Who ever said that business entity structuring wasn't fun, exciting, or at least sexy? In this Part 3, I'm going to discuss how properly structuring your business can significantly increase the net exit that a founder takes home to his family.
As a startup founder, one of the first questions that you are faced with is what kind of entity should you form. The possibilities are seemingly endless. You can go with a C-Corp, an S-Corp, an LLC, or an S-LLC. While much of the web says if you want VC money choose a C-Corp, the best entity for the founders, from formation to exit, is an LLC.
Pros and Cons of the Different Entity Types
- Pros. The pros of a C-Corp are the flexibility of capital structure and its attractiveness to all types of investments, both VC and debt financing.
- Cons. The cons of the C-Corp are its double taxation. This is not a big deal when the company is generating losses, but at the time of an exit, a founder can lose serious money. Another con of C-Corps is that there are many corporate formalities requiring compliance to maintain the liability protections of the C-Corp.
- Ideal Candidate. High-growth startups wanting to attract top national VC firms or whose exit plan is through an IPO.
- Pros. The pros of an S-Corp are the avoidance of double taxation as well as the ability to lessen FICA taxes on owner-employees.
- Cons. The cons of the S-Corp are that it is extremely limited in its capital structure. For example, all shareholders must be individuals with a few limited exceptions for grantor trusts, and there can only be one class of financial ownership interests, which means no preferred stock. Both of these are issues that will not allow for VC financing. An additional con of S-Corps is that there are many corporate formalities that need to be complied with to maintain the liability protections of the S-Corp.
- Ideal Candidate. Small businesses with individual owners who don’t plan on raising Venture Capital or Private Equity financing. A common and necessary use of S-Corps is in real estate developer transactions. In these transactions, a landowner/developer can use an S-Corp to take advantage of the land's appreciation in value during its holding period prior to development. If this structuring is properly managed the owner may be allowed to lock in capital gains on the appreciation and bump up the basis of the land for the development gains which will be taxed as ordinary income.
- Pros. The pros of the LLC are numerous: (1) pass-though taxation; (2) flexibility in capital structure; (3) attractiveness to vast majority of potential investors; and (4) flexibility in management and lack of entity formalities.
- Cons. Disfavored by some VC investors, but with proper planning as discussed below, the adverse tax consequences can be mitigated. Doesn’t have ability to minimize FICA taxes to owner-employees as all income is passed through to its owners.
- Ideal Candidate. LLCs are the preferred entity because they are well suited for most all businesses unless your planned exit is an IPO.
- Pros. The pros of the S-LLC are all of the benefits of LLC with the addition of being able to minimize FICA taxes.
- Cons. All of the cons of S-Corps except the rigid corporate formalities are lessened.
- Ideal Candidate. Same as for S-Corps but these entities are a little more flexible in entity formalities and are thus generally more favorable than S-Corps.
The following table compares the above listed entity types:
Why VC’s Prefer C-Corps
The primary and best reason I have encountered in my experience as to why VCs prefer C-Corps is related to who their investors are. Because many large VCs have institutional and charitable entity investors, VCs have to be careful that the taxation structure of the startup being invested in doesn’t trigger any adverse affects for those investors.
Because LLCs have pass-through taxation, an institutional or charitable investor in a VC could have a taxable event of Unrelated Business Taxable Income (UBTI). Receiving UBTI could result in the institutional and charitable investors potentially losing their tax exempt status. That would not be a good thing for a VC with those types of investors in its fund.
As to S-Corps and S-LLCs, because those entity types can only have common equity interests, VCs would not be able to invest in preferred stock. For that reason, VCs will almost always require S-Corps and S-LLCs to convert back to either a C-Corp or an LLC, which have much more flexible capital structures available to them.
Why Founders Should Stick to Their Guns and Insist on Staying an LLC
Just because some VCs can’t deal with pass-through income, and must live with double taxation, doesn’t necessarily mean that Founders have to as well. First, I’ll explain what double taxation means to a founder at exit, and then, I’ll explain a structure that can allow the VC to have the taxation protection of the C-Corp while also allowing the founders to continue to own their equity in an LLC.
Double Taxation Sucks. Double taxation could result in a significantly lower net exit for the founder. Assume you sell your business for $10,000,000. If you own that as an LLC after taxes at the highest individual tax rate (39.6%), you would walk with $6,140,000. Now assume you own the business as a C-Corp and are subject to double taxation, you would walk with only $4,912,000. That’s a difference of $1,228,000. I don’t know a lot of people who like to walk away from money like that.
What happens in the taxation of a C-Corp is that the $10,000,000 would first be taxed at the Corporate Tax rate of 20%, leaving only $8,000,000 to be distributed to the shareholders. Then the $8,000,000, that you would receive would then be taxed at you individual tax rate which would be 39.6%, leaving you only $4,912,000 of your hard-earned $10,000,000. The government is cool and all but not $1,228,000 cool.
Solving the UBTI Issue. Having an LLC converted to a C-Corp for a VC is only a major issue to VC’s that have institutional or charitable investors because, as discussed above, the UBTI could affect their tax exempt status. However, we can solve this problem by creating a buffer corporation as the member of the LLC between it and the VC Fund. What this would look like is the business LLC would be owned by the Founders and the Buffer C-Corp, which would be owned by the VC Fund. So what effect does this have? The VC’s net exit will remain the same, but the Founder’s net exit will be significant larger.
I know this sounds very self-interested, but this is one of many good reasons why startups should hire good corporate counsel prior to negotiating with VC firms. Often what happens is the VC comes in and negotiates with the startup and introduces it to its legal counsel to document the deal for both parties, but legal counsel's allegiance ultimately lies with the VC and because of that, VC’s legal counsel often fails to propose entity structures that maximize value for both parties.
The three take aways from this article are the following:
- Entity structuring is not a one-size fits all scenario and needs to take into account many factors including the type of business involved, its owners, and how it plans on raising money in the future.
- LLCs are ultimately the best entity structure for founders unless you are into throwing large chunks of money at the government.
- Hire good corporate counsel early, and the few thousand dollars you spend on them could save you mountains of money at exit.