Structuring Start-ups

Darian Ibrahim —  23 February 2007

Choice of entity is a standard topic in courses on small or start-up businesses. The usual materials cover the basic tax, liability, and governance issues relevant to the choice. These materials are fine for pointing students toward the LLC or S corporation forms for the typical small business, or “lifestyle” firm, as both forms enjoy limited liability and flow-through taxation. (Although my one quibble here is that insufficient attention is devoted to the ultimate choice between LLCs and S corps, where items such as the LLC self-employment tax can be relevant.) The general advice doesn’t hold, however, for start-ups seeking or potentially seeking venture capital.

In this paper, Vic Fleischer explains why start-ups are a different animal, and why they actually prefer C corps despite double taxation and the inability of shareholders to use significant corporate losses during the early years (think R&D expenses). The most interesting reason, to me, requires looking to the ultimate investors in venture capital funds. The VC funds are limited partnerships, so any gains/losses that flow through the start-up to the VC fund also flow through the VC fund to the fund’s limited partners. The majority of limited partners are tax-exempt entities such as pension funds, endowments, and foundations. These investors don’t care about flow-through losses, because they have no tax liability to offset. Also, they try to avoid flow-through gains, which are unrelated business taxable income (UBTI) that, because these entities are tax-exempt, can trigger an audit. Therefore, these investors prefer start-ups to be C corps, venture capitalists will aim to please these favored investors, and start-ups will aim to please the venture capitalists.

On another note, I think Vic’s article is instructive on the craft of writing. It’s tempting to find irrational reasons for start-ups to form C corps (we’ll never have losses!), and as Joseph Bankman documented in The Structure of Silicon Valley Start-Ups, 41 UCLA L Rev 1737 (1994), a “gambler’s mentality” probably does have something to do with it. But when sophisticated players like venture capitalists are involved, I tend to favor rational over irrational explanations for behavior. In fact, I’m taking this approach in a new paper to explain the puzzling behavior of angel investors (no draft yet, although blogged about at Conglomerate).