Yesterday, Jared Steffes asked about how a startup should incorporate if they plan on raising financing down the road. For gtrot, it was started as a C-corp from the beginning due to the Harvard I3 first prize package that included free incorporation from Gunderson Dettmer. This made closing our first round of institutional capital much easier.
So how should you setup your startup?
- If you plan on raising institutional money down the road, you should incorporate as a C-Corp off the bat. Flipping to an LLC down the road is a bit of a pain.
- If you plan on building a cash flow business and don’t plan on raising institutional capital, you should incorporate as an LLC.
- Now, as of August 1st, if you are a social mission-oriented business you can incorporate as a Benefit Corporation, or a B-corp, in Delaware. On Albert’s continuations blog he outlines why this is a huge move in creating a legal structure to align investors and entrepreneurs around social missions.
- If you are extremely concerned about taxation but hope to eventually raise capital, S-Corps can be converted to C-Corps. This may just add an extra step (and legal fees) if you plan to eventually convert to a C-corp to raise institutional capital. S-Corp’s restrictions on corporate ownership make it a less attractive legal structure for multiple investors.
The main differences between C-Corps and S-Corps come down to Taxes and Corporate ownership. Biz Filings breaks it down as follows:
C corporations. C corps are separately taxable entities. They file a corporate tax return (Form 1120) and pay taxes at the corporate level. They also face the possibility of double taxation if corporate income is distributed to business owners as dividends, which are considered personal income. Tax on corporate income is paid first at the corporate level and again at the individual level on dividends.
S corporations. S corps are pass-through tax entities. They file an informational federal return (Form 1120S), but no income tax is paid at the corporate level. The profits/losses of the business are instead “passed-through” the business and reported on the owners’ personal tax returns. Any tax due is paid at the individual level by the owners.
Corporate ownership. C corporations have no restrictions on ownership, but S corporations do. S corps are restricted to no more than 100 shareholders, and shareholders must be US citizens/residents. S corporations cannot be owned by C corporations, other S corporations, LLCs, partnerships or many trusts. Also, S corporations can have only one class of stock (disregarding voting rights), while C corporations can have multiple classes. C corporations therefore provide a little more flexibility when starting a business if you plan to grow, expand the ownership or sell your corporation.
One last caveat, if you are only at the idea stage of your business and haven’t building it yet, you should start off as a ‘sole proprietor’. Once you’ve started building, hiring employees, and gaining momentum you should invest the time and money to properly incorporate.
Disclaimer: I am not a lawyer or a tax accountant. Please consult with both professionals before incorporating.
What questions do you have about venture capital or scaling a startup? Ask me here, in the comments, or on Twitter @br_ttany.