C corporation

Intellectual property rights showcase a startup’s value, ability to dominate the market, and stand strong in times of adversity. Specifically, with trademarks and patents, startups are 10 times more likely to secure funding from investors and about 3 times more likely to have favorable odds when exiting as evidenced by a study from the European Union Intellectual Property Office (EUIPO). Accordingly, the acquisition of IP rights, for startups are fiscally essential in providing a durable foundation and may be correlated with the increase in filing in Trademarks from 28% to 72 and Patents from 10% to 44% from the initial seed stage to later funding stages. There are two key reasons why these IP protections incentivize investors to engage with startups.

Branding in Market Domination and Innovation   

First, IP protections are perceived as unique signatures connecting startups with a strong brand identity. This is significant to investors for three key reasons. First, IP protections demonstrate a sense of identity to investors for a startup’s potential recognition in the marketplace. Second, investors view IP protections as vital pieces to the construction of a valuable portfolio because they can provide tangible capital in future business dealings. Third, IP protections demonstrate to investors the startup is protected against infringement. 

A Mark of Innovation Signaling Potential Leadership in the Marketplace, Longevity, and Liquidity During Times of Change

Second, IP protections, demonstrate a startup’s innovative nature. This is significant for investors for three key reasons. First, IP protections, especially patents, showcase a startup’s innovative qualities signal and demonstrate to investors the startup is unique and has strong technical capabilities. Second, IP protections, demonstrate to investors startups can establish dominance in the market because IP protections reduce competition by preventing the use of the startup’s mark. Third, IP protections signal to investors they are safe to invest because the startup could liquidate its assets for sale in unpredictable times of change.

Conclusion 

With IP protections, investors are incentivized to fund your startup, leading it to have the ability to achieve fiscal success and dominance in the global marketplace. If you are interested in the potential to achieve fiscal success, recognition, and financial support from investors, please reach out to Lloyd & Mousill, a team of visionaries, who will protect your vision and future goals. 

The Future is Uncertain

Equity, or ownership, is a company’s most expensive and most valuable asset. When splitting ownership, it is important to keep in mind that no one knows what the future may hold. You might expect that if you and your partner have equal ownership, that your work, time, or financial contributions will be equal. The reality, however, could be very different. You may end up bearing more of the workload than your co-founder and still have the same equity split. As the startup grows, each of your commitments and life priorities may change and your share of the equity split or your partners’ may no longer be representative of each of your contributions to the company. 

Founders also have different ideas about the types of contributions they will be making, and this vision changes over time as the company grows. Some may envision taking an active role in daily operations and management, while others want to handle marketing, and some may prefer a more passive style of investment. It is important that the split in ownership be reflective of these styles. It takes time to understand these differences and how to work with them, and most startup founders do not have that degree of familiarity with each other, thus making a 50/50 ownership split a risk. Startup founders that negotiate longer are more likely to decide on an unequal split, as they have been able to discover and address important differences in their expected contribution levels.

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Higher Chance of Splitting Faster

Another risk with a hasty 50/50 ownership split is that it can lead to your startup falling apart fast. Compared to founders who took the time to establish a well thought and calculated equity split, those who neglected to have this discussion and chose to split equally shut down their companies significantly faster due to a fallout amongst the founders. This also applies to startup founders who are related to each other- they are more likely to spend less time negotiating equity, and in turn are also more likely to share equally and end up splitting faster. The consequences and tension of an ill established ownership split can be devastating for a startup. 

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More Difficulty Bringing in Investors

A major consequence of implementing an equal ownership split is that it makes bringing in investors a lot more difficult- equal splits are sometimes seen as a sign of bigger issues within the startup. Investors tend to pay attention to the way co-founders divide ownership because it tells a lot about their experience level and engagement within the company. They may find an equal split to be impractical, and see it as an inability to negotiate seriously within and outside the company. Teams who quickly establish an equal ownership structure may face significant difficulty in raising their first round of financing, either in reduced ability to raise or in lower average valuations.

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Stalemates on Key Issues

An equal ownership split between startup founders means that both partners have equal control and voting power. This inevitably leads to deadlocks and an inability to move forward on key issues, which at best could end up stalling the business. These stalemates can easily be avoided by having one founder maintain majority control, even through an almost-even split. This ensures one founder has majority voting power when it comes to important business decisions. Startup founders need to be able to compromise and negotiate for the good of the company.

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Conclusion

Making these decisions can be overwhelming. Lloyd & Mousilli can help you implement the right ownership split for your startup. Our firm has the experience necessary to set your company up for success.

