Company Formation – Choosing the Right Entity

As part of forming a startup business, the founders will need to select a form of business entity to launch the enterprise and to create the formal structures that separate the startup business from the founders as individual owners and operators of that business.   Among the possible entity choices are corporations (including “C” and “S” corporations), limited liability companies, partnerships and sole proprietorships (although a sole proprietorship is not really an entity separate from the owner), all of which vary to a significant degree in terms of taxation, liability protection for owners, ownership structures, governance, capital raising, employee equity incentives and documentation.   It is easy for founders to get lost in attempting to balance the positive and negative attributes of each possible choice in light of the founders’ specific circumstances, but based on a fair degree of experience I believe the choice can be greatly simplified: a Delaware “C” corporation is the startup entity of choice for businesses that (1) are being formed without significant capital contributions by the founders, (2) anticipate raising multiple rounds of venture financing, (3) intend to provide equity incentives to employees, and (4) do not intend to distribute current earnings to owners on a regular basis, but instead anticipate reinvesting earnings back into the business.   This general rule captures the intent of many, if not most, technology and similar startups, with the result being that most startups should (and will) be formed as “C” corporations (and, most often, in Delaware).

Why a Delaware C Corporation

A corporation is a separate legal entity organized under the laws of a specific state.   It is owned by one or more shareholders, who elect a board of directors to oversee the important activities of, and make the important decisions for, the corporation.  The board of directors appoint officers, who are responsible for managing the day-to-day business of the corporation.  The shareholders, in their capacity as shareholders, are not actively engaged in managing the corporation, and benefit from the corporate structure by not being held personally liable for the debts and liabilities of the business. 

This basic business structure works well for startups, and it is the business structure that entrepreneurs and investors have become most comfortable with.  Most public companies are C corporations, as C corporations may have an unlimited number of shareholders and shares in a C corporation are freely tradableoutside of contractual restrictions agreed to by the shareholders and compliance with applicable securities laws.  Venture investors have a preference for investing in C corporations because a C corporation can be structured with multiple classes of stock, allowing for the creation of preferred stock with enhanced rights, preferences, and protections as compared to common stock and because venture funds prefer not to invest in entities with flow-through tax treatment, such as LLCs, partnerships and S corporations, as such investments create potential tax issues for certain types of limited partners who commonly invest in venture funds.    C corporations have the ability to offer incentive stock options to employees (an equity incentive arrangement that employees and entrepreneurs are very familiar and comfortable with), allowing employees to participate in the rewards of the business in a manner that defers tax on the equity compensation until the employee sells the common stock underlying the option.  C corporations have the ability to offer certain fringe benefits to employees, with the cost of such benefits being tax-free to the employee and tax-deductible to the corporation. C corporation organizational and investment documentation have become highly standardized due to the preference for such entities by entrepreneurs and venture investors, with the result being that significant cost and timing efficiencies have been created by using a C corporation as a startup, venture backed entity. And the C corporation structure is familiar and predictable to founders and investors alike, due to well-defined state statutes and a long history of applicable caselaw (and among all of the states, Delaware stands out as having the most well-developed and transaction-friendly corporation laws, the most clearly articulated caselaw, and the most experienced judges, such that Delaware has become the preferred home for forming a corporation).

C corporations are, of course, not perfect (what is?).   C corporations are separate taxable entities, and under federal income tax law a C corporation will be taxed at rates ranging from 15% to 35% on its net income (gross income less allowable deductions).   If a C corporation makes a distribution or pays a dividend to its shareholders, the shareholders will be taxed on such dividends or distributions resulting in a double layer of tax (one tax on net income received by the corporation, another tax on the dividends and distributions received by the shareholders).   While double-taxation is not really desirable under any circumstances, the impact of this tax structure to a startup is limited because a  startup typically does not plan on making distributions of net income to owners on a regular basis (most often net income is reinvested to build and enhance the value of the business).    C corporations also must comply with a range of corporate formalities in order to preserve the limited liability status of the corporation’s shareholders, such formalities to include keeping books, records and funds for the corporation separate from the personal books, records and funds of the shareholders; holding regular board and shareholder meetings and obtaining and recording a significant number of legally required board and shareholder consents and actions; sufficiently capitalizing the corporation; maintaining an arms’ length relationship between the corporation and its principal shareholders and obtaining disinterested board or shareholder approval of any related party transactions between a corporation and its principal shareholders; and conducting business under the name of, and through, the corporation and not directly on behalf of any shareholder.   While foregoing corporate formalities may seem somewhat rigid, the organizational discipline and good recordkeeping practices established by following such corporate formalities outweigh, in my opinion, the limited difficulties caused thereby.

