Business Structures Are Not One-Size-Fits-All for Startups

Posted on Feb 1 2016 - 9:36pm by Lance Edwards

020116-ktrk-eric-merriman-imgBY ERIC MEERMANN— In the world of startups, especially in the tech startup community, these days there is no need to reinvent the wheel.

Entrepreneurs have access to a world of advice and experience, offered by those who have successfully launched similar businesses before. The availability of such information is undoubtedly a boon for today’s potential startup founders. But there is also a downside to this wealth of information: Sometimes, it can result in an inclination to follow the pack even if the most common solution may not be the right one for a particular enterprise.

A prime example is choosing a business structure. Within the tech startup world, the received wisdom is that new companies should always set up as a C corporation, preferably organized under Delaware’s business-friendly laws. It is not the case, of course, that every startup chooses this legal structure. But a quick search yields plenty of sources ready and able to tell entrepreneurs that a C-corp is the only way to go.

This strikes me as potentially naive, or at least overly simplistic, advice.

I understand what drives the impulse to push everyone toward C corporations over alternative legal structures. The main reason to favor it is to attract venture capital and institutional funding sources. Some individual angel investors also choose to stick to startups organized as corporations out of choice, but more often the funding problem is a technical one.

Venture capital typically arrives in the form of a venture capital fund, in which investments are pooled and directed by a fund manager. Some of these investments may come from foundations or charities with tax-exempt status. Such investors typically shun “pass-through” income that is generated by alternative structures such as a limited liability company (LLC) or an S corporation, because it can trigger problems for tax-exempt organizations under rules governing unrelated business taxable income (UBTI). Startups looking for venture capital will almost always need to be C-corps, at least by the time they seek funding.

Tech startups and venture capital seem to go hand-in-hand in many people’s minds, which is almost certainly the main reason for them to encourage founders to choose a C corporation. And for some entrepreneurs, being able to secure venture capital down the road – or even go public eventually – is indeed a primary concern. But it is worth considering what kind of business you envision before committing to that structure – and its downsides.

For one thing, C corporations are complex and expensive to set up and maintain. They create an array of legal and tax filing requirements, which founders will almost certainly need to pay professionals to handle. More importantly, however, C-corps suffer “double taxation” when distributing profits to shareholders. Because C-corps are taxable business entities, they report their profits and losses annually and pay federal and state taxes on the profits. When a C-corp pays out dividends to shareholders, those dividends are taxed again as income. This situation creates a hefty extra tax liability for a C-corp when compared to an LLC.

An LLC, in contrast, creates pass-through income, as mentioned above. This means that an LLC is not taxed as a separate entity. Instead, profits and losses pass through to each of the LLC’s “members” (that is to say, the LLC’s owners). The member or members report the profits and losses on their personal tax returns. In this way, the double taxation to which corporations are subject is avoided.

Some startups won’t anticipate paying out much to shareholders, in which case double taxation may be less of a concern. But a lot of considerations about business structure boil down to the type of startup under discussion. Not every startup will want to reinvest most of its proceeds right away; it depends on what the business is selling and how costly it is to expand.

Some businesses will have a relatively large negative cash flow, even if they are creating net profits. (This is often discussed in terms of “burn rate.”) This creates different concerns than businesses with smaller burn rates, regardless of either type of startup’s success. Businesses with high burn rates that expect to need outside capital to continue funding their expansion are best advised to go the C-corp route in order to attract that necessary financing from venture capital and angel investors.

On the other hand, for startups that are highly cash-generative, where the owner does not intend to seek outside financing through the sale of shares in the company to a broader group of people, an LLC may make more sense due to the tax-savings considerations.

The truth is that not every startup is the same, even in the tech world. A few may become profitable quickly enough to need relatively little in the way of investors. Some business owners may be able to secure business loans instead, or may apply for a startup accelerator like Y Combinator, which takes applications from any U.S. business entity, including both C-corps and LLCs.

While venture capital offers a “cool factor,” it also has some very real drawbacks even if a startup manages to attract investors’ interest. Like any form of equity financing, venture capital funding will mean giving up a measure of control and autonomy. Venture capital investors often expect a high return on their investment and may demand a strong voice in business operations in order to secure their own interests.

“One size fits all” is not a great way to approach any new business venture. Entrepreneurs can learn a lot from considering the experiences of those who succeeded before them, but they should not let the wisdom of the crowd lure them into forgetting the particular needs of the unique business they want to cultivate.

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