When you start your company you need to decide what form of corporate structure you want to use. Depending on what you are trying to achieve, you might operate as a sole proprietor, form an LLC or C corporation. In the interest of brevity, I’ll divide corporate structure alternatives into those that, for tax purposes, are “pass through” or not. “Pass through” entitities include sole proprietorships, partnerships and LLCs. Essentially, if an entity is “pass through” it means that any losses or profits will be passed directly to the owners of the entity on a pro-rata basis or as defined in the organizing documents. In a C corporation, all of the gains and losses are dealt with within the corporation and the corporation either pays taxes or accumulates losses with no effect on the ownership until there is some distribution. This is how we can categorize these organizations, but this is not what is important for you to know as an entrepreneur.
The key things for you to think about as an entrepreneur is which organizational form will best facilitate your short, mid and long term growth? Which structure will facilitate the types of investors you will likely seek and which will be appropriate for the “end game” size of company you expect to build? Ultimately, you will want to talk to an attorney about these things but following are some rules of thumb to get you started:
The biggest advantage of pass through entities is that they avoid the double taxation associated with C corporations. In a C corporation, the profits in the company are originally taxed when earned and, subsequently, when profits are distributed to owners, those owners are also taxed. Further, individual investors in small companies will often like pass through entities because they will take advantage of the early year losses which occur (e.g. they’ll get allocated their pro-rata share of losses to write off against other expenses). So, if you expect your company to be fully funded by a limited number of friends and family and / or wealthy angels and you don’t expect a need for multiple classes of stock or stock option plans, an LLC (or other pass-through) is right for you. For instance, Momentum is an LLC. While we expect it to be very profitable, there will be a limited number of investors and we’d rather avoid double taxation issues.
On the other hand, if you expect to build a large company, particularly if you expect to solicit institutional investors, you will probably be required to form a C corporation. Certain types of investors, such as pension funds, simply cannot invest in pass through entities - and VCs are backed by those types of investors. Also, C corporations better facilitate many classes of investors (preferred, common, etc) and also more easily allow for large numbers of investors (e.g. public companies).
The companies we work with at Momentum are all either initially or ultimately C corporations. This is because the profile of companies we work with requires them to take professional investors, establish multiple tiers of shareholders, initiate traditional stock option plans and maybe even go public.
It is possible to start as an LLC and transition to a C corporation. You can have an attorney walk you through the pros and cons of this. In my view, the benefits (a year or two of better tax treatment for owners) are generally outweighed by the disadvantages (the hassle and expense of making the transition to a C corporation).Matt Ridenour is Managing Director of Momentum Venture Management, a Los Angeles-based firm that helps early-stage companies achieve early business results and develop credibility in order to get funding and transform their ideas, technologies and products into sustainable, successful businesses. For more information, please visit www.mvmpartners.com.