Archives for March 2009

C corps, LLCs, and S corps differ significantly in the areas of taxation, ownership, fundraising, governance and structure, and employee compensation.  Almost all technology startup companies that I work with are C corps.  Any company that raises venture financing will need to be a C corp in order to issue preferred stock.

If founders want the benefit of flow through tax treatment with respect to losses prior to an outside financing, an S corp election may make sense as long as there are no entity or non-U.S. citizen/resident stockholders.  However, S corp losses can only be used to offset personal income up to the founders’ basis in the S corp stock, which may decrease the utility of the S corp election. In any event, the S corp election can be easily revoked at the time of a financing. The legal documentation for an S corp is basically identical to an C corp.

I generally avoid LLCs as most technology startup companies need to grant options to employees and consultants, and there is no easy “off the rack” method to do this.  In addition, the conversion of an LLC to a C corp results in additional legal and accounting expense.  However, LLCs may make sense for businesses like consulting companies.

The primary differences between C corps, LLCs and S corps are outlined below.

Taxation

• C Corps. A C corp is a separate taxable entity independent from its stockholders. Thus, the earnings of a C corporation are generally taxed twice: once at the corporate level on the corporation’s taxable income and a second time at the stockholder level on dividends or distributions. In addition, C corps often must pay higher state franchise taxes than LLCs or S corps.

Although the double-taxation feature of C corps may be undesirable, its impact may be diminished where a company does not pay dividends or generates taxable income at a lower marginal tax rate than the rate applicable to the individual stockholders. If a C corp generates net operating losses rather than net income, these are carried forward to offset future corporate taxable income. However, such operating losses may not be used to offset taxable income of the individual shareholders.

• LLCs. LLCs are flow through entities for tax purposes, meaning that taxable income earned by the entity is passed through to individual members. Thus, earnings are taxed only once, at the member level. An LLC may elect to be taxed as a C corp, an S corp, or a partnership. It may specially allocate items of income or loss among its various members. It may use taxable losses generated at the entity level to offset taxable income of the individual LLC members. However, such flexibility is countered by increased compliance costs due to the application of complex partnership tax rules that also apply to LLCs.

• S Corps. Similar to LLCs, S corps receive flow through tax treatment. However, an S corp must allocate its taxable income to the individual stockholders according to their ownership stakes in the company. Taxable losses at the entity level may be used to offset personal taxable income of the individual stockholders, but only to the extent of the tax basis of their interests in the entity.

Ownership (Stockholders)

• C Corps. C corps may have an unlimited number of stockholders (subject to SEC reporting requirements if the number exceeds 500). The owners do not need to have a relationship with one another nor have a role in running the day-to-day affairs of the company. Additionally, they may transfer their ownership freely and readily (by selling their stock) without affecting the continuing existence of the business or the title to its assets. Thus, the perpetual existence of the entity is unaffected by the death or withdrawal of any one shareholder.

• LLCs. Similar to a corporation, an LLC may have an unlimited number of members. However, ownership transferability for an LLC is not as flexible as that for a C corp. Generally, a member needs the approval of other members before selling an interest in the LLC. Also, a death, withdrawal, expulsion, or other departure of a member may constitute a termination of the LLC and a deemed liquidation for federal tax purposes.

• S Corps. Unlike C corps. and LLCs, S corps are limited to 100 domestic stockholders. Stockholders must be individuals, with limited exceptions for certain trusts, estates, and exempt organizations. Stockholders must also be U.S. citizens or residents.  Ownership transferability is flexible and similar to that of C corps. Finally, the perpetual existence of the S corp is unaffected by the death or withdrawal of any stockholder.

Fundraising

• C Corps. Most venture and institutional investors favor C corps because they may have separate classes of stock, allowing for the creation of various levels of preferences, protections, and share valuations. A C corp is also the easiest type of entity to take public in an initial public offering.

