Founders: C Corp, please!
I discuss this topic with Founders regularly and am writing this post as a reference point. My advice to Founders about entity type for their startup can be summarized as follows:
Almost every Tech startup should be a C Corp.
If you know you will raise money from investors — or even think it is highly likely — then you should form as a C Corp. It starts the 5 year clock for Section 1202/QSBS (see details below) right away and avoids negative signaling to investors.
If you are unsure about raising money from investors, then it’s fine to start as an LLC and convert to a C Corp later if you decide to raise money (although you are delaying starting the 5 year clock for Section 1202/QSBS). If you decide later to raise money from investors, then you should convert to a C Corp before you engage in the capital raise process to avoid negative signaling issues. You should also make sure the LLC to C Corp conversion is done correctly for QSBS purposes.
Why almost every Tech startup should be a C Corp:
Investing in an LLC means the investor becomes a partner in the company. The company must deliver to each partner an annual tax document called a K-1. Each partner must wait to file their annual taxes until they receive this K-1 from the company which can cause delays. If the company is profitable, those profits flow through to each partner creating a tax obligation. Additionally, there is potential for the company to create state tax obligations for partners in states other than the state of their residency. All of these issues create unnecessary hassles for the investor.
VC Funds will not invest in LLCs
As a general rule, VC Funds will not invest in LLCs. VC Funds have investors themselves called LPs (Limited Partners), to whom they must deliver annual tax documents. As described above in the Mechanical Reasons section, investing in an LLC means the investor receives tax documents from the company. This means the VC Fund would be unable to deliver tax documents to their LPs until they receive K-1s from LLCs they invest in. VC Funds also do not want the risk of having taxable income which they must flow through to their LPs.
Favorable tax treatment for C Corps
Section 1202 of the tax code, also called Qualified Small Business Stock (QSBS), enables investors (and Founders) to exempt a significant portion of their federal capital gains tax owed when they eventually sell their stock, assuming certain conditions are met. This tax code is extremely impactful for startup investors (and Founders) — enabling them to save potentially millions of dollars in tax — and is only available to C Corps. For this reason alone, all startups that qualify for QSBS should be C Corps if they are raising capital from investors. Another condition for Section 1202 eligibility is that you must hold the stock for 5 years before selling. Thus, it is beneficial for the company to be a C Corp as early as possible to start this 5 year clock.
Avoid negative signaling issues
This reason is more subjective than previously stated reasons and may vary by investor. A common situation I encounter as an angel investor is this: a company started as an LLC because they weren’t sure whether or not they would raise capital from investors (which is fine, as described above); now they are considering raising capital and they begin conversations with investors while they are still structured as an LLC.
As an investor, I interpret this negatively because it signals to me that the Founder is unaware of the issues described above. Or, more importantly, they might be “testing the waters” with investors and not fully committed to raising capital — because if they were, they would have already converted to a C Corp.
I recommend a Founder in this situation proactively convert the company from an LLC to a C Corp before they start talking to investors. Alternatively, start talking with investors but explicitly state that you are in the process of converting. You should avoid the framing or perception of we’ll convert if investors require it because that will be a turn-off for investors.
This advice is targeted to traditional Tech startups. There are exceptions where it may be beneficial for you to be an LLC. Examples: you never plan to raise capital from investors; your startup does not qualify for Section 1202; you plan to return capital to investors through distributions from profits rather than from an exit event; you value the flow through losses to your personal taxes more than you value starting the 5 year clock for Section 1202/QSBS.
As always, you should consult advice from your tax and legal advisors before making important decisions.