You must make a critical decision early on in the life of your firm: what corporate entity is best for your business? Will you form an LLC or start a corporation? If you choose a corporation, will your corporation be a C corporation, or will you elect to be an S corporation?
These decisions will have both immediate and long-term effects, particularly if you decide to raise capital, especially formal capital.
When it comes to raising funds, formal investors exceedingly favor C corporations over S corporations and LLCs.
Why C Corps Are Investor-Friendly
Why do investors prefer C corporations to S corporations and LLCs? We have narrowed it down to three reasons:
Designed to Distribute Ownership
One reason that investors prefer C corporations is that C corps are designed to distribute ownership. C corps have shares that are freely transferable, the ability to issue preferred shares, and the ability to issue stock options.
Let’s take a look at each of these features of a C corp.
Investors prefer C corporations over S corporations and LLCs because shares in a C corp are freely transferable.
By design, C corps have a well-established, standard framework for the issuance and distribution of equity (stock and stock options). Investors and VCs receive a certain number of shares, which entitle them to a percentage of profits.
While corporations that are designated as S corps also issue shares, there are several restrictions on the number of shareholders and who can be shareholders. S corps are limited to 100 shareholders, and these shareholders must be US citizens, residents, or “natural persons.” This makes shares in an S corp far less easily transferable than shares in a C corp.
On the other hand, LLCs do not issue shares at all. In order to adjust the ownership of the company to accommodate new investors, LLCs must revise their operating agreement. This process is significantly more complicated and complicates the purchase and sale of equity in LLCs.
For these reasons, investors vastly prefer the ease of buying and selling shares that comes with investing in C corps.
Another reason formal investors prefer C corporations is because they can issue preferred stock. Preferred stock is a class of stock that grants some rights to its shareholders, such as priority in receiving dividends and preferences in getting paid out in the case that there is a liquidation event.
Because investors take a significant risk by investing in your company, they often expect the benefits and protection of preferred shares.
Another benefit of C corporations is that they can use their equity to creatively finance their venture and attract key talent. C corporations have the ability to issue stock options and warrants.
The ability to compensate co-founders, advisors, and employees with stock and stock options is a key way many cash-strapped startups attract top talent while keeping their payroll manageable.
Friendly Tax Treatment
Another reason that investors prefer C corporations is that C corp investors enjoy especially friendly tax treatment. Unlike S corporations and LLCs, C corp investors are not subject to pass-through taxation, have much simpler, investor-friendly tax filing, and may even be exempt from taxes if they qualify for the Qualified Small Business Stock exemption.
No Pass-Through Taxation
Another one of the top reasons investors prefer C corporations is because the earnings of a C corp are taxed at the corporate level and do not pass through to its shareholders.
In LLCs and S corporations, the company’s earnings pass through to shareholders, whether they receive a distribution from the company or not. In a C corp, shareholders only have to pay taxes when they receive dividends from the company.
This is a major reason investors prefer C corps: they only need to worry about paying tax for the money they actually receive.
Investor-Friendly Tax Filing
C corporations are also preferable to investors and venture capitalists because their personal tax filings are considerably more simplified. This is owing to the manner in which their taxes are submitted with the IRS.
When investors purchase a portion of an LLC, they must wait until they get a K-1 form from the LLC before filing their own personal taxes. This can make the filing procedure more difficult for the LLC's passive shareholders.
Qualified Small Business Stock Exemptions
Finally, another big tax benefit that makes C corporations particularly appealing to formal investors is the Qualified Small Business Stock exemption.
The Qualified Small Business Stock exemption is a part of Section 1202 of the Internal Revenue Code that allows investors who have maintained a common or preferred stock investment for five years or longer to be entitled to sell out without paying taxes on gains of up to $10 million.
For some investors, this makes exiting a C corporation a tax-free transaction.
Finally, investors also prefer C corporations to LLCs because of the well-defined legal precedents for C corporations. Both S corporations and LLCs are rather new forms of legal entities.
While S corporations have been around since the 1950s, the State of Wyoming invented the first LLC in 1977, and other states didn’t pass legislation creating LLCs until the 1990s. In complex legal situations, this leaves little established case law and legal precedent for which these types of entities can draw upon.
On the other hand, corporations have numerous years of established case law and legal precedent from which to draw from. This is particularly true in Delaware (the most popular state in which to incorporate), which even has a special business court called the Court of the Chancery.