During Week 1 of my two-week Venture Capital series I discussed the different expectations held by entrepreneurs and VCs in a venture capital transaction as well as why certain types of business models will not interest VCs but will be perfect for upcoming crowdfunding opportunities under the new Jobs Act regulations.
This week I’ll delve a little deeper into the legal nitty gritty of the VC transaction, starting with a discussion of why certain entity structures are best suited for companies that plan on seeking venture capital infusions.
C-Corp vs. LLC
For starters, I will say that the C-Corp model (perhaps with temporary S-Corp status, more on that below) is the ideal choice for a company that plans on immediately, or in the short-term, seeking a venture capital infusion.
Many entrepreneurs like to found their start-ups as LLCs due to the simplicity of performing year-end tax accounting for that entity type. LLC’s are “pass through” entities for tax purposes, meaning that the year-end tax accounting amount to the partners simply filing their own taxes.
The LLC is fine for a brick and mortar shop or a small partnership that never intends to have a substantial array of investors. For example, LLCs do not have “shareholders” and do not issue “shares” as equity, instead they are composed of “members” who own a percentage of the company (or sometimes “membership units”). What this means is that, unlike the C-Corp which can issue shares of different classes with different voting rights, etc… the LLC has a much more sluggish capitalization system which is simply not suited to carry a large number of investors.
This is not to say that some serious legal wizardry cannot, via a nicely drafted operating agreement, make an LLC function almost identical to a C-Corp — but such wizardry will cost the company much more than it would to hire a good accountant to do the C-Corp’s taxes, plus all of the complicated paperwork will drive away a fair number of sophisticated investors who are used to seeing certain types of structures over and over again and do not want to be bothered to learn your new unique legal structure.
Advantages of the C-Corp
As mentioned above, the C-Corp can have an unlimited number of shareholders, issuing multiple “classes” of shares which have differing voting rights, dividend rights, sale and transfer rights, etc… Indeed, it is this flexible class of share system which makes C-Corps so appealing for venture capital transactions which often occur over several rounds of investment.
During each subsequent round of investment the company often finds itself in a better or worse bargaining position with the next round of investors — either because it was more or less profitable following the previous round — and therefore the company may want, and the investors usually insist, not only on a different volume of shares per dollar invested, but also on certain rights (often called “preferred rights” and go hand in hand with “preferred shares”) from the previous round of investors.
Some major VCs, such as Techstars, have published their own preferred model financing documents which help articulate their preferred structure for potential start-up investees.
Some Final Notes on S-Corp
An S-Corp is simply a C-Corp which has elected to be treated like a “small corporation” by the IRS and local tax agencies for tax filing purposes. As such, an S-Corp will have identical structuring to a C-Corp and can therefore take advantage of all of the above in its early start-up stages without needing to make many (or any) changes when it is time to negotiate venture funding.
S-Corps have certain limitation, for example a limitation on the number and types of shareholders. An experienced tax accountant would be the best point of contact for any start-up seeking to follow this structure.
Next I will discuss the specific preferences that sophisticated investors like to negotiate in a VC transaction.