Most tech start-ups are typically formed as a Delaware C-corporations (“Tech C-Corp”). However, in recent years an increasing number of tech start-ups have chosen to be formed as limited liability companies (“Tech LLC”). Based on the priorities of a tech start-up, either structure could be a viable option. This article discusses some of the advantages and disadvantages of being organized as a Tech LLC versus a Tech C-Corp.
Advantages of a Tech C-Corp
First, Tech C-Corps afford access to additional financing. If a tech-start up intends to seek financing from venture capital firms, then it should strongly consider organizing as a Tech C-Corp. Often venture capital firms will require tech start-ups be organized as a Tech C-Corp.
Venture capital firms require certain preferences in return for the capital provided to a tech start-up. To achieve this, a venture capital firms will typically seek some version of preferred stock, which enables the venture capital to:
- Secure special rights and privileges such as liquidation and dividend preferences;
- Obtain pro rata rights to participate in further investments rounds to maintain their ownership percentage; and
- Obtain an adjustment of their purchase price when stock is sold at a price per share less than the price paid by earlier investors.
Although Tech LLCs do not issue stock, they can be structured to give preferential rights as described above. However, this could become complex and difficult to structure as there is no conventional model for implementation.
Second, Tech C-Corps affords certain tax benefits. Tech C-Corps can issue “qualified small business stock” (“QSBS”), which could afford shareholders substantial tax benefits. To issue qualified small stock, a Tech C-Corp has to meet a number of requirements. If a Tech C-Corp qualifies, it could save a substantial amount of money from federal income tax upon the sale of the business.
Third, Tech C-Corps afford traditional equity compensation. Tech start-ups frequently pay their employees in stock options. A Tech C-Corp structure permits a tech start-up to issue traditional stock options and “incentive stock options.” It is more complex for Tech LLCs to issue the equivalent of stock options to their employees. Further, “incentive stock options” also are not available to Tech LLCs.
Advantages to a Tech LLC
First, compared to Tech C-Corps, Tech LLCs are afforded certain tax benefits, including:
- No Double Taxation. By default, the profits earned by a limited liability company pass through to its member(s). Each member reports his or her share of profits on his or her individual tax returns and is taxed at the member-level. On the other hand, C-corporations are subject to double taxation. A C-corporation’s income is taxed at the corporation level and then any “dividends” distributed to its shareholders is taxed again at the shareholder level.
- Pass-Through of Losses. Generally, a limited liability company’s losses can pass-through to its members to offset other income on their individual tax returns. A C-corporation’s losses do not pass through to its shareholders.
Second, Tech LLCs have a more simple corporate structure. Tech LLCs are not subject to the same bureaucratic requirements that a Tech C-Corp is subject. Namely, Tech LLCs are not required to hold an annual shareholders meeting, record meeting minutes, create a board of directors, document important decisions, etc.
Overall, the considerations discussed above are only a fraction of what tech start-ups should consider when deciding which entity structure is best aligned with their needs and goals. Please contact Parker McCay’s Corporate Department to discuss what which entity structure is most appropriate for your tech start-up.
The content of this post is for informational purposes only and should not be construed as legal advice or legal opinion. You should consult a lawyer concerning your specific situation and any specific legal question you may have.