Selecting the right type of incorporation for your startup is a crucial decision that can significantly impact your business’s future growth and success. In the United States, the most common types of business entities are sole proprietorship, partnership, Limited Liability Company (LLC), S Corporation (S-Corp), and C Corporation (C-Corp). Each comes with its own set of rules, regulations, and tax implications, making it essential for founders to consider their business needs, long-term goals, and potential investment opportunities when choosing the appropriate structure. However, in the realm of high-growth, venture-funded startups, the C-Corp reigns supreme. This article explains five reasons why most U.S. startups incorporate as C-Corps.
In the realm of venture-funded startups, the C-Corp reigns supreme.
1. Access to Funding
The number-one reason why most high-growth startups incorporate as C-Corps is investment. In fact, most venture capitalists will only invest in C-Corps. Why? To start with, most VC firms can’t legally be shareholders in an S-Corp. According to regulations, S-Corp shareholders must be U.S. citizens or residents and “natural persons”. This excludes other corporations like venture capital firms, as well as any non-resident foreign investors. For most startups, pursuing venture capital and other forms of institutional investment is reason alone to incorporate as a C-Corp.
To start with, most VC firms can’t legally be shareholders in an S-Corp.
2. Investor-Friendly Taxation
C-Corporations are also exceptionally attractive to investors from a taxation standpoint due to their unique structure which provides a high degree of flexibility in profit-sharing. While profits in other types of business structures are subject to pass-through taxation, meaning they are taxed at the individual owner’s tax rate, C-Corps are taxed at the corporate level. This allows for sophisticated profit-sharing mechanisms such as dividends, which are not subject to self-employment taxes. Moreover, investors in C-Corps can benefit from capital gains if they sell their shares at a profit. These features make C-Corps an appealing option for venture capitalists and other investors seeking a tax-efficient investment vehicle.
3. Limited Liability
Another one of the main attractions of a C-Corp is the personal liability protection it offers. In a C-Corp, the personal assets of shareholders, directors, and officers are shielded from business debts and lawsuits. This means if the company runs into financial troubles or legal issues, personal assets like a home or car are not at risk.
In a C-Corp, the personal assets of shareholders, directors, and officers are shielded from business debts and lawsuits.
Consider a scenario where a C-Corp called “TechVenture” is sued for patent infringement by a rival company. The lawsuit claims damages of several million dollars. As TechVenture is incorporated as a C-Corp, its shareholders, who are not directly involved in the litigation, are protected. That means, even if TechVenture loses the lawsuit and is required to pay the damages, the personal assets of the shareholders (like personal bank accounts, houses, or cars) are not at risk. The corporation’s assets are the only ones that could be used to settle such business debts. This distinct separation of personal and business assets is a primary advantage of C-Corp structure, offering peace of mind to the shareholders.
4. No Cap on Shareholders
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.
5. Preferred Stock
A final key difference between C-Corps and S-Corps lies in the type of stock they can issue. C-Corps have the flexibility to issue both common and preferred stock. Preferred stock grants the stockholder certain advantages, such as priority dividends and preferential treatment in the event of liquidation. On the other hand, S-Corps are limited to issuing common stock. This restriction is part of the IRS requirements for S-Corps, which also include a limit on the number of shareholders and restrictions on who can be a shareholder. VCs who take a significant financial risk investing in your startup will almost certainly expect preferred stock, making this another compelling reason for high-growth startups to incorporate as C-Corps.
The benefits of incorporating as a C-Corp are clear from the list above. However, startup founders should be aware that owning a C-Corp also comes with additional management overhead and responsibilities that must be taken seriously. A C-Corp is a fully legal entity that is responsible for issuing annual reports, appointing a board of directors, and of course paying corporate taxes. It might seem like overkill when you’re first starting out, but if you plan to raise capital, incorporating as a C-Corp from the beginning is almost always the way to go.
