Should Startups incorporate as c-corporations? 

Benefits of having a C-corporation (C-corp) startup

This is a very common question asked by a lot of our Startup clients in the tech world. This is a very important consideration and we spend a lot of time with our clients understanding their business, growth trajectory and whether they are going to be seeking funding or investment from either Angels or Venture Capital firms. Below are some considerations for making our case for startups to consider C-Corporation structure and why VC's prefer them and the risk involved. 

What type of Stocks do VC’s (Venture Capitalist) like to own?

VC's (Venture Capitalist) will more than often want to invest in C-Corporations. There are structural and tax restrictions that prevent them from owning stocks in S-Corp, or make investing in LLC's less attractive. 

We often get questions like: Why VC’s don’t like S-Corporation? What is the preferred corporate structure for VC’s? Or, what is the best way to incorporate a Startup?

Well, S-Corporation can only issue one class of stock and there are limitations on who can actually own the stock such as a person has to be a U.S citizen or resident and the number of shareholders cannot exceed 100. But this is not what deters VC’s. It is the very structure of Venture Capital Partnerships that make investing in S-Corporations non-viable; to hold stocks in an S-Corporation, in additional to the requirements I mention above, you have to be organized as a natural person; S-Corporation and C-Corporation are considered Natural Persons. If you look at majority of Venture Capital firms, they are organized as Partnerships or LLC’s, which are not considered Natural Persons by definition. So, if a VC firm you are seeking investment from is organized as a Partnership or LLC, they are automatically precluded from owning S-Corporation stocks. 

Why VC’s (Venture Capitalist) like preferred stocks in C-Corporations? 

Preferred stocks provide VC’s with additional rights over common stock. One such right is that preferred stocks enjoy a liquidation preference. What does this mean? Liquidation preference clauses protect VC’s in the event of liquidation. 

What does a liquidation clause(s) include in Venture Capital agreements?

Liquidation includes the obvious bankruptcy. It also includes events like merger, acquisitions, sale of corporate assets (usually substantial sale of all corporate assets). Hence, preferred stocks allow its holders to get paid before any of the common stock holders are paid. 

What is the risk you run with overly burdening Liquidated Clauses?

Image a situation where you are a holder of common stock, the company gets sold, and there is a 2x or 3x liquidation clause. What now? What does this mean? This means that preferred stocks holders will get paid 3 times the value of their equity leaving less for common stock holders. But there is some good news, the market standard for liquidation clauses is 1x multiple.

Can VC’s (Venture Capitalists) convert their preferred stocks to common stocks?

Yes, VC’s and other preferred stock owners can convert their preferred stocks to common stocks. Not all VC’s will exercise this option, it will all come down to math, they will do whatever that will make them the most money. 

Why should VC’s get a liquidation preference? 

Well, for starters, they took the risk to invest in your company, when your company was likely small, unknown or upcoming. The risk factor is huge. As logic goes, huge risk-huge reward potential. However, you do not want to be in a situation where you work hard and get nothing. This can happen. Always speak with a lawyer if you are in a Startup and have questions. 

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Contact us if you have any questions.
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