Structuring a Business For Venture Capital Investment
While venture capital investment can be notoriously difficult, for many entrepreneurs, VC investment is an ideal exit strategy. However, VCs typically look for certain characteristics and businesses that allow for easy entry and exit from the opportunity.
The most common business in the US, but the worst for venture capital investment.
- Sole Proprietorships appear lazy.
The lax requirements for maintaining a sole proprietorship typically reflect similarly lax attitudes among management. The owner and operators may be highly successful, highly intelligent, but the inability to incorporate basic legal protections is a leading indicator for many venture capitalists to look the other way.
- Sole Proprietorships are difficult to transfer.
Typically, sole proprietorships lack a significant paper trail to trace ownership or other interests in the business. Because of the lack of registered parties, investors, and other owners, sole proprietorships are vulnerable to “surprise” 3rd parties hoping to make a claim to some percentage of the business.
- Sole Proprietorships are difficult to fix.
If the company has been open for a significant amount of time, basic legal formalities may be difficult to implement for existing management and personnel. The company may also risk being exposed to liabilities the pre-existing sole proprietorship incurred when the new incorporation appears to attempt to insulate the original owners from that liability.
Limited Liability Companies
The workhorse of legal structures
- LLCs are the new standard.
Since its nationwide acceptance in the 1990s, the limited liability company has become the workhorse of the most business legal structures. The ease of incorporating, the pass-through taxation, and other benefits allow an LLC to have many of the benefits of a partnership, with the liability insulation of a traditional corporation.
- LLCs are not perfect, and vary by state.
LLC laws greatly differ from state to state. Many states even have multiple LLC designations, each with their own individual requirements. The lack of a uniform LLC law across the country makes some VC investors hesitant when investing in an LLC in a state in which they do not traditionally do business.
- Lawyers often recommend LLCs because they are flexible.
LLCs in most states do not require significant formalities to remain active. In fact, in most states, a simple phone call to a business partner is enough to satisfy the requirements.
- Corporate formalities in LLCs encourage good business practices.
Most LLC laws exhibit the rare combination of good business judgment with legal reality. Observing the law can benefit your business and not just in the “compliance” deductable on your tax return.
The VC gamble
- Corporate formalities, but pass-through taxation.
S-Corporations behave much like a traditional C Corporation, except for a simple “opt in checkbox” on tax filings. Owners must observe traditional corporate formalities like Board meetings, but they get taxed only on personal income.
- Restrictions limit initial size.
In order to maintain the pass-through taxation benefit that S corporations have, the total investors in the Corporation must be relatively small, geographically limited, with single-tiered stock. Overstepping any the restrictions placed upon S corporations will qualify that entity as a C Corporation, subject to federal corporate tax. Once that line is crossed, it is very difficult, if not impossible, to backtrack into the old S-Corp designation.
- S-Corp scalability makes it a powerful growth tool.
Because S-Corps can so easily become C-Corps, VCs tend to prefer this type of entity. S-Corporations can scale quite quickly, without having to file significantly more paperwork. For instance, an LLC cannot sell shares on the public market.
The Bottom Line
Most businesses are slow to medium growth companies. Cash flow is a perpetual problem, so an advantageous tax position is always critical. While sole proprietorships allow the company to be taxed on the individual’s income, the legal liability and the difficulties in transferring an interest makes all proprietorships the most difficult to transfer or sell. An S Corporation, on the other hand, is specifically tailored for potentially high-growth businesses, and benefits from pass-through taxation, but suffers from restrictions on ownership and internal operations.
While an S corporation may be an ideal legal entity for most VCs, the ideal entity for most businesses is still the LLC. The ease of formation, the relatively lax corporate formalities, and the benefits of pass-through taxation allow for an LLC to protect its investors while still providing opportunities to bring in new investors at a later date. An LLC will eventually have to do significant legal restructuring if it ever plans to go public, but for an overwhelming majority of companies, a public stock sale will never occur. The bottom line is, if you’re going public in less than 10 years, choose an S-Corp configuration, otherwise choose an LLC, but never remain a sole proprietorship.