Choosing the wrong business structure for a tech startup will create unnecessary taxation and could negatively affect your ability to raise funds in subsequent stages of funding via institutional investors. Venture capitalists and angels will not consider signing your term sheet if they are required to accept pass-through taxation limitations or reset of holding periods on their investments.
The following is a breakdown of essential technical factors associated with the cost of compliance, tax limits, and the mathematics required by jurisdiction for you to create your startup properly from inception.
Quick Tips for New Startup Founders
Do not attempt to figure out how to legally structure your startup. There are a number of items that data within the marketplace provides strict guidelines related to tech startups that are primarily based on the amount of capital required and the time to turnaround profitability:
Due to preferred stock mechanisms, the structure of a Delaware C-Corporation provides institutional VCs with predictability regarding corporate laws and a clearer picture of capitalization tables.
The S-Corp tax status provides positive net cash flow only if your company's net profit exceeds $60k to $80k; otherwise, compliance costs will absorb all savings.
According to QSBS rules, if you hold your original C-Corporation shares for five (5) years, you will not have to pay federal tax on up to $10 million in capital gains.
If you start as an LLC to save startup costs, you will ultimately incur large tax penalties and legal expenses when you transition into a corporate structure for investors.
Founders of foreign businesses selling their products to customers in the US may be forced to choose between keeping their local business or establishing a US-based holding company. This choice will have a serious impact on your ability to access banks and enter into commercial contracts.
Choosing the Right Business Structure for a Tech Startup
Each individual operational entity has a unique calculation for tax burdens, administrative overhead, and investor perception. Every business needs to develop its legal and operational framework to achieve its operational goals over the next 24 months.
1. Delaware C-Corporation
Most companies seeking to raise institutional capital will form a Delaware C-Corporation. Venture capitalists will only invest in Delaware C-Corporations since they allow the company to issue “preferred stock,” which protects the downside risk for the investor in the event of liquidation.
Delaware is governed by the Delaware General Corporation Law (DGCL) and has a unique judicial system called the Delaware Court of Chancery. Here, no juries are used, and instead, the cases are decided by judges with expertise in corporation law, providing the level of legal predictability that investors want.
The dominance of the Delaware C-Corporation is evident in the statistics: approximately 2/3 of the Fortune 500 companies and 81% of all U.S. IPOs will occur in Delaware in 2024. If two founders are at the pre-seed phase, and they will be seeking angel investors in the next 6-9 months, they should incorporate a Delaware C-Corporation as of day one to avoid costly conversion processes down the line.
While a C-Corporation has a dual tax structure (the corporation pays a flat federal corporate tax on net income, and then the shareholders pay taxes again when the corporation pays dividends), early-stage technology companies typically do not distribute dividends and are reinvesting all capital into growth.
One of the most significant financial benefits of a C-Corporation structure is the benefits afforded under Section 1202 of the Internal Revenue Code. This section provides a tax exclusion for Qualified Small Business Stock (QSBS). Therefore, if you hold original shares of a domestic C-Corporation for at least five years, you can exclude up to 100% of any federal capital gains taxes when you exit the company.
The standard exclusion threshold is set at the highest of $10 million or 10X the stock's original cost basis. New legislation proposes increasing the exclusion limit for certain structures to $15 million.
You will be liable for compliance costs. An early-stage Delaware C-Corporation can expect to spend approximately between $1,000 and $3,000 each year on compliance. Compliance costs include Delaware's franchise tax, registered agent fees from Capitol Services, CT Corporation, CSC, etc., and foreign qualification expenses incurred in the state(s) where you operate.
2. Limited Liability Company (LLC)
The Limited Liability Company (LLC) is a pass-through tax structure that is designed to minimize operational complexity while providing personal liability protection.
The LLC is an excellent structure for a solo founder of a software tool who has no plans to raise outside capital for the next 12 to 18 months. Profits and losses pass through to the owner's individual tax return, thereby eliminating the double tax faced by traditional corporations, while the formal administrative requirements are minimal. There is no need to conduct formal board meetings, create written minutes, or issue various classes of stock.
Venture capitalists are strongly opposed to the LLC structure. If you attempt to raise institutional financing using this business structure for a tech startup, you will face significant challenges from potential investors.
The pass-through taxation associated with LLCs creates unrelated business taxable income (UBTI) for venture capital funds. A significant number of venture capital funds have tax-exempt limited partners, such as pension funds and universities, which, under federal law, are prohibited from accepting UBTI.
LLCs issue each owner a Schedule K-1 and, therefore, every owner will be subject to income tax on their LLC's income, regardless of whether they are a limited partner in the LLC. Investors do not like to receive K-1s because they are typically sent late in the tax-filing season and add to the complexity for investors who have to file their own tax return. Typically, bootstrapped agencies that evolve into product companies have started as LLCs but should prepare for a difficult transformation when they begin discussions with potential investors.
3. S-Corporation
An S-Corporation is not legally a separate entity; it is simply a tax status filed with the IRS. To qualify for S-Corp status from either an LLC or a C-Corporation, the IRS requires the filing of IRS Form 2553 by March 15 of the tax year in which the S-Corp status will be effective.
The primary benefit of S-Corp status is that it will save money in self-employment taxes. In an LLC, the owner must pay a 15.3% self-employment tax on all net income earned. In an S-Corp, an owner is allowed to divide the earnings between a W-2 wage and a normal owner distribution, and only the W-2 wage is subject to self-employment taxes.
Due to the complexity of the S-Corp calculation, determining when to elect S-Corp status must be done carefully. Industry data show that there are two threshold values of net profit ($60,000 and $80,000) for electing S-Corp status. Below this threshold, the administrative costs of being an S-Corp will exceed any tax savings.
