Startups · Entrepreneurship

LLC, C-Corp, or S-Corp for tech startups?

Ryan Thompson Commercial Real Estate Agent at Stidham Commercial

September 8th, 2016

I am wondering what is the best structure for a tech startup in New York City. Especially keeping in mind that the future will entail being capital intensive requiring outside capital for execution.

Mike Moyer

September 8th, 2016

  • Form an LLC with a Slicing Pie equity agreement for founders and early participants.
  • Give angel money convertible notes or a SAFE
  • Convert to a C-corp at Series A.

Peter Weiss President at American Outlook, Inc.

September 8th, 2016

If you are going to need substantial equity infusion(s) start and stay a "C" corp.

If you are based in New York City and choose LLC (assuming pass-through tax status, the main reason for using an LLC) all investors will receive K-1s and likely will have to file New York State and City returns and pay taxes on the allocated income, whether or not you have done cash distributions to cover the obligation.  For smaller investors the cost of the tax return alone can be a disincentive.  

There are operational and financial reasons to avoid unnecessary conversions from LLC to corporation.  While the conversion is relatively simple from a legal and tax perspective you will have a new EIN/TIN which means you need to reopen or restart bank accounts, insurance policies, credit histories, ratings based accounts like unemployment or workman's comp, etc.  You will also have to change "LLC" on all your webpages, printed materials, business cards, etc. to "Inc."  

One of the most important reasons for being careful about conversion is that when you become profitable, you will have no tax loss carry forwards to shelter your first taxable income which means you will probably need to find additional capital to the extent you have to pay taxes sooner.  For example, if you lose $2 million prior to profitability and pass the losses to the LLC owners, when you convert you will have foregone $2 million in offsets to taxable profits.  At a combined 40% tax rate (and in NYC it might be higher) that's $800,000 in taxes the company will pay rather than retaining for working capital or investment in future growth.

LLCs are great for companies that will not need may equity infusions and are expected to generate lots of free cash flow but they are best used in situations where the structure can be relatively stable.  

Don Ross Managing Partner Digital Health at Life Science Angels

September 8th, 2016

Martin, I am the first to acknowledge that I know nothing about LLCs in MA. 
This brings me to my final points:
- Variation among states: From the investment side, Delaware has a nice multi-class LLC where liability can be siloed by deals. California does not have this. 
- By intent, an LLC is a blank slate. Everything is defined in the operating agreement. The structure is designed for maximum flexibility but this also means that each LLC is unique with rules that have not been tested in the courts. By contrast, a Delaware C-corp is a well understood structure, governed be well understood rules that have stood the test of time and challenge in the court system.  To consider investing in an LLC, good due diligence would include a legal review or the operating agreement, which still won't be as solid as a C-corp.
- Silicon Valley venture capital LP agreements generally prohibit investing in anything other than a c-corp. If VC investment is expected, it will have to be a C-corp.
--Given all the issues, it's just not worth it for me to invest in an LLC. Some other investors feel differently. I know of investors outside Silicon Valley who have done well investing in LLCs and like them. Investments in LLCs seem to be more popular outside Silicon Valley. 

Ted Weverka License Manager

September 8th, 2016

you can do an llc. it is easy to switch to a C corp upon getting outside funding.

Alf Poor Chief Operating Officer at Global Data Sentinel

September 8th, 2016

You're right, David. I meant when you're ready for VC investment be a C Corp. Tried to say that, without writing more than people would read.

Peter Weiss President at American Outlook, Inc.

September 8th, 2016

One more challenge with the LLC conversion:  if the company has a negative net worth when you do the conversion the LLC owners have attributed taxable income because the LLC's obligation is extinguished when the corp assumes the liabilities.  For example, if the LLC has $1 million of notes and accounts payable which are assumed by the new corp, as the LLC closes its tax books that $1 million becomes income to the owners.  Using a blended 40% tax rate, this means writing tax checks for $400,000 without receiving cash.  

You can solve this problem by converting the debts to LLC units prior to conversion but the requires multiple steps and cooperation from the creditors.  It  is workable with convertible note holders but difficult with trade payables.

Mike Moyer

September 8th, 2016

Hi Darius, I like to start with LLCs because it allows you to allocate losses however you want. The cash investors should get the losses regardless of the equity split an LLC makes this easy. And, most companies fail so there's a good chance that all a company has is losses! -Mike www.SlicingPie.com

Don Ross Managing Partner Digital Health at Life Science Angels

September 8th, 2016

As an investor, I do not invest in LLCs. Some investors do. My issues:
- when LLC makes money, there is pass through tax liability. There may or may not be cash availble to pass through to pay this liability. I won't invest, because my potential total liability exceeds my investment.
- LLCs are designed to have one class of ownership. They do not have structures analogous to common and preferred stock. A structure can be forced into the LLC structure, but it is not backed by a body of law as c-corps are.

Alf Poor Chief Operating Officer at Global Data Sentinel

September 8th, 2016

If you're planning to raise capital from the VC community, typically they would expect you to establish a C Corp in the state of Delaware 25,000,000 shares as initial capitalization. But, don't do this until you are 100% committed to move forward, as otherwise you'll give your accountant a headache. LLC is sometimes useful, if you're self-funding, but 99 times out of 100 C Corp is the tech start-up standard.

Joe Hipsky Co-Founder, CSO at iraLogix

September 8th, 2016

Never an S-corp... too limiting for the purpose you are likely here for. We started as a LLC knowing  that it's a 90% chance that we'll need to convert to C-corp for an institutional investor. They don't like pass through vehicles.

As an LLC your vehicle to raise is either a convertible or priced round. SAFEs are tracked like options on a cap table so they are for C-corps. You can tweak the language to make it work but you then lose the simplicity and the point becomes moot