Startup Battlefield: Why VCs Prefer C-Corps over LLCs for Startups (2024)

Startup Battlefield: Why VCs Prefer C-Corps over LLCs for Startups (2)

Introduction

I have had many founders reach out that they want to set up a Delaware company, but often get confused on whether or not to register a C-corporation or a Limited Liability Company (LLC) based on their business model or structure. It’s natural to wonder which option would be better suited for your needs especially when you are looking for Venture capitalists (VC) funding either in the early stage or the near future.

Registering a company in Delaware, whether as an LLC or a Corporation, is a popular choice for many businesses due to Delaware’s favourable business-friendly laws for startups. While both offer limited liability protection, VCs, including venture capitalists and angel investors, typically prefer investing in C-Corporations for various reasons, including but not limited to the ease of issuing different stock classes and flexible corporate governance.

To understand why VCs prefer LLCs, let's look at the whys in this article:

Taxation

LLCs operate as “pass-through entities,” meaning that profit or loss is passed through to the owners as income, and is taxable as such. In short, LLCs pass through operating income & losses to its members (investors). In the case of venture funds, that would mean that the fund’s Limited Partners (LPs) including the LPs could incur taxable income when they do not want to. Investors do not like the tax implications of an LLC because as a partner, they’ll be taxed on the entity’s income even in years when no cash is distributed to them personally. VCs often avoid this structure as they don’t want business profits or losses passing through to them directly. Preferably, VCs want to invest in C corporations, where the profit and loss are ascribed to the business and not the owners, allowing losses to be used to offset future revenues for tax purposes.

Also, some investors, such as venture capital funds/LPs, especially pension funds and foreign entities, cannot incur such income due to the way their entities are structured, they can not invest in pass-through companies such as LLCs, because the VC fund has tax-exempt partners that cannot receive active trade or business income due to their tax-exempt status. Let’s break it down a bit. Imagine you’re running a venture capital fund, and within that fund, you’ve got partners like pension funds or foreign entities. Now, these partners have a sweet deal — they’re tax-exempt, meaning they don’t have to pay taxes on certain types of income.

Here’s where it gets tricky: if the venture capital fund decides to invest in a business structured as an LLC, that’s a pass-through entity. This means the profits and losses of the business flow through to the owners (in this case, the venture capital fund and its partners).

Now, tax-exempt partners, as the name suggests, don’t want to mess with taxes. But if the business they invested in, as an LLC, starts churning out profits, that income is flowing through to them, potentially creating a tax headache. Tax-exempt entities usually have restrictions on the types of income they can receive without losing their tax-exempt status, and active trade or business income might be a no-no.

So, to keep things simple and tax-efficient for everyone involved, venture capital funds often prefer to invest in C-Corporations. In a C-Corporation, the profits and losses stay with the corporation itself, not passing directly through to individual partners. This setup aligns better with the tax-exempt status of certain partners, avoiding any unwanted tax complications and allowing the venture capital fund to focus on growing businesses without worrying about tripping up their tax-exempt partners.

It’s like a strategic financial dance — choosing the right structure to keep everyone happy and tax-efficient.

Another reason why VCs prefer C corporations is that sometimes the terms of venture capitalists’ limited partnership agreements simply do not allow them to invest in any type of entity but C corporations. Sometimes, the terms outlined in venture capitalists’ limited partnership agreements restrict them from investing in anything other than C Corporations.

Double Taxation with C-Corporation

You might come across advice saying you should avoid forming a C-Corporation because of the dreaded “double tax.” Here’s the scoop: A C-Corporation indeed pays tax on its net income, which is the income left after covering expenses and salaries. If this corporation then dishes out dividends to its shareholders using that net income, those shareholders have to pay tax on those dividends.

But, for many budding Software as a Service (SaaS) businesses on the growth path — aiming to raise funds, reinvest, expand rapidly, give out stock incentives, and ultimately be acquired or go public — this double-tax scenario is more of a rare occurrence. The focus for these businesses is on utilizing their profits to fuel growth and innovation, making the double-tax penalty less of a concern in their game plan. But here’s where the plot twist comes in for these businesses. Their focus is not on dishing out dividends; it’s on using those profits to fuel their rocket-like growth and innovation. They want to reinvest, hire more talent, develop new features, and expand their market reach.

In this case, the so-called double-tax penalty becomes more of a background noise than a front-and-centre issue. These businesses are playing the long game, strategically using their profits as rocket fuel for expansion rather than distributing them as dividends. The aim is to create a powerhouse that attracts more investors, climbs higher in value, and positions itself for a potential acquisition or IPO.

So, while the double tax is real, for these businesses with their eyes on the future, it’s like having a distant storm on the horizon — something you’re aware of, but it doesn’t dampen your enthusiasm for the exciting journey ahead.

Does it mean start-ups registered as LLCs do not get VC Investments?

No, but it might make them less attractive to certain VCs, especially when they weigh their options and the impacts on their LPs. Three options we generally see investors explore:

1. Invest as is. Potential for tax problems in the future.

2. Invest through a “blocker”. The blocker is created by the investor and is owned 100% by the VC fund and will be taxed like a C-corp to prevent any income from flowing through. The blocker then makes the investment. Keep in mind the double taxation of any proceeds in case of an exit (proceeds get taxed on the blocker level plus on the individual LP level). That is why most LLCs become C-Corps once they’re raising from VC firm. Most VCs do not invest in LLCs, as creating this blocker would also cost the VC in setting up.

3. Don’t make the investment

Can I Register an LLC and later convert to a C-corporation if needed?

