One of the most important issues entrepreneurs and business owners have to address when forming an entity for their business is fundraising. An entrepreneur that will be raising capital has to make the choice of entity that she believes will be most conducive to that objective. Two entities that are often chosen as the entity for new businesses are limited liability companies (LLCs) and C-Corporations. When it comes to fundraising, there are a variety of factors and questions an entrepreneur must address in deciding which of those entities to choose for the business. We address two of those issues here: (a) the source of the capital and (b) long term goals & exit strategy.
The Source of the Capital
The source of capital refers to the investor from whom an entrepreneur is seeking capital. Investors in your business can take many forms. Generally, the high level distinction is made between institutional investors and individuals. Institutional investors include banks, investment funds, private equity, and venture capitalists. Individuals include high-net worth individuals and angel investors.
With respect to institutional investors, there is a systemic preference among institutional investors for entities to take the C-Corporation form. Institutional investors, namely venture capital groups, which are structured as partnerships and may benefit from tax exemptions, face tax complications when investing in LLCs since those entities have flow-through taxation. Furthermore, most venture capital and institutional investors prefer C-Corporations because they can issue separate classes of stock, which allows for various preferences, protections, and share valuations for venture capitalists compared with common stockholders. C-Corporations can also issue convertible preferred stock, a common financing instrument for institutional investors. LLCs, in contrast, require an operating agreement, which can be complicated and voluminous, and it may deter institutional investors. LLCs are also unattractive to tax-exempt venture fund investors because their investment in a flow-through entity can produce unrelated taxable income.
While high-net worth individuals and angels may also prefer these kinds of extra protections enabled in C-Corporation form, it is likely on a case by case basis and the terms of an investment can be more freely negotiated to particular circumstances and facts. An individual investor may also not face the same tax implications from a potential investment as an institutional investor.
Therefore, if you believe your path forward and capital needs should come from an institutional investor, the likely best option is a C-Corporation to maximize your chances of securing institutional capital. Alternatively, if capital from high-net worth individuals and angel investors is sufficient for your purposes, then the choice of entity is not as critical and you have more flexibility to choose.
Long Term Goals & Exit Strategy
Long term goals and exit strategy refer to the ultimate future outlook for the business. An entrepreneur may wish to grow the business quickly and then sell the business, merge into another company or become acquired, or issue a public stock offering (IPO). Conversely, an entrepreneur may simply want to create a business and continue to operate it and generate returns, without a definite exit strategy in place.
If the goal is to grow the business quickly and exit, through a sale or IPO, C-Corporations are typically the best option. C-Corporations are the main corporate form for publicly traded stock exchanges and receive higher IPOs. Section 1202 of the Internal Revenue Code enables C-Corporation stockholders to benefit from a $10 million exclusion from tax for qualified small business stock held for at least 5 years, which is a benefit only applicable to C-Corporations.
Alternatively, a business owner that does not necessarily have a firm exit strategy and does not want to feel pressure from investors to realize return on their capital contributions, LLCs may present better options that allow the owner to operate the business as she sees fit for as long as she wishes. An LLC owner would also benefit from flow-through taxation with the LLC form.
Entrepreneurs who are seeking to raise capital for their businesses will need to decide which entity form is most advantageous toward their aims. Two considerations in making that decision are the source of the capital being raised and the long term goals of the company & exit strategy. A C-Corporation is likely the best entity for institutionally backed, high-growth companies with exit strategies in place. LLCs are likely the best entity for business owners who want to raise capital but do not want pressure from investors to generate returns on their investments and create a firm exit strategy.