In answering, I have in mind a startup which anticipates (1) issuing equity to its workforce; (2) seeking third party investment (venture capital and angels); and or (3) going public or being acquired.
It’s all about the (corporate) constituencies, their expectations, their needs, and the ease of meeting those expectations.
1. Work Force.
A. Employees and consultants. Most employees and consultants have are familiar with stock options or restricted stock units (for those that have worked with some public companies or very successful pre public companies). These can only be issued by a C corporation or an S corporation. Most are not familiar with options to purchase LLC interests (or whatever name someone might be giving to them). So, by having an LLC, you have already created a marketing obstacle to this constituency by needing to explain why you are deviating from the norm. Oh, and when you are explaining, you’ll need to explain tax consequences of option exercise of a pass through entity which is an entity where taxation does not occur at the entity level but rather is passed through to the owners. In English, this means that if they exercise but do not sell (which happens with departing employees before a company is public), then the company will need to issue them an IRS K-1 report every year to report on their taxes and, if the company is profitable, they will have to pay their share of the tax, even if the company does keeps profits to finance growth and does not distribute it to owners. The result is the same for an S corporation which is also a pass through entity. Also, S corporations can only have 100 shareholders which is not going to work.
B. Founders. Founder’s stock? Yes please. That can be issued only by a C corporation or an S corporation. Founder’s LLC interests? What are those? You may have the same marketing issue for the curious founder. You do not want to be explaining this to your co founders or worse, if you find yourself needing to recruit a new founder six months after formation.
A. Venture Capitalists. Most venture capitalists will not invest in a pass through entity like an LLC or an S Corporation. It is that simple. The reason is because the VCs themselves are usually structured as pass through entities (LLCs or Limited Partnerships). They do not want to deal with the hassles of annually passing through the K-1s of each of portfolio companies to their investors. And, their investors want it less. In some cases, they have foreign investors which makes it a much bigger headache, if not outright impossible. Note also that with an S corp, a corporation can only have one class of stock outstanding, so this wreaks havoc on the way VCs invest (with securities with various rights, preferences and privileges over sweat equity owners and parties who invest at different times).
B. Angels. Domestic angels are probably more willing individually to do invest in a pass through, but they will have the concerns about the other constituencies and, if given a choice, would probably prefer a C corporation.
A. Merger. Take a look at your prospective acquirors. Most of them are corporations. It is easier to complete a corporation to corporation merger than an interspecies merger. More important, if the currency of the transaction is stock, you can probably get tax free treatment in a stock for stock exchange but will not be able to get it in a stock for LLC interest exchange.
B. IPO. Take a look at the public companies in your space. They are all C corporations. If you are fortunate enough to get to that point, the last thing you want to do is spend time with investment bankers trying to convince them why your company should be the only public LLC in the space.
That should be enough. But there are other legal and accounting issues involved. A C corporation is the easiest to form. Accounting for capital account balances and preparing Schedule K-1s annually is expensive and time consuming. The “double tax” rarely occurs in the early days because profits get retained for business growth. Tax losses allocated from pass throughs will usually turn out less than expected.
Michael W. Prozan, Attorney at Law +1 650 348-1500 mike [at] mgcgroup [dot] comThis blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact a lawyer directly.