• LLCs. Although LLCs may be attractive to businesses financed by a small number of corporate investors and/or individuals, they are often not suitable for companies planning to attract venture capital or pursue multiple rounds of funding. LLCs require complicated operating agreements that may render the operation of the LLC undesirably difficult with a high number of members. They may be unattractive to tax-exempt venture fund investors because their investment in a flow through entity may produce unrelated business taxable income. Finally, investors simply may be less familiar with LLCs and therefore less willing to invest in them.

• S Corps. S corps are not a popular entity choice because, in addition to presenting the same challenges to tax-exempt venture fund partners as those presented by LLCs, S corps are limited to one class of stock (meaning no preferred stock financings) and 100 stockholders. Such inflexible features are typically unattractive to venture investors.

Governance/Structure

• C Corps. C corps have well-defined structural accountability, with governance responsibilities held separate and apart from the owners. Management is accountable to the board of directors and therefore has the ability to transact business without stockholder participation in each decision. However, corporations are required to pay attention to formalities that legislatures and courts have determined to be significant (e.g., meetings of boards of directors and maintenance of corporate bylaws, corporate minute books, stock ledger books, separate bank accounts, etc.).

• LLCs. LLCs operate more informally then C corps and are either managed directly by the owners or managed by one or more owners (or an outside party) designated to fulfill such responsibility. Unlike corporations, they are not bound by corporate formalities such as holding regular ownership and management meetings. However, in contrast to corporations, they do not operate under a well-defined regime of uniformity and legal precedent.

• S Corps. S corps operate in a manner similar to C corps. and must therefore adhere to statutory formalities for decision making.

Employee Compensation

• C Corps. Businesses that plan to use equity incentives (e.g. stock options) to attract and retain talent often prefer to operate as C corps. C corps can offer incentive stock option plans that allow employees to defer tax on the equity compensation until they sell the underlying stock. Additionally, C corps. may offer certain fringe benefits to employees that are tax-deductible to the company and also tax-free to the employee.

• LLCs. While an LLC may reward employees by offering them membership interests in the LLC, the equity compensation process is awkward and may be unattractive to employees. Furthermore, LLCs are not able to offer certain forms of equity compensation available to C corps., such as incentive stock options.

• S Corps. Although S corps can grant stock options, they should not be granted to non-U.S. residents. S corps are less flexible than C corps with regard to fringe benefits and must either report the benefits as taxable compensation to the employees or forfeit the fringe benefit deduction available to the company.

I think there are three primary choices for the state of incorporation for most technology startup companies:  (i) Delaware, (ii) the state where the company has its headquarters (i.e. California), and (iii) the Cayman Islands.

Almost all of the companies that I represent that intend to receive venture financing are incorporated in Delaware.  I represent a few pre-VC financed California companies were already incorporated by the time that I met them.  I also represent a few Cayman companies that have headquarters outside the U.S.

Reasons to incorporate in Delaware

Regardless of where the operations of a business entity are located, Delaware is frequently chosen as the state of incorporation for the following reasons:

• Investors insist on Delaware

Almost all investors, regardless of where they are located, are familiar with Delaware corporate law.  They may also be familiar with the corporate law of state where they are located.  Because of the various advantages that Delaware law provides, most venture capital investors insist on investing in a Delaware entity. 

If a company is incorporated in another state, such as California, and needs to reincorporate in Delaware in connection with a venture financing, the company will incur additional legal expenses in connection with the reincorporation.  If a company ultimately undertakes an initial public offering of its stock, the underwriters will usually require that the entity be incorporated in Delaware.  In order to complete a reincorporation, a California company typically creates a subsidiary in Delaware and merges into it, with the Delaware company surviving.  Compliance with securities laws may be problematic if there are lots of shareholders. All contracts of the company must be reviewed in order to ensure that the reincorporation doesn’t accidentally terminate an agreement.

One example of a material difference in corporate law between states is the stockholder vote necessary to sell a company.  California corporate law provides that a merger requires the approval of a majority of the outstanding shares of each class of the corporation. This means preferred stock as a class and common stock as a separate class.  In contrast, Delaware corporate law provides that a merger requires the approval of a majority of the outstanding stock entitled to vote.  The fact that holders of common need to approve a merger of a California corporation is one reason why venture funds prefer Delaware. Venture funds don’t want common holders to have the ability to block a merger.