Taking into account and balancing all of the foregoing (and other) considerations, the result is more often than not to form a startup entity with the key intended attributes as outlined in the first paragraph above as a Delaware C corporation.   That being said, there are certainly situations where founders and investors alike would benefit in the short or long term from forming and operating an alternative startup entity, typically an S corporation or a limited liability company.   This may occur when one or more of the key attributes of a startup identified above differs in a particular situation (i.e., the startup (1) will be formed with significant capital contributions by the founders, (2) does not anticipate raising multiple rounds of venture financing (and anticipates capital to come mainly from investors that are not venture funds), (3) does not intend to provide equity incentives to employees (or is willing to address the additional complexity of providing equity incentives to employees outside of a C corporation structure), and (4) intendsto distribute current earnings to owners on a regular basis.  Such a decision will require a more complex analysis and discussion with attorneys and tax advisors, and to avoid creating confusion with too much detail I have chosen not to dive deeply into this analysis.    I leave you with the general rule on choosing a startup entity provided in the first paragraph above (together with the specific situations mentioned in this paragraph) when you may want to consider an S corporation or LLC alternative), and the guidance to consult with your attorneys and tax advisors when forming your startup entity to make sure that the founding team is appropriately balancing all considerations.     For a bit of context on the S corporation and LLC alternatives, some general points are set forth below.

When to Consider an S Corporation Election at Formation

An “S” corporation is similar in terms of legal structure, liability protection, corporate documentation and the need to follow corporate formalities as a C corporation, with some very critical differences.   An S corporation is not allowed to have more than 100 shareholders, and all of an S corporation’s shareholders must be individuals (only U.S. citizens or resident aliens) or certain types of tax exempt organizations, trusts or estates (as a result, a venture fund cannot invest in an S corporation).   An S corporation may only have one class of stock (as a result, an S corporation cannot issue preferred stock to angel and institutional venture investors).  An S corporation is not treated as a separate taxpayer – profits and losses of the business are allocated to the shareholders based on share ownership and the shareholders (and not the corporation) pay the tax on profits, or receive the tax-deductible benefits of the losses (to the extent of a shareholder’s tax basis in the corporation), of the business (so no double taxation for an S corporation).   S corporation status is obtained by filing a Form 2553 with the IRS, together with a written consent of shareholders, on or before the 15th day of the third month of the taxable year for which S corporation status is to be effective.  And S corporation status can easily be revoked by making certain additional filings with the IRS (with the advantage – as between an S corporation and a limited liability company - being that the S corporation’s organizational and other documentation will not need to be redone to convert to a C corporation).

S corporations are most often used for small or closely-held businesses that distribute the business earnings to their shareholders on a regular basis and desire to avoid two layers of tax, but in certain cases when all of the shareholders also work for the business and receive business earnings by way of salary and bonuses the advantages of an S corporation may be limited.    With respect to a startupcompany that will be generating losses and not earnings prior to a venture funding (and, most likely, for some time thereafter), there may in certain circumstances be advantages to electing S corporation status upon formation (with the expectation to revoke such status prior to a venture funding).   If the founders or the startup’sinitial individual investors (which may also be the founders) are contributing seed capital to the corporation (remember, for common stock only) and such persons can take advantage on their individual tax returns of the startup’s business losses, an S corporation election during the period between formation and initial venture funding may be advantageous.  Note, however, that an investment by the founders or individual seed investors in common stock of the corporation will set a higher price for the common stock than if such investment was made in preferred stock, with the result being that the startup will be granting options to key employees at potentially higher exercise prices (most likely not a desirable outcome).  

 When to Consider Forming a Limited Liability Company

A limited liability company is a business entity that combines a C corporation’s liability protection for its owners with an S corporation’s flow through tax treatment, and does so in a manner that provides much greater economic, tax, ownership and operational flexibility when compared to corporations.  An LLC does not have any of the ownership restrictions of an S corporation.  An LLC has greater flexibility in allocating profits and losses to the owners (called “members“) of the LLC as compared to an S corporation.  An LLCcan be organized with the same corporate formalities as are required of corporations or can be structured to provide much greater flexibility in terms of governance and operating provisions.  And an LLC can be converted to a C corporation on a tax-free basis to the members at any time.  

So, as with the S corporation, there are certain circumstances when a limited liability company structure may be an appropriate business structure for a startup, particularly when the members can take advantage of the tax losses in the business, it is anticipated that outside funding will either not be needed or will come from individual investors in a limited number of rounds as compared to venture funds or other institutional investors, and/or when it is anticipated that business earnings, once generated, will be distributed to the members on a regular basis.    There are increased compliance costs in operating an LLC due to complicated partnership accounting rules and, although an LLC can be converted into a C corporation at any time, such a conversion is complex and can be expensive, so the factors above (as well as other factors to consider in forming an LLC) must be considered carefully with the startup’s attorneys and tax advisors to determine if an LLC structure is best. 

 

 

 

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