No venture blog is complete without at least one post on the debate about what legal structure to use in launching your business. However, I have a little help (and will cheat a little) since I am attaching Jack Levin’s presentation on the subject to this post. I was on a panel this Saturday at Northwestern’s Law School with Jack and Randy Kaplan, co-founder of Akamai. Jack is the senior Private Equity partner at Kirkland & Ellis and the dean of corporate law in this space. I highly recommend getting a chance to listen to him if you ever get the chance. At a very high level (and doing a disservice to the topics), here are some quick takeaways. I would recommend looking at the attached presentation for more detail Download nwu_entre_conf_406.ppt
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1) In forming a company, make certain that you have formed it sufficiently before any capital comes into the company. If not, the new capital will place a value on the firm and, by definition, on your share of the business. In a worst case scenario, if you form the company in conjunction with a financing, you will owe tax (section 83) on the value of your share of the business. New investors can leverage preferred securities to take some of the bite out of this valuation, but the longer the time between formation and funding, the better.
2) Entrepreneurs generally have three primary choices for the legal entity of their firm: S Corporation, C Corporation or LLC (each is hyperlinked to their Wikipedia definitions below).
— C Corp is the structure of choice from an institutional investor perspective. If you are are going to be taking professional capital, you will most likely be "encouraged" to convert to a C Corp. Institutional investors often have tax-exempt investors. UBTI (unrelated business taxable income), which can often be triggered in a business, will flow through pass-thru entities like an LLC or Sub S Corp to these investors, requiring them to file a tax return on this income. There are many articles on UBTI such as the Drinker Biddle post for more information. The primary issue with C Corps is that you incur double taxation on both income and at sale. As a result, you only want to use this structure if you are considering near-term institutional capital.
— S Corp is a pass-through entity that enjoys the liability protection of a C Corp while avoiding the double taxation issue. However, it is limited to 100 shareholders, does not allow for different classes of equity (e.g. preferred stock) and does not allow corporate or partnership entities to be shareholders. Jack’s main criticism of S Corp’s is that they are fragile in the sense that they can be blown (often converting automatically to a C Corp often) by a multitude of issues. S Corps also have various burdens that LLC’s do not including by-laws, boards, minutes, etc.
— LLC is a pass-through entity (limited liability entity) that also enjoys liability protection while enjoying single taxation. It allows for multiple classes of stock and has a more flexible management structure. However, few institutional investors will invest in an LLC and converting them to a C Corp requires more effort than an S Corp. People are least familiar with this entity, including employees (stock versus membership units).
In short, if you are not expecting to raise institutional capital, you are best off using an LLC or S Corp (preferably the former). If you are looking, in the near-term to raise PE money, then you should consider coming out of the blocks with a C Corp. Some firms have raised PE capital from an LLC structure, but it makes your fundraising efforts significantly more difficult due to PE investors’ biases against it.