If Your Company is a Candidate for Venture Capital Investors, Use a Structure That Investors Actually Like
At the start of any business, the founders have to decide what type of business entity structure to adopt. Should you establish your business as a limited partnership, a limited liability company ( an “LLC”) or an “S” corporation (an “S Corp”) that is not taxed at the corporate level, or should you use a “standard” taxable corporation (a “C-Corp”) l. The decision turns on the sort of business you are going to conduct and, in particular, whether you intend to attract venture capital investors.
While the three options have their advantages and disadvantages, if you envision your business as one with potential for rapid growth, fueled by equity investment and reinvestment of earnings, your best choice is a C-Corp. Why? The main reason is that many professional investors dislike or will not look at investing in pass-through entities like LLCs because they do not want to become enmeshed with the tax matters related to their portfolio companies. Unless it elects to be treated as a corporation, an LLC is required to distribute an IRS Form K-1 to its equity “members.” Earnings may be deemed to pass through to the investors. Unless the company makes a distribution to pay the taxes (money which could be used for better purposes) investors will have to come-out-of-pocket to pay the taxes. That will not endear the company to its investors. Moreover, making distributions to pay taxes is not what you planned on doing with your early profits. While we do occasionally see venture backed companies that are LLCs, in most cases we think it’s a mistake.
Using a pass-through entity for a venture backed business is further complicated by the fact that most standard agreements and investment precedent in the industry is geared to C-Corps. As a company progresses through the initial stages of garnering seed capital to doing a true Series A raise, why spend legal time reinventing investment documents to fit an LLC structure? Anti-dilution provisions, qualified stock option plans, shares issued to vendors in lieu of cash, etc. – they all work better and have ample precedent if the business is a C-Corp. Generally, people know what a share of stock is.
But this is the clincher – if you want to attract true venture funding and you know that some of the biggest venture capital investors will not look at an LLC or an S-Corp (or may even be prohibited from investing in that type of entity), why would you cut yourself off from these investors?
But What if Your Business is Not a Venture Capital Start-up?
The term, “start-up” as commonly used today connotes a new business that will have high growth characteristics and the potential to provide outsized returns to investors. If the business plan is to buy a gas station and sell gas, that may be a perfectly solid business but, it is not a candidate for venture capital investment. Where we see new businesses that contemplate more traditional forms of investment and financing, our recommendations change.
For example, a “family business” that will have individual owners, family members as employees and may be the subject of estate planning as the business passes from generation to generation could qualify as a good candidate for an S Corp or an LLC. In this case, using a “pass through” entity could save taxes. The Form K-1 is not an undue burden for the owners because this business is their primary means of making a living. Using a limited liability company may be a more flexible option than an S Corp because entities cannot hold shares in an S-Corp and there cannot be foreign shareholders. There are other restrictions that are specific to the S Corp rules.
Real estate and oil and gas investment entities are frequently established as limited partnerships and limited liability companies that elect partnership tax treatment. Here, the tax benefits in the form of deductions and credits can play a significant role in the return to investors. Also, passive investors can come in as limited partners and avoid exposure for the entity’s general liabilities while the general partner runs the business and has a fiduciary duty to the investors. Investors expect to see an LLC or a limited partnership when investing in these projects.
Technology start-ups that will hold intellectual property such as a patent (“IP”), may be formed as S-Corps or LLCs (better choice) where they have been established as a vehicle for licensing the technology rather than establishing an operating business. Usually, the capital investment in these situations is the responsibility of the licensee rather than the entity that grants the license and holds the IP. The licensee then develops the business and pays the licensor (the company holding the IP) a royalty. If the royalty is the primary source of income to investors, why encumber it with two levels of taxation? Use an LLC or an S Corp.
Professional services firms are typically partnerships. Among the reasons, they may be required to be partnerships under state law. However, the flow-through tax status is a true advantage for these businesses. If a business generates primarily fees for service, there is no reason to interpose an extra layer of taxation.
Feasible Exit Strategies
Every venture capital investor will try to engineer several possible exits to the investment, and most of that planning will occur when the investment is made. Another reason venture capital investors prefer C Corps is that the exit strategies may be more flexible. For example, limited liability companies generally cannot be directly publicly traded even if their membership interests are transferable. To be listed for trading, a limited liability company generally must first convert to a C Corp or use another vehicle. Since an IPO (initial public offering) is a foreseeable liquidity option for a start-up, why complicate that scenario at the inception of the business?
Why You Should Use an Attorney to Incorporate Your Company
Well, this advice is perfectly self-serving, but it’s a law firm newsletter so we are going to say it.
There are strategic decisions involved from the outset in building a successful company. In addition to the investor considerations, you need to choose the state in which you should incorporate (which may not be the state in which the business is located), the number of shares to be authorized initially and the classes of shares that should be authorized. Your organizational documents, the minute book and the cap table are part of a picture that you will present to investors, banks and business partners. Our goal in organizing a corporation focuses on several things: (i) efficiency, (ii) the organization of the company should project thoughtful decisions, (iii) voting control should be established (perhaps with some speed bumps to prevent a change-in-control) and (iv) the company should not leave gaps in the organization that third party investors will want to fill. The more that is done and solidly in place, the better the company will stand the tests of having investors and third parties examine it. In particular, we like to put employment agreements in place for the founders of the company before they ever speak with an investor. Those agreements may get re-negotiated later, but it is harder to change something that already exists. Likewise, confidentiality and “IP” agreements should be in place up front. And of course, we want to make sure that the ownership of the IP really is in the hands of the new company. We will cover some of these topics in more detail in future editions of this Newsletter.
We like to talk. You can send us an e-mail to schedule a phone call or Zoom conference.
Jon Gardner at jgardner@kavinokycook.com
Danielle Fahey at dfahey@kavinokycook.com
Ryan White at Rwhite@Kavinokycook.com