Which type of entity should you form for your startup?
As a founder, you will naturally be attracted by the Limited Liability Company (LLC) or S-Corporation (S-Corp), both of which are Flow-Through Tax Entities. A Flow-Through Tax Entity is a legal business entity that passes income on to the owners and avoids double taxation - a characteristic of the C-Corporation (C-Corp).
However, Venture Capital (VC) investors will not invest in LLCs or S-Corps for a variety of reasons: (1) Many VC firms are not eligible to own shares in S-Corps, (2) VCs do not want the company's income to pass through to them, preferring that the entity pay the tax, (3) VCs expect preferred shares to be issued to them in return for their investment. S-Corps are not allowed, by the tax laws, to issue a class of preferred shares. LLCs do not issue shares.
Another advantage of the LLC is the lower cost to form and maintain the entity. However, if your long-term plan is to eventually raise VC funding, it may be best to start with the C-Corp entity from the get-go as the conversion from an LLC, or an S-Corp., to a C-Corp, while doable, can be complicated and expensive. The level of complexity, and cost, increases the longer you have been operating as the former entity.
Below are a few videos that discuss the legal aspects of forming your startup's entity including the topics of debt liability, pass-through tax treatment, fundraising considerations, and other legal issues.
Should I Incorporate as an LLC, S-Corp, or C-Corp? (Jason Calacanis/Wilson Sonsini Startup Basics)
Legal aspects of getting your startup off the ground.
Avoiding Co-Founder Legal Disputes & C-Corp vs LLC (Jason Calacanis/Wilson Sonsini Startup Legal Basics)
- Debt liability, pass-through tax treatment
- Why VCs prefer C-Corps
- What to do if you don’t know what entity to be
- Preemptively avoiding co-founder legal Issues