Choosing the best corporate structure for attracting investors, is a very important decision to consider when launching a startup. When an entrepreneur decides to launch a new business, he or she has to determine the most appropriate legal structure for the venture. The basic choices include sole proprietorship, partnership, limited liability corporation (LLC) or corporation (C corporation or Sub-S corporation).
For an entrepreneur seeking outside investors such as Venture Capital (VCs), Angel Investors (Angels), High-Net-Worth Individuals (HNWIs) or other sources such as Reg + funding or similar, to support launch, scale, research, development of new products and/or technologies, or similar capital-intensive strategies, the choice of how to structure the corporate is of vital importance.
There are of course, pros and cons associated with each type of business structure, particularly if you are looking for the best corporate structure for attracting investors. While LLCs, Sub-S Corporations and C-Corps, all three provide basic liability protection, each varies in terms of its impact on factors such as taxation, financing, ownership, flexibility and attractiveness to investors.
If your firm intends to attract private investment through traditional sources (e.g., Venture Capital, Angel Investors, Private Equity, etc.), or if you are a growing firm in the BioTech, MedTech, Life Sciences or Pharma sectors seeking funding through Reg A+, then having the corporate structure investors prefer or even require is essential to securing the investment capital you.
Here is an overview of the pros and cons of various ways you can structure your company and where each stands in terms of being the best corporate structure for attracting investors through traditional sources or Reg A+ funding.
Sole Proprietorship
In my opinion, this type of business structure does not even warrant consideration or discussion. Other than being easy to set up, I have never found any valid reasons to structure a business--if it is just a single-person operation--as a sole proprietorship.
Pro
- In nearly all states, this is this simplest, and usually, least costly, business structure to set up.
Cons
- With a sole proprietorship your business is YOU. This means that a sole proprietorship offers you no protection against damages incurred to people and property while you are conducting business. If the business cannot afford to pay whatever damages are assessed, then YOU become personally liable for all damages.
- If your business and you personally are not able to pay for the assessed damages, then your family (e.g., spouse) can become legally liable for the damages, AND you risk losing any or all of your personal possessions including your home. While this may not be true in every state, in all states where I am familiar with the laws about sole proprietorships, this is the case.
- If you have an employee (or employees) and he/she causes or is involved in an accident while on a work-related trip--or simply causes damage to property or causes injuries (or even the death) to others while engaged in any sort of work activity on your behalf, again you, your family and your assets can be directly at risk.
- Investors such as VCs, Angels, HNWIs, other private equity sources or mechanisms such as Reg A+ funding will not invest in a sole proprietorship.
LLCs
An LLC is a hybrid corporate structure that combines the pass-through tax benefits of a partnership with the “limited liability” of a corporation. The financial gains and losses generated through LLCs pass directly through to the owners’ personal income tax return, thus avoiding double-taxation. Some of the other pros and cons of LLCs are below.
Pros
- Members are protected from financial and tax liability.
- The amount of members/investors an LLC can have is unlimited.
- Members share in profits and losses in proportion to their percentage of ownership.
- A manager’s share of the profit is considered earned income and not self-employment tax.
- LLC members can choose to either invest capital or other assets into the company.
Cons
- An LLC cannot have just one member but requires two or more, making it unsuitable for a single-person business
- Members of an LLC are not allowed to pay themselves wages.
- The pro-rata share profits are considered taxable income.
- Passive investors may face taxation in other states.
- Not suitable for securing outside private investment such as VCs, Angels, HNWIs or other sources such as Reg A+ funding.
Attractiveness to investors
An LLC is not the best corporate structure for attracting investors through traditional sources or Reg A+ Funding. While there may be exceptions to the rule, most VCs, Angels, HNWIs, private equity or other private investors do not find the LLC to be a good corporate structure for outside investment.. And as noted, an LLC is just not a suitable corporate structure for firms seeking to raise up to $75 million per year through Reg A+ funding, which is growing more popular for firms in the BioTech, MedTech, Life Sciences and Pharma sectors.
I know this because I asked my good friend and colleague, Stephen Brock, founder of Medical Funding Professionals, a firm that specializes in helping firms in the BioTech, MedTech, Life Sciences and Pharma sectors secure up to $75 million per year in capital through Reg A+ funding and non-dilutive funding sources such as government grants, cooperative agreements or other types of non-traditional, government-backed financial instruments. In general, the opinion is that LLCs are best suited to companies that will not seek outside investments.
Corporations
Corporations offer another option for entrepreneurs to structure their startups. These come in the form of S- or C-corporations. Corporations do not require more than one owner and can in fact, even be owned by another corporation. Both corporate structures offer liability protection. How taxes are handled is one of the biggest differences between the two corporate structures. Pros and cons are below.
S-corporation
Pros
- Profits and losses can pass through to your personal tax return, therefore avoiding the double taxation of C corporations
Cons
- Lacks flexibility in that the number and type of persons who can own equity in the company are restricted. There can be no more than 100 stockholders and all of them must be (i) US citizens or residents, (ii) estates, (iii) eligible trusts, or (iv) certain tax-exempt entities.
- Only can issue one type of stock (common).
- Generally, S-Corps are not the best corporate structure for attracting investors or pursuing a capital raise through Reg A+ funding.
Attractiveness to investors
S-corporations are not an attractive option for VCs, Angels, HNWIs or other types of private investors, because: a) these types of investors either want to receive preferred stock for their investment and b) the pass-through tax advantages offered by the S corporation, can present a host of other challenges, of which I could probably write ten pages alone.
C-corporation
Pros
- Offers a high degree of flexibility in regards to who can be a stockholder and in structuring the rights of various stockholders, including with respect to valuation, preferences and protections.
- Can offer multiple types of stock (e.g., preferred, common)
- Can adopt a stock option plan. This allows the corporation to issue equity as incentive compensation to employees, directors and others.
- The only option for firms in the BioTech, MedTech, Life Sciences and Pharma sectors, seeking to raise capital through Reg A+ funding, then this is the only corporate structure that will work.
Cons
- Subject to double-taxation in that the corporation pays taxes and then the shareholders pay taxes when the corporation makes distributions.
Attractiveness to investors
Of the three corporate structures, C-corporations are the best corporate structure for attracting investors through traditional sources or Reg A+ Funding. VCs, Angel Investors, and other private investors, including individuals who invest in your firm by participating in your Reg A+ capital raise, will only invest in C-corporations. Furthermore, if a company plans to go public and do an Initial Public Offering (IPO), a C-corporation is the only way to go.
Summary
If you are an entrepreneur trying to determine the best corporate structure to attract investors such as VCs, Angels, HNWIs and/or other traditional private investment sources, or your goal is raise up to $75 million through Reg A+ funding, then the C-corporation is the only way to go. An S-corporation can be ideal for an early stage company that plans to convert to a C-corporation within 24 months of launch but the founders want to take advantage of the initial tax losses. An LLC is a good choice for a startup that includes multiple founders and will not require external financing or investors for launch or growth. Like an S-corporation, an LLC can be converted to a C-corporation at a later date. And finally, like I said, under no circ*mstances would I consider setting up a business as a sole proprietorship--even if you have no intention of ever seeking outside investment. The liability risk of a sole proprietorship is just too great.
