You’ve formed a new startup, but now what? What kind legal entity should you choose? What kind of entity do angel investors and venture capitalists prefer?
If you don’t know, you aren’t ready to incorporate. Before you get your startup off the ground, it is important that you familiarize yourself with the different organizational and legal structures that are available to you. Each entity is tailored for different goals and management structures. It is important for any new entrepreneur to become familiar with all the different kinds of entities available for their business. What are your goals?
The three most common types of entities available to a startup are C Corps, S Corps, and LLCs. They all have strengths and weaknesses, and vary in their relative advantage with respect to taxation, ownership, fundraising, governance, and employee compensation.
Types of Legal Entities
- Taxation: The earnings of a C corporation are often taxed twice: once at the corporate level and once again at the stockholder level. While this may seem undesirable, the impact could be diminished in actual practice, depending on the facts. Also, the ability to include non-recourse indebtedness in the tax basis of a shareholder that has no personal liability for the debt can be a big advantage to C Corps vs S Corps in certain real estate transactions.
- Ownership: C corps can have an unlimited number of stockholders. The owners do not need to have a relationship with one another or a role in running the day-to-day operations of the company. Therefore, the existence of the company is unaffected by the death or withdrawal of any one shareholder.
- Fundraising: Most venture investors favor C corps. It is also the easiest type of entity to take public.
- Governance: C corps have well-defined structural accountability, with governance responsibilities held separate and apart from the owners.
- Employee compensation: Businesses that use equity incentives to attract and keep talent often prefer to operate as C corps. It is easier to issue these incentives in a C corp.
- Taxation: Instead of having two levels of taxation, taxable income is passed through the entity to individual members. An S Corp must allocate its taxable income to the individual stockholders according to their ownership stakes in the company. An owner’s tax basis in company assets only includes assets contributed by the owner, and liabilities for which the owner is personally liable.
- Ownership: Limited to 100 domestic stockholders who cannot be partnerships or corporations. Ownership transferability is flexible and similar to that of a C Corp.
- Fundraising: These are not a popular entity choice because they can only carry one class of stock and 100 stockholders. For this reason they are normally unattractive to venture investors.
- Governance: S corps operate in a manner very similar to the governance structures of C corps.
- Employee compensation: S Corps are less flexible than C Corps. They also cannot grant stock options to non-U.S. residents. Stock options in C Corps are more commonly used and better understood (and thereby more appreciated) by employees and consultants than in S Corps or LLCs.
- Taxation: LLCs are similar to S Corps in that the taxable income flows through the entity to the individual stockholders. LLCs can choose to be taxed as a C Corp or a partnership. But this flexibility is countered by their increased compliance costs.
- Ownership: An LLC may have an unlimited number of managers and/or owners. But the transferability is not as flexible as that of a C Corp or S Corp.
- Fundraising: LLCs are more attractive for a small number of corporate investors or individuals. They are not as suitable for companies planning to attract venture capital.
- Governance: LLCs have a more informal management structure. They are not as bound by corporate formalities as a C Corp or S Corp.
- Employee compensation: Equity incentives in LLCs are much more complicated (and for this reason less interesting to employees and consultants) that options available to C Corps and S Corps.
With such complicated rules and regulations governing each of these different alternative entities, it can be difficult for startups to decide what kind of entity to form. Such a decision has to be based on many different factors that require a thorough understanding of your startup, its goals and structure, and the intricacies of the law.
Learn more about how Company Counsel can help you choose the right entity before you incorporate.