Start-ups Article 5: Entities & Legal Formation of a Business
There are three common entities for technology-driven start-ups: C corporations, Limited Liability Corporations (LLCs), and S corporations. These entities differ significantly regarding taxation, ownership, fundraising, governance, and employee compensation.
Selection of the business entity that best suits a particular start-up should be done with the consultation of an attorney and/or accountant who has experience advising start-up companies. Consequently, the following sections are meant as an introduction to common business entities and should not be construed as professional advice.
C Corporations
C corporations are separate taxable entities from their shareholders. Consequently, the earnings of a C corp are generally taxed twice: first at the corporate level based on the taxable earnings of the corporation, and then at the shareholder level based on distributed dividends. C corporations may have an unlimited number of shareholders who are not required to manage the corporation’s day-to-day operations. Generally, venture capital investors prefer to invest in C corporations because of a C corp’s ability to issue preferred stock to investors. The structural accountability of a C corp is well defined, with management reporting to the board of directors. C corporations can issue incentive stock options to employees, giving employees an equity stake in the success of the corporation.
Limited-Liability Corporations (LLCs)
For tax purposes, LLCs are flow-through entities. Corporate revenue is not taxed at the corporate level but passes through to the LLC’s owners, where it is taxed at the individual level. Like C corporations, LLCs may have an unlimited number of owners. However, transference of ownership is more difficult, usually requiring the approval of the other owners. For this reason (among others not touched on here), venture capital investors generally do not favor investing in LLCs. Additionally, the pass-through tax treatment of LLCs can cause undesirable taxable income to investors. LLCs generally operate without the formalities of a C corp, with the owners managing the day-to-day operations. An LLC may offer membership interests to employees, but cannot offer incentive stock options.
S Corporations
S corporations, similar to LLCs, are generally flow-through entities for tax purposes, with the S corp’s taxable income distributed to its shareholders in equal proportion to their ownership share. S corporations may have no more than 100 shareholders. Additionally, the shareholders must be individuals, with some limited exceptions. Like C corporations, S corporation ownership transference is flexible. However, S corporations do not have the ability to issue multiple classes of stock. Most venture capital investors want preferred (rather than common) stock as a condition of the investment. Consequently, S corporations are generally unattractive to professional investors. S corporations closely mirror the accountability standards of C corporations. S corporations may issue incentive stock options to employees. However, unlike C corporations, Federal law restricts S corporations from issuing stock to certain individuals, most notably non-U.S. citizens and non-U.S. residents.
Place of Incorporation
In addition to deciding which type of entity is best for the start-up, an entrepreneur must also determine in which jurisdiction to incorporate the business. Often entrepreneurs will incorporate the start-up in their home state, however, many venture capital firms prefer — or even insist upon — incorporation in Delaware because of Delaware’s predictable and business friendly laws. Before making any decision, it is best to consult with an attorney to help weigh the pros and cons concerning different places of incorporation.