• Delaware has a predictable, fair and well-developed body of corporate law

Delaware has a specialized court (the Court of Chancery) that has original jurisdiction over corporate law matters.  Because of its unique expertise on corporate and business law matters, the Court of Chancery has produced a large body of decisions that has clarified and interpreted the Delaware corporate statutes. In addition, the Court of Chancery (and the Delaware Supreme Court which hears appeals from the Court of Chancery) is focused on the timely resolution of corporate law disputes.  An appeal from the Court of Chancery may often be heard and ruled upon by the Delaware Supreme Court in a matter of days.

• Directors of Delaware corporations are afforded a high degree of protection

While the directors of Delaware corporations have a fiduciary duty to act in the best interest of the stockholders, Delaware courts will, as a general matter and absent fraud or self-dealing, defer to the good faith business judgments made by the directors.  In addition, Delaware corporate law allows for a corporation to indemnify its directors for losses that they may incur from being sued.  Attorneys are generally more comfortable advising directors on their fiduciary duties under Delaware law as opposed to the law of any other state.

• Complying with procedural formalities is efficient in Delaware

Observing proper corporate formalities under Delaware law is efficient, which is critical to preserving the limited liability feature of corporations.  Delaware was one of the first states to allow voting by electronic proxy and attendance at stockholder meetings through the Internet.  Additional areas of flexibility include the ability of less than all stockholders to act by written consent and the allowance of electronic signatures.  Filings, such as an amendment to a company’s certificate of incorporation in connection with a venture financing, can be made electronically and are generally accepted upon submission within a day.

In addition, Delaware law is more flexible with respect to the number of directors.  When a California corporation has two shareholders, it must have two directors, and when it has three or more shareholders, it must have three directors.  Delaware corporations are only required to have one director.

Reasons not to incorporate in Delaware

There are some reasons why a company may not want to incorporate in Delaware, including the following:

• Delaware franchise taxes

An entity that operates in a state other than Delaware will need to comply with tax and regulatory requirements in both Delaware and the state in which it operates (including qualifying to do business as a “foreign” corporation in that state and paying the relevant fees).  In particular, Delaware has an annual franchise tax that it levies on its corporations, although this amount is generally negligible for a start-up company with few assets and stockholders.  If a company is not going to raise venture financing and will not otherwise be forced to reincorporate to Delaware, then incorporating in the state where it conducts business will save the company from paying Delaware franchise taxes.  However, the cost and hassle of reincorporating to Delaware in the future may be greater than any tax savings in the early stages of the company.

• Non-U.S. businesses

Some companies may be initially incorporated in the U.S., but may determine that establishing an off-shore parent entity is beneficial for investment or tax reasons.  For example, some non-U.S. venture funds are prohibited from investing in U.S. companies.

Companies incorporated in tax-favorable jurisdictions like the Cayman Islands, the British Virgin Islands and Bermuda are not subject to taxation in their jurisdiction of incorporation, although depending on the nature of their operations, they may be taxed on their earnings in higher tax jurisdictions.  Thus, a Cayman company may avoid paying U.S. corporate taxes on a portion of its worldwide income. 

However, there are serious tax issues associated with establishing an off-shore parent company when there is an existing U.S. entity or if intellectual property originates in the U.S.  Thus, if there is some reason that a company may need to establish an off-shore parent company in the future, then legal and tax advisors should be consulted prior to incorporation.

The Cayman Islands has become the preferred jurisdiction for many Chinese companies.  Only companies established in the Cayman Islands, Bermuda, China and Hong Kong are pre-approved for listing on the Hong Kong Stock Exchange.  In addition, Cayman corporate law has enough flexibility to permit U.S. style preferred stock financing arrangements and most venture capital investors that regularly invest in companies with headquarters in China are familiar with Cayman law and the documents used in these financings.