Incorporating a business is the process of forming of a new entity that is recognized as a separate “person” under the law. At the very early stages of your business, you will need to decide which entity is the best fit for your purposes. This is often overwhelming for founders and first time business folks. The three types of entities discussed in this article (C corporation, S corporation, and LLC) all partially shield the individual owners from certain types of personal liability. They each have varying benefits regarding fundraising and stock option grants. They also each result in different tax implications or benefits, and provide your company with greater credibility among investors, clients, and customers.

Some Legal Implications of Incorporating:

• Partial protection against personal liability: A corporation or limited liability company (LLC) partially shields individuals (stockholders, directors and officers) from business liabilities such as loans, accounts payable, and legal judgments. We use the word “partially” because some courts have decided against completely shielding individual owners from personal liability, depending on their behavior and knowledge of the matter. On the other hand, the assets of the corporation or LLC may be protected if an individual is involved in a personal lawsuit or bankruptcy.
  
• Transferable ownership: Owners of a corporation or LLC may easily transfer ownership interests to others, depending on state requirements and their own company agreements or bylaws.
  
• Conversion: Depending on the rules of the applicable state statutes, one type of business entity may be converted to another (for example, an LLC to a corporation) and may even be transferred to another state (i.e. from California to Delaware). Read a short Lloyd & Mousilli article on conversion if you’re considering starting with an LLC: LLC Now, Corporation Later?
  
• Taxation: Corporations are typically taxed at a lower rate than individuals. Corporations may also own shares in other corporations and resulting corporate dividends can be partially tax-free. If you have any doubts or want to explore tax questions, you should speak with a tax advisor. Our firm does not provide tax advice.
  
• Duration: Either an LLC or a corporation may continue indefinitely and beyond the lifetime of its owners.
  
• Raising capital: A corporation may raise funds by issuance of convertible debts and sale of stock. An LLC may raise funds by issuing membership interests.
  
• Employee incentives: A corporation may issue incentive stock options to employees as a form of compensation for their work and tenure. A similar structure may be created for an LLC, but it is typically more complicated and more expensive to manage and setup.
  
• Credit rating: A corporation acquires its own credit rating unassociated with the owner’s personal credit rating, even though the owner may be asked to provide some collateral or personal guarantee at times, especially early on after formation.

C Corporations

A C corporation is the standard corporation structure. An S corporation is a corporation that has elected special tax status with the IRS. Both of these corporate entity statuses share the following:

• They have shareholders, directors and officers.
• Both are required to follow the same internal and external corporate formalities and obligations, such as adopting bylaws, issuing stock, holding shareholder meetings, filing annual reports, and paying annual taxes and fees as required by state law.
• Articles of Incorporation are the same for both C and S corporations.
• Both C corporation and S corporation ownership is transferred by the selling of shares.

The advantages of C corporations are:

• Investors typically prefer this form of corporate structure when investing in accelerated growth tech companies due to multiple classes of stock available to C corporations, especially preferred stock. Preferred stock provides preferred returns and further protective provisions.  
• C corporations are also a more favorable setup for employee compensation. A company creating incentive (via stock options) to attract and keep talented employees often prefer C corporation status. C corporations may allow employees to defer tax status on the equity compensation until they sell that initial stock by offering incentive stock option plans, variations of which are possible, but more complicated, in an LLC. Tax-free and tax-deductible benefits are also available to employees in a C corporation (again, check with your accountant on all tax matters).
• C corporations allow the owners to take advantage of certain provisions in the tax code with respect to exclusion of a certain amount of capital gains and the deduction of certain losses. However, please check with your accountant with respect to these benefits.
• Non-US citizens or and non-residents are permitted to be shareholders / founders of a C corporation.
• Since ownership is unrestricted, C corporations are often the best choice for large companies that are or plan to be publicly traded.

The disadvantage of a C corporation is double taxation:

• FIRST at the corporate level on the corporation’s net income.
• SECOND to the shareholders when the profits are distributed, if corporate income is distributed to business owners as dividends.

When a corporation is originally chartered by the state, it exists as a C Corporation. It will remain a C corporation unless the company wishes to elect S corporation status.

S Corporations

The main difference between a C corporation and an S corporation is the taxation structure. S corporations only pay one level of taxation: at the shareholder level. To choose S corporation status, a tax lawyer or accountant may assist with filing IRS Form 2553 and ensuring all S corporation guidelines are met. Since S corporation election is not required at the time of incorporation as a C corporation, a company may wish to momentarily hold off on S corporation election in order to consult with an accountant or tax lawyer.

