Do Startups Really Have to be C-corps?

Summary

• The recent downturn in the VC market has fostered renewed criticism of many of the assumptions that have driven entrepreneurship discussions recently.

• Among conventions needing reevaluation - the idea of the C-Corp as the default entity type for a new business.

• The choice between an LLC and a C-corporation depends on individual strategic considerations, including financing and growth plans, tax strategy, operational structure, and employee compensation.

• Each structure has its advantages, with LLCs providing a flexible alternative for entrepreneurs not seeking VC funding. LLCs generally offer simpler structures, lower state compliance burdens, and pass-through taxation benefits.

• C-corporations are generally better suited for raising capital and offering stock options

The Details

Before the recent downturn in the venture capital (VC) market, we witnessed a period where the fountain of VC money available (for some) seemed endless. This drove many aspiring business owners to conjure ambitious-sounding ideas (especially in tech) without building real value solely to attract round after round of VC funding.

Now that VC has cooled off a bit, the chorus of voices questioning the assumptions of VC has arisen anew. At a high level, many have grown suspicious of the VC-backed startup as the one-size-fits-all path to entrepreneurship. At a more granular level, I am finding clients (and myself) reconsidering when and where the structural and procedural conventions of VC should apply.

Entity type is one of those conventions to reevaluate. VC has overwhelmingly favored the c-corp as the entity type for new ventures. However, aspiring business owners may find that a limited liability company (LLC) structure might equally or even better serve their specific needs and goals.

In deciding whether to form a new business as an LLC or a C corporation, you might consider the factors below.

An LLC may be preferable when:

1. You don't plan to raise venture capital. VCs generally prefer to invest through instruments (SAFEs, convertible notes, preferred equity) that provide certain governance rights, protection on the downside, and opportunity to maximize profit where upside occurs. These instruments preferred by VCs only exist in, or are available more easily through, a c-corp structure. I have done deals with convertible equity in LLCs, but this convertible LLC equity brought additional complexity to the transaction.

2. You want a simpler structure and less maintenance. VCs generally prefer to invest through instruments (SAFEs, convertible notes, preferred equity) that provide certain governance rights, protection on the downside, and opportunity to maximize profit where upside occurs. These instruments preferred by VCs only exist in, or are available more easily through, a c-corp structure. I have done deals with convertible equity in LLCs, but this convertible LLC equity brought additional complexity to the transaction.If you don't intend to seek outside VC funding, an LLC can offer greater flexibility. LLCs generally have simpler formation requirements and fewer ongoing compliance obligations compared to corporations. They often require less paperwork and have fewer formal requirements like board meetings or establishing a board at all.

Below are some specific use cases for LLCs based on their simpler structure.

• SPVs. For investment management clients looking for an entity to pool capital from investors, invest that capital, and ultimately provide returns to investors, LLCs often fit the bill. Not just for investment managers, I at times recommend LLCs for my individual clients looking to form holding companies for their personal investment portfolio.

• Businesses with simple ownership structures. I have recommended LLCs for businesses run by a sole proprietor or a small, close-knit ownership group. Recent examples include an event planner client with a single owner that solves for labor needs through temporary, independent contractor arrangements.

• Businesses with straightforward operational needs. In a completely different industry, I have worked on various deals involving manufacturing or supply chain companies where an LLC covered the needs of the lucrative, but relatively straightforward businesses.

• Subsidiaries to a C-Corp Parent. I have also recommended LLCs to certain clients looking to create a subsidiary to their existing C-Corp (e.g., to house a particular application or vertical of the main product/service).  For them, the costs of forming another C-Corp with its own, separate governance and compliance obligations outweighed the benefits at the subsidiary level. To the extent they wanted to raise VC capital, they still could do that at the parent C-Corp level and direct the funds to the LLC subsidiary.

3. You want pass-through taxation. By default, LLCs are taxed as pass-through entities, meaning profits and losses pass through to the owners' personal tax returns. This can avoid the potential "double taxation" risk of C-Corporations.

4. You want flexibility in management structure. LLCs generally offer greater flexibility in management and the allocation of profits/losses than corporations. As already mentioned, LLC do not impose board requirements. To the extent you (or an investor) need or desire a board, however, you could still create a “board of managers” in your LLC.

LLCs are not new concept, and c-corporations have by no means turned obsolete. Despite the discussion above, a C-Corp might still make more sense for you if:

1.You plan to raise venture capital.

(See discussion above)

2. You plan for rapid growth and eventual IPO.

For reasons already explained, C-corps may be better suited for companies planning rapid growth through outside investment, and potentially going public[3].

3. You want to issue stock options.

If you intend to compensate employees with incentive equity, this is more common, and more straightforward under the C-Corp structure. I do have experience with drafting workable substitutes for stock options (e.g., profits interests, and unit and phantom unit plans) in LLCs, However, these alternatives require different, potentially more complex, tax planning.

4. You want certain tax benefits.

C corps offer tax advantages like Qualified Small Business Stock (QSBS) exemptions that are not available to LLCs.

Conclusion:

So you want to start a business - should you form a C-Corp? The right answer depends on your specific circumstances and goals. Much of the decision-making will stem from your tax attorney or accountant. That tax expert, coupled with experienced corporate legal counsel like Cadet Legal can help guide you in that strategic decision.