In our recent webinar When, Why, & How to Incorporate Your High-Growth Startup, Dan DeWolf of Mintz Levin and I discussed a number of topics related to incorporation, many of which we’ve touched on previously on this blog or in my book, The Startup Checklist: 25 Steps to a Scalable, High-Growth Business.
We’ve covered the reasons that all companies using Gust Launch are formed as Delaware C-corporations, but most of the discussion so far has revolved around the many benefits this entity offers to founders. In our webinar, however, we touched upon some of the reasons this type of legal entity is also strongly preferred by investors, and our live audience seemed interested enough in the subject that I thought I would document the reasons here.
Let’s start with the obvious:
The C-corporation structure is designed to distribute ownership
While it is certainly possible to distribute equity (part-ownership of a company) to investors by writing appropriate terms into the Operating Agreement of a given LLC, the concept of stock is built directly into the way a C-corporation works:
- C-corps have stock, which they expect to issue to shareholders
- C-corps have a well-understood, standard structure for the distribution of options to buy that stock, which is used to attract, retain, and incentivize key talent
On the other hand, since LLCs are technically always partnerships, any equity-like features need to be custom-written into the Operating Agreement each time, in order to approximate the equity functions of corporations.
Sophisticated professional investors often have portfolios with dozens—or even hundreds—of companies. If an LLC is among them, investors are required to deal with these ad-hoc equity agreements on an individual basis. Even though these may look and behave similarly to stock in a C-corporation, the reality is that each one must be treated separately because there are no standards. Compare this to the known and understood mechanisms of C-corporation shares, and you can understand why investors prefer the known commodity: it’s less work for the investors and their lawyers, making these types of investments significantly more efficient.
It’s also important to note that the efficiency isn’t just a one-time benefit at the moment of investment. It remains a concern for the duration of the relationship as it impacts everything from additional equity issuances to investor protective provisions. But the biggest pain for investors comes around every year at tax time. That’s because...
LLC K-1 forms complicate investors’ tax returns
Regardless of how closely the equity-like instruments are written to mimic the effect of a C-corporation, as far as the IRS is concerned, income still passes through the LLC to the partners. This means the tax burden becomes onerous to file and track. Everyone who buys into the LLC as an investor becomes a partner, and the LLC is invisible for tax purposes. In tax season, the partners (including each of the investors) have to file a document with the IRS that explains the attributed income they received (whether or not they actually received any of it in cash) from the partnership. These forms are called K-1s, and they are not popular with investors.
Every year, like everyone else, I file my tax returns. If I had any ownership interest in an LLC during the previous year, I cannot file my return without the K-1 form that the LLC is required to give me! And as a startup founder with a million things to do at all times (ie, every single founder since the beginning of time) you may not be as prompt about delivering this form as my accountant would prefer. So, every year around March, every investor’s accountant has to remind busy founders to take care of an administrative task, which, of course, becomes very annoying. No investor wants to add to the complexity or annoyance of taxes, let alone pay a tax penalty for late filing, simply because one of their portfolio companies didn’t deliver their K-1s on time (and believe me, this happens much more often than you would expect). That will inevitably sour what is supposed to be a mutually beneficial, satisfying relationship between the investor and their founders.
But even assuming an investor does decide to invest in an LLC, that all does go well with the company, and everyone does deliver the K-1 sometime in March every year, there’s still another big issue with LLCs that makes them problematic for investors:
Only C-corporations can shield $10,000,000+ in capital gains taxes at an exit
With startups, the moment everyone is waiting for is the positive exit. This will typically take one of two forms: the company is acquired by a larger company, or it does an initial public offering (IPO) allowing its shares to be bought and sold on an open stock market.
In both cases the investors end up selling their equity and profiting from the difference between the low price at which they invested, and the high price at which they sold. And since the only certain things in life are death and taxes, that profit is subject to capital gains tax of at least 20%. This means that for an angel investment on which I make a $1,000,000 profit, I have to turn around and pay the government $200,000. Unless that startup was formed as a C-corporation, I made my investment for Common or Preferred stock, and I held the investment for longer than five years. In that case, because of great tax break called the QSBS or Qualified Small Business Stock exemption, the tax I owe on my angel windfall will be… zero!
For all those reasons, I will only invest in a C-corporation
Given a choice between shares in a company that looks and behaves like every other investment in the portfolio or a company with an exotic ad-hoc approach to equity, the added difficulty of tracking down and filing a new tax form every year, and the availability of the QSBS tax credit only to C-corporation shareholders, every investor will obviously prefer the known commodity of a Delaware C-corp. LLCs, while useful for other types of businesses such as investment funds, legal practices and closely held partnerships, are completely inappropriate for a high growth startup seeking to raise funds from outside equity investors.
Why put yourself through that difficulty when a C-corporation is now even easy and quicker to create than an LLC? Gust Launch will do it for just $99 per month and help make you “investor ready” for the duration of your startup’s life.
Learn how to pick the right startup legal entity:
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.