Choosing Between C-Corp, S-Corp, and LLC When Venture Capital Is Already Knocking

If investors are interested in your company, your business structure can affect how they approach an investment. C-corporations, S-corporations, and LLCs each have different ownership and tax rules. Venture-backed startups commonly use C-corporations because they can accommodate different classes of stock. They also do not have the shareholder eligibility and one-class-of-stock restrictions that apply to S-corporations. 

Investor interest can be exciting, but it may also raise legal and tax issues that were not important when you started the business. If you formed an LLC or elected S-corporation status, you may need to reconsider whether your current structure still fits your plans before accepting outside investment. 

At Porter Law Firm in Mount Pleasant and Hilton Head Island, South Carolina, we advise business owners on corporate formation, capital raises, corporate governance, and other business matters. Our lawyers can review your current structure and help you address legal issues related to a proposed investment. Contact us now to discuss your business and funding plans. 

Why Your Business Structure Matters When Seeking Venture Capital

Your venture capital business structure affects more than how your company pays taxes. It can also affect who can invest, what ownership interests the company can issue, and how investors receive economic and voting rights. 

Venture capital financings often involve preferred stock, a type of ownership that can give investors rights or financial benefits that common stock does not provide. For example, preferred stock may give investors priority over common stockholders when the company is sold or liquidated. The investment documents may also provide specific voting rights and other investor protections. 

Your structure can also affect later financing rounds, equity compensation, governance, and a potential sale. If investors are already approaching you, reviewing these issues before the financing moves forward can help you identify needed structural changes. 

C-Corporation: A Common Structure for Venture-Backed Companies

A C-corporation is generally taxed separately from its shareholders. The corporation pays federal income tax on its taxable income. If it distributes after-tax profits as taxable dividends, shareholders may also owe tax on those dividends. This is commonly called “double taxation.” 

Even with this tax treatment, businesses seeking venture capital commonly use C corporations because they offer flexibility in issuing stock. Subject to state law and their governing documents, they can issue different classes or series of stock with different rights. For example, founders may hold common stock while investors receive preferred stock with specific financial or voting rights. 

C-corporations also avoid the shareholder eligibility and stock restrictions that apply to S-corporation status. This flexibility can make it easier to bring in multiple or institutional investors. 

Still, forming or converting to a C-corporation should not be automatic simply because investors are interested. Your ownership, tax consequences, financing terms, and long-term plans can affect which structure makes sense. We can review the proposed investment and identify legal issues that may affect the transaction. We can also help you form or restructure your business and prepare the corporate documents needed for outside investment. 

S-Corporation: Pass-Through Taxation With Ownership Restrictions 

An S-corporation is not a separate state-law business entity in the same way a corporation or LLC is. Instead, S corporation status is a federal tax election available to qualifying corporations and certain other eligible entities. Generally, the company's income, losses, deductions, and credits pass through to shareholders for federal tax purposes. 

This tax treatment can work well for some businesses, but the eligibility rules can create problems when venture capital enters the picture. An S-corporation generally: 

• Cannot have more than 100 shareholders: Federal tax law limits the number of shareholders, although special counting rules apply in some circumstances. 

• Can have only one class of stock: This can conflict with a financing in which investors want preferred stock with different economic rights. 

• Has restrictions on who can own shares: Partnerships, corporations, and nonresident aliens generally cannot be S-corporation shareholders. 

These restrictions can make S-corporation status difficult to maintain when institutional investors become involved. A company must continue to satisfy the federal requirements to remain eligible for S-corporation treatment. 

If your company currently has S-corporation status, changing its ownership or capital structure can affect its eligibility for S-corporation treatment. Our South Carolina business law attorneys can review the proposed financing and help you address any corporate changes needed before bringing in outside investors. 

LLC: Flexible but Not Always the Investor's Preferred Structure

An LLC can offer significant flexibility in ownership and management, while its federal tax treatment depends on the number of members and any tax elections it makes. By default, a domestic LLC with at least two members is generally taxed as a partnership unless it elects to be taxed as a corporation. A domestic single-member LLC is generally disregarded as separate from its owner for federal income tax purposes unless it elects corporate treatment. 

An LLC taxed as a partnership generally passes income, deductions, gains, and losses through to its members. Members then report their respective shares for federal tax purposes. 

This tax treatment may not fit every venture investor's investment or tax structure. Investors may also prefer the corporate stock and governance structure commonly used in venture financings. As a result, an LLC seeking institutional venture capital may be asked to convert to a corporation before the financing closes. 

However, an LLC is not legally prohibited from receiving venture capital simply because it is an LLC. Whether conversion is necessary depends on the proposed transaction, the investor, the LLC's tax classification, and the company's plans. 

What If You Already Formed an LLC or Have S Corporation Status?

Receiving investor interest does not necessarily mean you chose the wrong structure when you started your company. An LLC or S corporation may have met your needs before outside financing became realistic. The question is whether that structure still works for the transaction you are now considering. 

Before changing your entity or tax status, review the proposed financing and the possible legal and tax consequences. Depending on your circumstances, a restructuring can affect existing owners, tax treatment, contracts, equity arrangements, and other business matters. 

At our law firm, we can review your governing documents and ownership records before investor due diligence begins. We can also help address outdated agreements, transfer restrictions, ownership discrepancies, and other corporate matters that could affect the financing. 

Discuss Your Business Structure With Our Business Attorneys

When investors are interested in your company, your business structure should support both the proposed investment and your longer-term plans. While C-corporations are common among venture-backed companies, the right structure depends on your ownership, tax considerations, financing terms, and other circumstances. 

At Porter Law Firm, we help business owners with corporate formation, capital raises, corporate governance, and related business matters. With an office in Hilton Head Island and two office locations in Mount Pleasant, South Carolina, we serve clients throughout the state, including Charleston, Dorchester, Berkeley, and Beaufort.

We can review your existing structure and help address legal issues related to bringing outside investors into your business. Contact us to schedule a consultation.