- An LLC or Partnership can only offer preferred rights to an investor by drafting it into the articles, operating agreement or partnership agreement.
C can do anything you can do, better
If you read our last post (you can find that here), we praised the flexibility of the LLC. So, naturally, one would think that would mean the other entity types would be inherently un-flexible. However, if you read the legal blogs which celebrate the C-Corporation as THE entity to form if your seeking investment you will start to think that a C-Corporation can do anything just like the LLC.
But, there is a distinct difference that sets the LLC and C-Corporation apart, that is that the C-Corporation is primarily governed by the respective state statutes, and the LLC is primarily governed by contract law between the members. This is why the LLC is also frequently referred to as a “hybrid” entity type between the partnership and the corporation.
Therefore, if you want to take advantage of the LLC’s flexibility and provide for certain preferred rights you can do so by drafting these rights into the operating agreement between the members. Startup lawyer Joe Wallin has referred to this practice as simply a “lipstick” solution. In the case of a C-Corporation you can simply just authorize and issue a preferred class of shares. However, under either scenario somebody has to designate what the preferred rights actually are.
Investors care about control
Did you see that? Probably not, right? The secret is control. Investors always want the most possible control over their investment. At Briefcase we would argue that the myth is really more of a preference of investors who want to ensure they can always set the terms of their investment. With a C-Corporation there is a higher probability that at formation the company will just issue common stock to the founders. On the other hand, with either the LLC or the C-Corporation a founder could chose to create their own preferential rights from the beginning.
At Briefcase we believe that a basic essential is planning for who will have ultimate control over your business. Willingness to give up control to others is an important and strategic decision not to be taken lightly. Were here to help guide you through these decisions and share our experiences as business attorneys so you can launch, grow and protect your business on your terms, not your investors.
Question: How can you consider the control provisions that would attract investors? Are you drafting for your interests only or looking to the future for what makes sense for the organization as a whole?