S-Corp's vs. LLC's

S-Corp vs. LLC is always a great debate. Brad Feld provides a nice twist on the commentary.

S-Corp's vs. LLC's

Last week, I blogged an answer to the question “What’s The Best Corporate Structure For An Early Stage Company?“ A few people responded asking why I didn’t like LLC’s more.
While there are several advantages of an LLC over an S-Corp (ability to issue different classes of securities, ease of set up, informality of operating agreements, lower state taxes, non-US investors), venture funds typically cannot (or don’t want to) invest in LLCs. When a VC invests in an LLC, they risk getting an income tax called UBTI (unrelated business tax income). This type of income is frowned upon by investors in venture funds partnerships and most funds have a provision in their fund agreements that they will use best efforts not to bring UBTI into the partnership. As a result, VC funds shy away from investing in LLCs.

The able minded entrepreneur says “yeah Brad, but I’m not ready for venture capital yet – I’ll just do an LLC now and convert to a C-Corp when I raise VC in a year.” Ok, but in order to "convert" an LLC into a C-Corp, one actually has to go through a complete merger, whereby a new entity is created, which usually drops down a wholly owned subsidiary, that sub is merged into the LLC, leaving the LLC as the sub of the parent. In short, it’s complicated and makes the lawyers and accountants some extra cash. Yuck.

In contrast, converting an S-Corp to a C-Corp is simply a "check the box tax election” (or - actually – “unchecking the box”) - this can be done in a day with a single tax form. No lawyers, no accountants, no money. Therefore, while the LLC has some benefits, the costs of converting the LLC into a fundable entity is substantially higher and usually not worth the additional effort.

The previous post, stemmed from this post below.

What's The Best Corporate Structure For An Early Stage Company?

I got the following question from a reader a week ago.

A project I'm involved with is aiming to go from a team of "4 founders with a great idea and a prototype" to a full fledged online service. I believe that even at an early stage, structuring ourselves to allow for growth/investment is critical. Naturally passion for our core mission, competence, and an ability to connect with the existing team are critical. Yet compensation (with an equity component) is a big part of the equation. I want people to have a sense of ownership and our current back of the envelope structure just isn't suited at the moment for bringing people onto the team. To avoid reinventing the wheel, is there a "best practices" template for early stage companies with respect to structure/incorporation? What's the smartest structure for an early stage company?

There are two logical choices (S-Corp or C-Corp) and a third one (LLC) that pops up occasionally. The best choice depends on the financing path you are ultimately planning on going down. Rather than define each of them in-depth, I’ve linked to the Wikipedia definitions which are very good.

S-Corp: If you are not going to raise any VC or angel money, an S-Corp is the best structure as it has all the tax benefits / flexibility of a partnership – specifically a single tax structure vs. the potential for double tax structure of a C-Corp – while retaining the liability protection of a C-Corp.

C-Corp: If you are going to raise VC or angel money, a C-Corp is the best (and often required) structure. In a VC / angel backed company, you’ll almost always end up with multiple classes of stock, which are not permitted in an S-Corp. Since a VC / angel backed company is expected to lose money for a while (that’s why you are taking the investment in the first place!) the double taxation issues will be deferred for a while, plus it’s unlikely you’ll be distributing money out of a VC / angel backed company when you become profitable.

LLC: Often an LLC (Limited Liability Company) will substitute for an S-Corp (it has similar dynamics) although it’s much harder to effectively grant equity (membership units in the case of an LLC vs. options in an S-Corp or C-Corp – most employees understand and have had experience with options but many don’t understand membership units.) LLC’s work really well for companies with a limited number of owners; not so well when the ownership starts to be spread among multiple people.

Based on your question, it seems like you’ll ultimately want to raise money in which case a C-Corp is probably best for you. An established lawyer who does corporate work with early stage / VC backed companies can set this up quickly, easily, and inexpensively for you - they are often the best source for the equivalent of a “best practices template” since this is routine work and requires simple, boilerplate documents and filings.