In order to operate as an S-Corp, you must maintain a formal payroll for your employees via one of the many payroll software services available, for example, Gusto or QuickBooks. You will also be required to pay payroll taxes, file a Form 1120-S corporate tax return, and you will incur higher CPA fees.
S-Corporations are heavily scrutinized by the Internal Revenue Service (IRS) to ensure the owners are being paid a reasonable salary. If an owner of an S-Corporation pays themselves an artificially low salary in order to maximize tax-free distributions, the IRS will audit the S-Corporation and impose substantial penalties.
Furthermore, the use of an S-Corporation eliminates the ability to utilize any of the mechanics associated with venture capital funding. For example, S-Corporations can have no more than 100 shareholders, only one class of stock, and may not have any foreign shareholders or corporate investors.
4. Private Limited Company
The private limited company is the vehicle of choice for raising institutional capital for tech startups in countries outside of the United States (e.g., India).
The private limited company has the same fundamental structure as a US C-Corporation. Founders of a private limited company can issue preferred shares, have a clear capitalization table, and create separate option pools for employees who were early in the company. If an Indian-based SaaS company plans to raise funds from international venture capital funds, a private limited company is the only acceptable business structure for a tech startup.
Founders of a private limited company will endure a lot of administrative burden. Founders will have to comply with strict requirements regarding board meetings, annual audits, and a large volume of government filings annually.
The private limited company structure will provide a perfect foundation for a company in the future to execute a "flip" to a C-Corporation in Delaware. To get money from US investors, a company will have to have a clear history of equity, which is something the private limited company will require from day one.
5. Limited Liability Partnership
In some jurisdictions (e.g., India and the UK), limited liability partnerships (LLPs) are often a good option in a similar way that an LLC is in the United States. The LLP provides the advantage of limited liability and flexibility with respect to how the partners manage the affairs of the LLP, as well as being taxed as a partnership.
Compared with a private limited company, the administrative constraints are far less on an LLP than on a 'Pty Ltd' company. Administration is easier for an LLP, as there are fewer mandatory annual audits, and less need to follow strict corporate governance standards.
It will not be possible to invoke the LLP business structure if your aim is to grow a globally-oriented technology start-up. Funding through institutional equity rounds will fail at the outset under an LLP structure.
The LLP will prevent you from easily providing employees with stock options, and you will not be able to structure your organization's capitalization table to allow for the more complex preferred equity rights that venture capital funds typically require. Thus, an LLP structure is typically only appropriate for business entities that provide pure services or for local bootstrap operations.
When to Change Your Startup to a C-Corporation
When you choose a legal structure for a business, you must project your estimated revenues and capital-raising events accurately. Transitioning between legal structures without preparing for the consequences can create extreme legal ramifications.
Starting as an LLC in the hope of saving costs until you receive your first term sheet from a venture firm and subsequently switching to a C-Corp is a very risky strategy. When you convert an LLC to a C-Corp, you effectively reset the holding period of your qualified small business stock (QSBS). Under Section 1202, the original share must be held for five years.
If your LLC was in existence for only two years before you converted it, and the two years did not count toward the five-year holding period, you started over with your five-year holding period from the time of your conversion to C-Corp.
It is important to note that the conversion process itself leads to extreme administrative delays. The founder must pay legal expenses to draft the written consent forms from the directors and officers of the company, prepare a new founder stock purchase agreement, and file the complicated merger filings.
The company could incur large, unexpected tax liabilities if the LLC has a debt that is greater than the asset's base. If the founder wants to get angel or venture capital money in the next six to nine months, it must pay these initial costs and set up as a Delaware C-Corporation now.
Selling to U.S. Customers as a Foreign Founder
Non-U.S. founders selling primarily to U.S. customers face immediate banking and contracting issues. U.S. enterprise customers routinely refuse to sign software agreements and wire transfer money to foreign companies.
To resolve this issue, non-U.S. founders normally incorporate a Delaware C-Corporation as their principal business entity within the United States. The U.S. entity will enter into all customer contracts, process payments through U.S. banking systems, and be the vehicle for any potential investments by U.S. investors.
This creates an immediate complication with respect to QSBS eligibility. Under Section 1202, to qualify for the exclusion, a company must be a domestic U.S. C-Corporation using 80% or more of its assets in connection with a "business." The founders must structure all inter-company agreements to guarantee that the U.S. entity does not remain a passive shell and report all proper foreign qualifications on IRS Form 8949.
Protecting Your Core Intellectual Property
If your core intellectual property is held by the primary operating company, then it could potentially be exposed to general lawsuits from vendors, employees, or customers when the LLC faces litigation from those parties. If a primary operating company is facing a lawsuit, the assets of that operating company are at risk.
Smart founders use a dual-entity holding structure, which consists of a separate holding company (HoldCo) to hold all the core intellectual property, patents, and software code. Once you have the HoldCo formed, the HoldCo should create a strict licensing agreement with the OpCo.
The OpCo will take on the day-to-day risk of the business (i.e., hiring employees, signing office leases, and selling products), but in the event that the OpCo is sued and subsequently files for bankruptcy, the intellectual property will be completely protected in the HoldCo. The founders must execute assignment of IP agreements from the founders to the HoldCo as well as thoroughly document the inter-company licensing agreements between the HoldCo and OpCo.
Final Steps for Your Startup
Formalizing your business structure for a tech startup is imperative to avoid permanent tax oversights and to ensure the integrity of your capitalization table. Make your capital strategy for the next two years clear, file the appropriate legal document within the next week, and concentrate on selling your product.