The traditional answer to this question is C-corp, and a Delaware corporation to be specific. The reason is simple. Every corporate lawyer worth his salt has sat the DE bar. DE corporate law is the defacto standard, being well known and well respected. However, DE franchise taxes can be come cumbersome quickly, which is the reason most C-corporation startups will jumpstart with a local state C-corp filing and then reincorporate in DE if they decide to go for very large venture capital rounds or an initial public offering. C corporations are vastly preferred by investors unless they want to enjoy the benefit of early losses on their personal taxes. C corporations require substantially more corporate governance. And, things you can do happily in an LLC, you can go to jail for in an LLC. Being able to retain losses is a big advantage for C corporations from a corporate financial management perspective. The downside of a C-corp is double taxation. All gains must be declared profit before any dividends can be issued, which are then again taxed as either short or long term gains on the investors’ personal balance sheet.LLC’s are not actually corporations in the traditional sense. They are based on partnership law, which is not well understood by many outside the legal and forensic accounting professions. Over the last 10 years, they have grown in popularity with startup founders because of the key advantage of being able to pass through losses to the shareholders in the early stages of startup and growth. They are easy to form and to manage. However, they are easy to abuse as well. In an LLC, the operating agreement is key. You should carefully review the OA before investing. It will define when the management team can take money out of he company and for what purposes. The advantage of having an LLC structure is the ability to absorb losses of the company on the shareholders’ personal balance sheets. And, if an LLC wishes to issue a dividend, it is only taxed once as a gain on the investors personal balance sheet. But, beware, when the company begins to make money, you may also be hit with gains for which you have no disbursed capital to cover. This is the core reason most VC’s require a company to convert to a C-corp before funding, especially as they graduate their growth stage and begin to scale. The good news is it is very easy and cheap to convert your LLC to a C-corp.
Unfortunately, many entrepreneurs get back legal advice on this issue and select the S-corporate status (technically, this is a C-corp with an S election). An S-corporation is essentially a C-corp that act like an LLC. It sounds great, but it has some tragic flaws:
- They present the same financial and tax issues as LLC’s
- To hold shares in an S-corp, you must be a “natural person,” which means no corporations or partnerships
- S-corps only have one class of stock, Common, meaning there can never be a preferred class of stock to account for standard industry liquidation and investor protection terms.
- S corporations are limited to 100 shareholders, meaning they can’t expand beyond that limit, much less hold an initial public offering.
Like an LLC, it is relatively easy to switch to a C-corporation from an S-corporation, but understand that no informed investor will invest in an S-corp.
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