If you are planning to start a business in the USA, you will need to establish a legal entity. Currently, the most popular corporate forms are the Limited Liability Company (LLC) and the C-Corporation (C-Corp). This article will briefly review the key differences between these two forms and provide recommendations on choosing the right one for you.
Raising Investments
One of the main factors to consider when choosing the form for your company is attracting investments from angel investors and venture capital funds. If you plan to raise investments, you should almost always opt for a C-Corp. Here’s why:
Reasons to Choose a C-Corp
1. Taxation: LLCs are less convenient for investment in terms of taxation. In an LLC, members pay taxes on the company's income through their personal tax returns, which can deter investors.
2. Management: LLCs are more flexible in terms of management, which can include restrictive conditions that may be undesirable for investors. Conversely, a C-Corp has a more rigid management structure, making it attractive to venture funds and angel investors.
Corporate Governance
In terms of corporate governance, LLCs and C-Corps have significant differences.
LLC:
- Less formalized structure.
- No requirement for annual member meetings.
- Managed either by the members themselves or a manager appointed by the members.
C-Corp:
- Requires annual shareholder meetings.
- Managed by a board of directors elected by the shareholders, who then appoint officers (CEO, CFO, etc.).
Corporate Taxation
Taxation is another crucial aspect when choosing a legal structure.
LLC:
- Subject to "pass-through taxation."
- Members pay taxes on the company's income through their personal tax returns.
- This can be burdensome for investors as they may be required to pay taxes even if no dividends are received.
C-Corp:
- Subject to double taxation.
- The company itself pays corporate income tax, and then shareholders pay taxes on dividends.
- This makes the structure less tax-efficient but more attractive to investors, as they are not required to pay taxes on the company’s retained earnings.
What to Choose?
When deciding on the legal structure for your startup, it's crucial to focus on your long-term goals and the need for external investment. For startups aiming to attract investments, a C-Corp is generally the more advantageous choice. Here's why:
C-Corp Advantages for Investment
- Investor Appeal: C-Corps are highly attractive to venture capitalists and angel investors. The structured governance and well-defined shareholder rights provide a level of confidence and security that is crucial for investors.
- Stock Options: C-Corps can issue stock options, a powerful tool to attract and retain talented employees. Stock options align employees' interests with the company's success, driving growth and innovation.
- Tax Treatment: C-Corps are taxed separately from their shareholders. This means investors are not immediately taxed on the company's earnings, only on dividends they receive. This avoids the issue of "phantom income" that can occur with LLCs, where investors might owe taxes on earnings they haven't received as distributions.
- Scalability: The corporate structure is designed to scale. It supports multiple classes of stock, which can be crucial when raising multiple rounds of investment. This flexibility can facilitate the complex financing structures often required by high-growth startups.
LLC Disadvantages
- Tax Complexity: LLCs face "pass-through taxation," meaning profits are taxed at the individual level, regardless of whether profits are distributed. This can result in a situation where investors owe taxes on income they haven't received, a significant drawback when trying to attract and retain investors.
- Management Flexibility: While the flexibility in management and fewer formalities can be beneficial for small businesses, it poses a problem for larger entities. The absence of strict governance structures might deter investors who prefer the predictability and oversight provided by a board of directors in a C-Corp.
- Limited Growth Potential: LLCs are less suitable for high-growth strategies that require multiple investment rounds. They lack the ability to easily issue stock options, and the complexity of adding new members can complicate the process of raising capital.
- Administrative Challenges: The flexibility of LLCs can lead to complex and varied operating agreements. This requires significant legal effort to review and understand, which can deter investors looking for a straightforward, standardized investment vehicle.
Conclusion
While an LLC might be suitable for small, closely-held businesses or holding companies that do not intend to raise significant external capital, a C-Corp is typically the best choice for startups aiming for rapid growth and substantial investment. The ability to attract and secure funding through venture capital and angel investors, combined with the structured and scalable nature of a C-Corp, makes it the preferred option for startups with ambitious growth plans.
Choosing the right legal structure is a critical decision that can significantly impact your startup's ability to raise capital and grow. For those with aspirations of substantial investment and expansion, the C-Corp structure provides the necessary foundation and flexibility to support those goals.
Authors:
Yauheni Khodzkin
Partner – IT Launchpad
