What Entity Type Is Best When Seeking Venture Capital?

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Guest Article By Chris Whalen, CPA:

Starting a business is extremely complex, and it is very easy to make mistakes that can incur tax penalties and also hurt your chances for acquiring financing.

Let’s say you were starting a company and needed to raise capital. You have to decide what entity to create.

What are your choices? The basic entity types are: Partnership, S Corporation, or C Corporation. LLC was not excluded by accident. Remember, for IRS purposes, the LLC does not exist as an entity, and the owners of an LLC have to choose between a Sole Proprietorship, Partnership or S Corporation as their filing status.

99% of the time, when seeking venture capital, The C Corporation is the logical and practical choice, and most Venture Capital firms will demand this.

Will an S Corporation Work?

No. While the S Corporation structure is a popular choice for entrepreneurs and other small businesses, it comes with regulatory limitations that do not make it a feasible vehicle for raising venture capital. The three main regulatory limitations are:

S Corporations may only have one class of stock;

S Corporation stockholders must be natural persons (except for some extremely limited circumstances); and

The one class of stock requirement may be fatal to a venture capital investment since venture capital firms usually demand preferred stock in return for their investment. Also, most venture capital firms are organized as limited partnerships and less frequently as LLCs–but both legal entity types aren’t “natural persons.” And finally, as your startup grows, the 100 stockholder maximum comes into play once your startup begins issuing stock and stock options to employees.

Thus, the C Corporation may be the only type of corporation viable for a venture capital investment.

Why not an LLC?

While the LLC is also a common startup vehicle, the C Corporation wins hands down when it comes to raising venture capital. The following 4 reasons explain why:

1. Pass Through Entity

While the pass through feature (income/losses are passed down to the shareholders rather than dealt with at the entity level) of LLCs are desirable to most entrepreneurs, venture capital funds do not find pass through taxation to be a similarly desirable feature. The venture capital firm does not want the accounting and tax matters of a funded venture to be passed down to the firm, and thereby be attributed to the venture capital firm’s tax exempt and foreign limited partners. Such a scenario could create unrelated business taxable income (UBTI) issues or have their foreign investors be deemed “doing business” in the United States and thus have to file a U.S. tax return.

2. Transferability

The membership interests of an LLC are typically not freely transferable by state statute. This makes the LLC a lousy entity for one of venture capital’s exit strategies: the IPO. (Not that IPOs for venture backed companies are hot at the moment.)

3. Predictability

Started in the late 1980s and only made more popular in the last decade or so, LLCs are a relatively new type of legal entity. Thus, there just isn’t a well developed set of laws and regulations for LLCs. Corporations, on the other hand, provide a larger degree of predictability with regards to corporate governance and stockholder rights.

4. The Venture Capital Firm’s Organizational Documents

Primarily due to the reasons outlined above, many venture capital funds will have specific provisions in their own organizational documents that prohibit them from making a venture capital investment in an LLC, or any other legal structure than a C Corporation. Thus, if your startup is absolutely against being a C Corporation, you could be declined by the venture capital firm regardless of how spectacular your startup is.

The Conclusion

The C Corporation is a venture capital firm’s clear-cut choice for the type of entity in which to place their investment. When the to-be-venture-funded startup is a C Corporation, various administrative and other burdens are minimized for the venture capital firm, which allows them (and their capital) to focus on developing the startup company’s business.

Starting a business is extremely complex, and it is very easy to make mistakes that can incur tax penalties and also hurt your chances for acquiring financing.

 

Before you move forward with any financial transaction, or attempt to create a new company on your own contact Chris Whalen, CPA, The Investment Advisor, Your CPA, Accountant, Attorney and Your Financial or Investment Advisor.

This article was written by Chris Whalen CPA. As a CPA his views come from a tax and accounting perspective. The Investment Advisor is a Registered Investment Advisory Firm. The Investment Advisor does not offer tax, accounting or legal advice.

The information presented is meant to be informational only. It does not constitute a recommendation. Investment and Financial Planning recommendations can only be made in consultation with each client individually after each client has discussed their situation with The Investment Advisor. Before making any investment, financial or legal decision you should always consult your Accountant, CPA, Attorney and Financial or Investment Advisor.

For Further questions about the information contained in this article contact Chris Whalen, CPA or The Investment Advisor. The Investment Advisor can be contacted on its website at  http://www.theinvestmentadvisor.net/request-consultation.html or by calling (877) 414-9021.

Chris Whalen can be contacted at the website of Chris Whalen, CPA at  http://www.chriswhalencpa.com/contact/ or by calling (732) 673-0510

 

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