While every business has a beginning stage which could be termed “the startup phase,” increasingly this term is being reserved for a narrower category of high-growth ventures. In the digital era, these “concept” businesses have become known generally as “startups”. While many of these businesses are focused around technology, a variety of businesses may be considered startups if they have certain characteristics. Generally, the founder is looking to grow the business quickly then exit. In the meantime, they need to show user growth, revenue growth, or a proof of concept with the help of capital from angel investors or early-stage venture capital firms.
Oftentimes, before a founder’s exit, is a lean stage of constant growth also fueled by reinvestment. The venture is kept lean by not taking dividends or a large salary. The business plan is to cash-out for a hefty return after a few years.
A Delaware corporation taxed as a C-Corp is often preferred and well adapted to venture capital and angel investing over other forms of business entities. Frequently these Delaware corporations have 10,000,000 shares of common stock authorized with $0.0001 par value and about half of the shares issued to founders.
In addition to providing limited liability to the owners, Delaware corporations can be critical to securing future investment because they are generally preferred by angel investors and venture capital firms.
The main reason to choose Delaware is for its predictable laws that protect investors. Accordingly, legal professionals and capital investors have always been comfortable with the Delaware laws and procedures governing these entities. Familiarity can streamline financial and legal procedures, thus increasing efficiency and valuations.
The Subchapter-C corporation is well-suited for most startups. That is because most startups have extended periods of losses that can be “rolled forward” year after year to offset future gains. Many startups have years of losses until they reach a tipping point where scale turns profitable. When profits are created, they are reinvested in the business and not distributed as dividends to shareholders. As a result, the only tax paid is a relatively low corporate tax rate and not personal income tax by the shareholders. Other S-corporation and partnership tax regimes “deem” profits to be distributed and taxed as personal income. This is even if profits are reinvested in the business. The result of using an LLC taxed as a partnership or an S-Corporation is a higher effective tax rate than a C-Corporation for a business looking to reinvest in itself.
What if you are not at the point of seeking venture capital investment yet? It may be best to form a simpler LLC or partnership, then convert when you are ready. You can always convert an LLC to a C-corp later, which would be deemed a tax “reorganization.” This could be helpful for simplicity at the very initial stage of the business and could be converted later when funding is sought if the investor does not want the LLC form of business.
In the hypothetical event where you have an LLC taxed as a disregarded entity, partnership, or S-corporation you would forego the benefit of being able to reinvest in the business at a lower effective tax rate. If you are wanting to grow quickly and expect losses and funding from outside angel investors or venture capital, then incorporating a Delaware corporation taxed under Subchapter-C may be your best bet from the start.
When forming a startup, you need to project your business’s sources of capital and likelihood of losses and possible exit options to come further down the road. Often careful choice of entity and choice of tax election can be helpful when positioning your startup for growth.