Startup companies will choose an S corporation if the founders wish the benefit of a flow through tax treatment. In other words, a founder can include business losses on their personal tax returns as deductions, which may be particularly attractive during the early stages of a company. A startup can elect S corporation status before the financing stage and revoke S corporation status at the time of a financing. However, S corporation status prevents a startup from having entity (other corporations or LLCs) or non-US citizen/resident stockholders.

The disadvantages of S corporations, unlike C corporations, are:

• Limited ownership to 100 shareholders, who cannot be non-resident aliens, nor can S corporations be owned by other corporations.
• An S corporation cannot have multiple classes of stock.
• S corporations are not allowed to conduct certain types of business. Banks and insurance companies are not eligible for S corporation status.
• S corporations are less flexible than C corporations for employee fringe benefits.
• S corporations must report employee taxable compensation.

Limited Liability Companies

A limited liability company (LLC) blends elements of partnerships and corporate structures. An LLC is an unincorporated association that protects the liability of a company.

Startup companies often avoid LLCs because most technology startups seek to grant options to employees and consultants, and it’s very difficult to get professional investors interested in investing in an LLC. LLCs provide no standard or easy way to grant such options. A startup may convert from LLC status to a C corporation but, depending on the state, there may be statutory limitations or additional requirements in doing so. Consultancy and bootstrapped businesses, on the other hand, are often the best choices for LLC status.

Benefits of LLCs:

• Flexible management structure. Unlike corporations, LLCs are not required to comply with a formal management structure.
• Like the C corporation, LLCs have no ownership restrictions and members of an LLC may be non-US citizens and non-resident aliens.
• Flexible tax regime. An LLC can elect to be taxed as a sole proprietor, partnership, S corporation or C corporation. Using default tax classification, profits are taxed personally at the member level, not at the LLC level.
• LLCs can be set up with just one natural person (in some states) and thus partially separates the liability of a company from that member.
• LLCs can offer membership interests in the LLC to employees.

Disadvantages of LLCs:

• Investors may be wary of the LLC structure and prefer the traditional corporate structure of a C corporation or S corporation. This can make raising capital difficult for LLCs.
• Many states levy a franchise tax on LLCs, which is essentially the fee to pay for the privilege of the LLC status.
• Renewal fees may also be higher than a C corporation or S corporation.
• LLCs are not considered corporations for the purposes of civil procedure. Instead, LLCs are treated as partnerships by the courts. This affects diversity jurisdiction. Thus, if a member of an LLC is a citizen of the same state as a member of the opposing party, the LLC may not remove to federal court under jurisdiction (whereas the corporation can).
• The equity compensation process for employees is not straightforward and standard incentive stock options employed by C corporations are not typically available.

You should consult with the Lloyd & Mousilli team if you have any doubts about the appropriate entity type for your business.

Founders have been known to set up LLCs at the earliest stages of their ventures for obvious reasons, including:  

• LLCs tend to have flexible management structures and are often easier to maintain. Unlike corporations, LLCs are not required to comply with a formal management structure; and  
• LLCs tend to have flexible tax regimes. An LLC can elect to be taxed as a sole proprietor, partnership, or corporation. Using default tax classifications, profits are taxed personally at the member level, not at the LLC level.  

For more information, check out our article on What’s the Difference between a C Corp, S Corp, and LLC?

Potential Problems with Forming an LLC for your Startup

LLCs have some notable limitations and are not the best choice for accelerated growth startups for many reasons, including (but not limited to) the following:  

• The equity compensation process for employees is not as straightforward in LLCs  and standard incentive stock options employed by C corporations are typically not available. Moreover, if you have any inclination to pursue outside funding, you’ll be better off steering clear of creative, complex equity structures that fall outside the C corporation norm so that you avoid unnecessary scrutiny from potential investors and acquirers.  
• Investors may be wary of the LLC structure and prefer the traditional corporate structure of a C corporation. This can make raising capital very difficult for members of an LLC.  

Can’t I just convert my LLC to a C Corp later on?  

Not so fast! You may run into some problems if you try to convert your LLC into a C corporation at a later date:  

• Not all states permit the conversion from an LLC to a C corporation;  
• A conversion from an LLC to a C corporation may have surprising tax implications and you should make sure you hire an experienced accountant to advise you. If your IP development, employee acquisition, and customer engagement are well underway, the conversion costs can be costly and time consuming.  
• Even if a state permits the conversion to take place, make sure you hire an experienced startup lawyer to lead this charge on your behalf. Your Lloyd & Mousilli team is well positioned to represent you. Remember that potential investors and acquirers will run you through a thorough due diligence process, which will expose any corporate vulnerabilities and put the transaction at risk. Do things the right way to start!