Yes, you can initially register your company as an LLC and later convert it to a C Corporation if needed. However, this is not advisable as it can be complex and not cost-effective.

Conclusion

So, if startup founders hope to win VC investment, they should form their companies as C corporations. Starting as an LLC and converting to a C corporation later is possible, but it’s a messy and expensive process.

Startup Battlefield: Why VCs Prefer C-Corps over LLCs for Startups (2024)

FAQs

Startup Battlefield: Why VCs Prefer C-Corps over LLCs for Startups? ›

Investors do not like the tax implications of an LLC because as a partner, they'll be taxed on the entity's income even in years when no cash is distributed to them personally. VCs often avoid this structure as they don't want business profits or losses passing through to them directly.

Why do VCs prefer C-corp? ›

C-corps offer more flexibility to VC investors than S-corps. Some VCs cannot invest in any other type of entity due to managing public funds. This makes C-corps a preferred choice for many VC investors.

Why is C-corp better than LLC? ›

LLC: Advantages. In the C-corp structure, company profits can remain in the company rather than being paid out to shareholders. A C-corp can also easily issue shares of stock to raise money to expand the business.

Should a startup be an LLC or C-corp? ›

Corporation vs LLC for Startups. The general consensus is that start-ups seeking venture capital should incorporate as C-Corporations, not LLCs. Interestingly, an LLC is a highly customizable entity through which a company could set up structures similar to a C-Corp.

Why are most startups C-Corps? ›

Unlike other business entity types, such as S-Corps which cannot have more than 100 shareholders, C-Corps have no restrictions on the number of shareholders. This is important for startups that plan to go public or attract a large amount of investors.

Why do VCs not like LLCs? ›

Investors do not like the tax implications of an LLC because as a partner, they'll be taxed on the entity's income even in years when no cash is distributed to them personally. VCs often avoid this structure as they don't want business profits or losses passing through to them directly.

Why would you choose an C corporation? ›

C corporations provide limited liability protection to owners, who are called shareholders, meaning owners are typically not personally responsible for business debts and liabilities.

Why would you choose a corporation over an LLC? ›

It can be easier to obtain outside funding as some investors and banks prefer to invest in corporations than LLCs because corporations are generally better for recapitalizing and reorganizing over time as a business grows.

What is the difference between LLC and C corp venture capital? ›

VCs usually won't invest in LLCs because of how they're taxed. LLC taxation can be a big turn-off to VC investors, because LLC members are taxed on gains even if they aren't paid a distribution. C-corp shareholders, on the other hand, are only taxed on shares when they sell or receive a distribution (e.g. a dividend).

What is the greatest disadvantage of a C corporation? ›

As explained above, one major disadvantage for C corporations is that profits are effectively taxed twice, first on the company's income taxes, and again when shareholders receive dividends. An S corporation is a "pass-through" entity, meaning that it does not pay corporate income taxes.

When should I switch from LLC to C corp? ›

It's a good idea to learn how to convert from LLC to C Corp when you're seeking to:
  1. Offer common stock to shareholders.
  2. Offer limited liability for directors, employers, officers, and shareholders.
  3. Lower self-employment taxes.
  4. Raise money from investors.
Feb 8, 2023

What are the tax benefits of a C corp? ›

From a tax standpoint, C corps also provide advantages for smaller business owners, such a mechanism for avoiding the self-employment tax and greater flexibility when it some to deductions, salaries, and dividend distributions.

Should I tax my LLC as an S Corp or C corp? ›

If you run an LLC, it's automatically taxed as a sole proprietorship or partnership, but you can elect to be taxed as a corporation instead. S Corp is the more likely choice for an LLC, while C Corps are usually corporations.

Why use C corp vs LLC? ›

LLCs have more flexibility in profit distribution: they can distribute profits however they see fit, as long as it's outlined in the LLC operating agreement. C corps have perpetual existence, meaning the corporation can continue indefinitely, regardless of what happens to its individual owners or managers.

What is the best legal entity for a startup? ›

Limited Liability Company (LLC)

An LLC is advantageous for a few reasons: The cost is relatively low. You record the company's financial results in your personal tax filing. Owners of an LLC are not personally liable for the company's debts and legal obligations.

Why switch to C corp? ›

One reason to convert your S-Corp to a C-Corp is to generate more funding. One of the benefits of a C-Corporation is that is has more flexibility when raising capital. Since C-Corps can have an unlimited number of shareholders, it is usually much easier to attract investors.

Do VCs invest in Series C? ›

Series C funding typically comes from venture capital firms that invest in late-stage startups, private equity firms, banks, and even hedge funds. This is the point in the startup lifecycle where major financial institutions may choose to get involved, as the company and product are proven.

What is the difference between C corp and S corp venture capital? ›

Ownership Structure.

C Corps can have an unlimited number of shareholders, while S Corps are limited to no more than 100 shareholders. Additionally, S Corps can only issue one class of stock, while C Corps can issue multiple classes of stock with different voting rights.

What is a benefit of C corporations in raising capital? ›

Advantages and Disadvantages of a C Corporation

They are also subject to greater regulatory scrutiny, which can increase the company's legal expenses. Limited liability for directors, shareholders, and other company officers. C corps can raise capital by issuing and selling shares of stock.

What are some advantages of C corporations compared to S corporations? ›

C-Corp vs. S-Corp Comparison Chart
C-CorpS-Corp
Classes of StockMultiple (can offer preferred)Restricted to one class
IRS ScrutinyAverage, all else equalAbove average for balance of salary vs. dividends
Equity FinancingEasier to raise capitalHarder to raise capital
7 more rows
Jun 13, 2024

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