What type of entity should I form?

Takeaway: 99% of domestic founders who intend to raise venture capital should form a Delaware C-corporation. Foreign founders typically should also form corporations but may consider doing so in other jurisdictions.

For startup founders looking to raise venture capital financing, choosing the right entity structure is critical. Almost all domestic startups that I work with are C-corporations. The entity structure determines how the company is taxed, managed, and structured, which can impact the startup's ability to attract investors and raise capital. Here are some factors to consider when deciding what type of entity a startup founder should form if they expect to raise venture capital financing.

C-Corporation

C-corporations are the most common entity type for startups seeking venture capital financing. This is because they offer several advantages, such as limited liability protection, flexibility in raising capital, ease of issuing equity compensation to employees and consultants, and the ability to issue multiple classes of stock. The disadvantages to C-corporations are that (i) they are subject to double taxation (once at the corporate level on the company’s income and once at the stockholder level when income is distributed) and (ii) C-corporations require more formality of corporate records than LLCs. Startups typically do not make distributions to stockholders until an acquisition so the negative impact of double taxation is limited. Venture capital firms typically prefer to invest in C-corporations because they are familiar with this entity type and the legal and tax requirements that come with it.

S-Corporation

S-corporations are a popular choice for small businesses, but they are generally not recommended for startups seeking venture capital financing. S-corporations have several limitations, such as a limit on the number of shareholders and restrictions on the types of stock that can be issued. These limitations can make it difficult to attract venture capital investors who want the flexibility to invest in different types of stock. Some founders elect to start with an S-corporation to take advantage of pass-through tax losses in the early stages and the most significant tradeoff for that is delaying the start of your qualified small business stock (QSBS) clock (you must hold shares of a C-corporation for at least 5 years). You can learn more about QSBS in this post.

S-corporations can offer the opportunity to take advantage of pass-through taxation with respect to losses prior to an outside financing. However, the amount of S-corporation losses that can be used to offset the founders’ personal income is limited to the founders’ basis in their S-corporation stock, which often decreases the utility of an S-corporation election because the founders’ basis in their stock is typically very low. You “form” an S-corporation by making a tax election with the IRS; it is otherwise the same process as forming a C-corporation.

Limited Liability Company (LLC)

Limited Liability Companies (LLCs) offer similar liability protection to corporations, but they have a more flexible structure. LLCs are often preferred by smaller businesses or startups that want a more streamlined management structure. However, venture capital firms are generally less interested in investing in LLCs because they are not as familiar with this entity type and may prefer the structure and tax benefits of a corporation. Additionally, giving employees and consultants equity compensation is more complicated with LLCs and will in the long run cost more in legal fees. As a result, I generally counsel clients to avoid using LLCs.

Partnership

Partnerships are not typically recommended for startups seeking venture capital financing. Partnerships do not offer limited liability protection, which means that the partners are personally liable for the business's debts and liabilities. This can be a significant risk for venture capital investors, who want to ensure that their investments are protected.

Conclusion

In conclusion, C-corporations are the most common entity type for startups seeking venture capital financing. This is because they offer several advantages, such as limited liability protection, flexibility in raising capital, and the ability to issue multiple classes of stock. S-corporations and LLCs are less commonly used, as they may have limitations that make them less attractive to venture capital investors. Partnerships are generally not recommended for startups seeking venture capital financing, as they do not offer limited liability protection. It's important for startup founders to consult with a legal and tax professional to determine the best entity type based on their specific needs and circumstances.