What Type of Entity Should Your Startup Be?

In counseling entrepreneurs, one of the first questions that arises is about choice of entity type – in other words, should the entrepreneur’s business be contained in a C corp, S corp, LLC, limited partnership or general partnership, or be structured in some other way? While there are obviously a number of factors that must be considered when answering this question, my answer is – with few exceptions – that an LLC is the best form. This is not yet the universal view, and some excellent attorneys have a different predisposition. So, I’ll lay out my basic reasons here, and I’ll be curious for comments – especially from people with a different viewpoint.

To keep it simple, my reason is that an LLC provides the benefit of limited liability for the owners, pass-through tax treatment (that is, no double tax), and ultimate flexibility in structuring the equity ownership and management rights of owners. No other entity form has this combination of features.

I sometimes word my advice on when to switch from an LLC to a C corp in this way: “when dragged kicking and screaming into being a C corp”. The main downside of C corps is that they result in double tax – once at the corporate level, and once again when profits are distributed to owners. Even if the profits are not distributed, upon the sale of the business there will either be two levels of tax (in case of a sale of assets) or an implicit reduction of sale price (in case of a stock sale that does not permit a write-up of the value of the assets for tax purposes).

Here are three main downsides to LLCs, along with my counter-arguments:

  • First, the legal and accounting costs to set them up and administer them properly are somewhat higher than with corporations. This is true – with all the flexibility comes some complexity, and partnership (pass-through) accounting is, I believe, intrinsically more difficult than corporate accounting. However, the effect of double taxation can be almost 15 percentage points of tax on all of the business’ profits and ultimate exit value (above the original investment). Such big dollars, in my view, outweigh the transaction costs and complexity of operating an LLC.
  • Second, most venture capital firms don’t want to (or refuse to) invest in LLCs. This is also true, at least for now. The most common and well-understood form of venture investment is still preferred stock in a corporation, and it is difficult to exactly match that in an LLC. Also, something called UBTI (unrelated business taxable income) that can result from ownership in a pass-through entity, can create a problem for some VCs. I have three responses to this:  (1) a small but growing number of VCs, and even more strategic investors, are willing to invest in LLCs to get the tax savings; (2) a transaction can be structured so the VC invests through a “blocker” C corp that, in turn, invests in the LLC; and (3) this is no reason to start out as a C corp – only to become one later if you have a VC that is willing to invest and demands it (getting a lot of capital is a good reason to let go of the “kicking and screaming”).
  • Third, equity compensation arrangements for employees are somewhat more complicated in LLCs than in corporations. Again, guilty as charged. In corporations, the tried-and-true method – albeit not without its own problems – is stock options. In LLCs, the most common method is “profits interests”, which are inartfully named but are in fact equity interests in the LLC. More on these creatures in another post, but, again, I view the absolute dollars of tax savings as outweighing the challenges of equity compensation in LLCs.

Please share your experience and views on these topics.

5 thoughts on “What Type of Entity Should Your Startup Be?”

  1. Jeff,

    A great post on what you consider the advantages of an LLC over a C Corp. I’m interested in hearing more on your third point relating to the equity compensation angle. It seems that your run of the mill employee is going to be more familiar with stock options than LLC equity, like profit interests and others. How do you convince an owner, who then needs to convince his future employees, that the LLC equity works better than stock options?

    Looking forward to reading more from you.

    Jeremy

    1. Thanks, Jeremy. I’ll write a longer post about LLC equity compensation in the next week or so, but I have to revert back to the big tax savings of almost 15 points of income tax. If a typical owner is offered the alternative of a more customary way to compensate his employees, if he’s willing to bear an extra 15 points of tax on all future upside, or a more challenging solution but he saves the tax, I think most will choose the former. I then suggest that profits interests can be a good alternative for executives, while other employees can be compensated with profit sharing or “unit appreciation rights”. More to come… Thanks again.

  2. What about sub-chapter S elections in establishing a corporation. This removes the double-tax issue but makes things a bit easier from a formation, accounting, and compensation standpoint. It would be great to see a writeup on the positives and negatives of sub-chapter S verses LLC since both methods avoid double-taxation. In addition, you may want to comment on DE verses the local state regarding incorporation. I’ll have you writing a book here pretty soon.
    Thanks for publishing Jeff

    1. Thanks for the questions, John. S corps can be a good choice for “mom and pop”-type businesses, but now that LLCs have emerged over the last 15+ years I think S corps are not the right choice for growth-oriented companies. In my view, S corps have three critical problems and fourth limitation (albeit less critical in practice): (1) they can only have one class of stock, meaning common only (no preferred); (2) they can not have non-U.S. investors; (3) they cannot have entity investors; and (4) they can only have up to 100 shareholders. The effect of these limitations is that S corps are severely constrained in their flexibility to raise capital. As an aside, LLCs can convert more easily to S corps, should that ever be desired, then S corps can convert to LLCs.

      Regarding the Delaware question, I think the bottom line is there is a benefit to so-called “network externalities” (that is, it’s better to be in Delaware because everyone is in Delaware). Put differently, my sense is that almost every corporate lawyer in the country knows two state’s laws – his or her own state’s, and Delaware’s (and probably Delaware’s better). That means you’ll find more comfort with Delaware on a national basis than anywhere else. In addition to that benefit, Delaware also works hard to keep its statute modern and has the greatest level of case law interpreting the statute, so it remains current and adaptable. There are also fewer provisions in Delaware that can cause unexpected problems. Finally, the Delaware Secretary of State’s office is extremely efficient and flexible, which means it’s easier to get transactions done there.

  3. Thanks for the post Jeff, I didn’t realize that VC’s weren’t big fans of the LLC. I guess since so few companies are really VC material, most business owners don’t need to worry about it. Like you said, if a VC comes knocking, the LLC could just be converted to a C corp.

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