About Social Media Today
This is Part 1 of a series called “Angel Investing and Company Structure.”
C Corps. S Corps. LLCs.
Does the form of entities you invest in matters?
You bet it does. The differences in taxation and flexibility in ownership and capital structuring among them can be significant.
Does one structure trump over the others? Let’s do a head-on comparison.
Company Structures
C Corporation (C Corp.). Owners of a C Corp are called “shareholders” or “stockholders.” Investors of a C Corp. are part owners of the company and are given stock certificates to evidence ownership.
A C Corp. is treated as a separate entity from its owners/shareholders in the legal standpoint. This separation shields shareholders from debt or obligations incurred by the company.
S Corporation (S Corp.). Like a C Corp., owners of an S Corp. are also called “shareholders” or “stockholders” and are given stocks to evidence ownership.
An S Corp. is also a separate entity from its shareholders, providing them limited liability protection from creditors.
The main difference between a C Corp. and an S Corp. is in the way income is taxed. We’ll expand the discussion of taxation in the next article.
Limited Liability Company (LLC). Owners of an LLC are called “members.” Instead of stocks, investors (as part owners of the LLC) receive “membership interest.”
The membership interest is usually expressed in percentages (e.g. a 10% membership interest) or units (e.g. 10 units), which generally correspond to percentage ownership, according to attorneys Jere Friedman and Jeffrey Bojar.
Unlike shareholders of a C Corp. and an S Corp., who receive stock certificates to evidence ownership, LLC members receive charter documents, i.e. the Articles of Organization and Operating Agreement.
An LLC also provides members limited liability protection from incurred debts.
Ownership / Structuring Flexibility
C Corp. There’s high flexibility in who can hold equity or invest in a C Corp., and in structuring special rights (e.g. valuation, preferences, and protections) for various shareholders; that is, different shareholders can hold different rights.
S Corp. In comparison, an S Corp. lacks flexibility. The number and type of persons who can own equity in the company are restricted.
Specifically, there must be no more than 100 stockholders in an S Corp., and all of them must be (i) US citizens or residents, (ii) estates, (iii) eligible trusts, or (iv) certain tax-exempt entities, comment Greg Lynch and Melissa Turczyn, attorneys at Michael Best.
In addition, thanks to limitations imposed by tax laws, only 1 class of stock is allowed in S Corps. You see, experienced investors typically invest in preferred shares whereas founders and early employees hold common shares. This requires the company to issue 2 classes of stock. Therefore, the 1-class stock restriction has driven many investors away from investing in an S Corp.
LLC. LLCs have tremendous flexibility in who can be a member and in structuring the rights of various owners or members. This structure is appropriate for smaller companies with a limited number of members.
“An LLC is governed by the operating agreement, which can be modified any way the founders want to modify it,” Jeff Solomon, the head of audit at public accounting firm LKN+S, told ACEF.
For instance, they can say, we are going to allocate all the losses to you and profits to me. Or the agreement can say that I get all the cash, and you don’t get any.
In complicated investing deals, if certain investors need certain preferences, you can do better with an LLC because you can make that agreement do whatever you want.
I have seen [operating] agreements at hundreds of pages as well as simple ones.
Next, we’ll look into how company structures affect tax payments, filing, and reporting.
