Which Legal Structure Is Best For Your Startup?

May 18, 2010

11:34 pm

Picking the right legal structure for your startup can save both money and hassle. The three structures most often mentioned are LLCs, Delaware S Corps, and Delaware C Corps. Deciding which structure to go with is dependent upon what your goals are. Venture Capitalists (VCs) will only invest in Delaware C Corps, but sometimes it makes sense to use another structure. So this is important to keep in mind when you are setting up your business if you are looking to get VC funding.

Scenario 1: You never need to raise capital or hire strategic employees, and you want to avoid taxes. In this case you probably want to use the LLC structure. The biggest advantage of the LLC structure is that it avoids the potential for “double taxation.” Double taxation happens when your startup pays corporate taxes for its profits, and then makes its owners pay taxes on any dividends and personal income taxes on owner/employee salaries.

LLCs are kryptonite to a VC.

LLCs expose your investors to an obscure tax called UBTI. LLCs also make it difficult to create a stock option plan for key employees, not to mention the fact that the LLC equivalent to preferred shares, preferred membership units, are notoriously difficult to work with. VCs invest almost exclusively using preferred shares and won’t touch their LLC equivalents.

If you’re getting the sense that I don’t like LLCs, you’re right. I think that outside of a simple mom and pop business or franchisee (the vast majority of small businesses) this scenario is very unrealistic. Unfortunately, if you ever want to raise capital or issue options, converting an LLC to a Delaware C Corp is a messy process that will make your lawyer a small fortune.

Scenario 2: You aren’t raising capital any time soon, and you want to avoid taxes. In this case, you want to use the Delaware S Corp Structure. It’s a bit restrictive on who can invest (VCs aren’t allowed), but still protects you from double taxation. S Corporations are also prohibited from issuing preferred stock, another deal killer for VCs. If you don’t plan on raising VC funding in the near future, an S Corporation makes a lot of sense. When you are ready for VC funding, converting an S Corporation into a C Corporation is super simple.

If you truly think there is less than a snowball’s chance you will raise VC funding, you may opt for your local state’s S Corp structure. Doing so could potentially save you a few hundred dollars a year in franchise tax and agent fees. This varies from state to state. A good startup attorney will know if this is feasible.

Scenario 3: You want to raise VC funding now. There is only one real choice if you want to raise VC funding and that’s the Delaware C Corp. It doesn’t expose your investors to UBTI taxation, allows for VC investment, and permits stock option plans for employees and preferred shares. It’s a beautiful thing.

But why Delaware?
The state of Delaware decided a long time ago that it wanted to create a business friendly code of corporate law that was both flexible and predictable. It has a specialized court system full of very professional judges that do nothing but handle corporate law. VCs and their lawyers know Delaware law, and have already built their standard templates around it.

A local VC might be okay with using your state’s C Corp structure if they are familiar with it, but everyone is definitely okay with Delaware’s.

A good startup attorney will be able to walk you through the pros and cons of each of these structures, and help you make the right decision for your situation. Listen carefully to their advice because every situation is a little different and may need a unique approach.

How do you pick an attorney?
As a VC, my point of view is pretty skewed. If I was an entrepreneur and I wanted to raise VC funding one day, I would ask a potential attorney how many VC financings they had executed in the last 12 months. The more financings they have handled, the more likely they are to understand what current market terms VCs are looking for. They will also have a sense if local VC’s are OK with the local S Corp and C Corp structures. You should definitely take their advice over mine.

Editor’s Note: This article was written by Aziz Gilani. Aziz is an Associate at DFJ Mercury. He has significant experience as an operator, consultant, and investor in technology companies, with a particular focus on enterprise and consumer software. You can read Aziz’s full bio here. He sometimes blogs over at TexVC and you can follow Aziz on Twitter: @TexasVC.

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Aziz Gilani is a Director at DFJ Mercury. He has significant experience as an operator, consultant, and investor in technology companies, with a particular focus on enterprise and consumer software. You can follow Aziz on Twitter at: @TexasVC