Last Updated on
August 9, 2022
By
Excedr
A huge part of being an entrepreneur in the life sciences is fundraising. The amount of money (and time) it can take to fund research and development and bring a product to market, whether it’s something like a therapeutic, medical device, or diagnostics kit, is generally eye-popping, sweat-inducing stuff. Bootstrapping isn’t necessarily a viable option as you grow either. So, we’ll assume you’re interested in raising capital with angel investors and venture capitalists.
If that’s the case, you may come to realize that many of these investors are looking for specific things beyond your idea and business plan. Specifically that they like to invest in startups that are organized under Subchapter C of the Internal Revenue Code, or C-corporations, commonly referred to as C-corps. But why is that?
In this article, we’ll review what is a C corporation and explore why raising equity and venture capital can be “easier” as a C-corp.
In the early stages of starting your company, you’ll have to decide which type of business entity you will form. The legal entity you choose has an immediate and lasting impact on you and your business when it comes to pursuing venture capital and your possible exit strategy (as a founder, your exit strategy is simply the plan you have in place to sell your company or shares in your company by going public through an initial public offering, getting acquired through a merger and acquisition, or being bought-out entirely).
Lots of founders choose to form entities other than C-corps, like limited liability companies (LLC) or S-corps (corporations that have elected the S-corporation status). Both of these business structures have their benefits. They are treated as pass-through tax entities, meaning the business does not pay income taxes. Instead of paying income taxes as the business, the income taxes pass through to its shareholders (owners) who then pay the tax themselves. One benefit about LLCs is that, despite the default differences, they can elect to be taxed as a corporation, changing the way in which they are taxed. This makes them more similar to a C-corp.
Now, lots of founders choose to form C-corps instead. However, there are some notable drawbacks people like to shine a light on to argue against the value of forming a C corporation. These drawbacks include things like double taxation, where the business is taxed once at the corporate level and again at the shareholder level. Double taxation is seen as simply disadvantageous to some business owners, and they choose to avoid it.
That said, C-corps are much more organizationally attractive to potential VC and angel investors, whose limited partners typically consist of things like pension funds and endowments. Since these funds are considered tax-exempt entities, they must avoid receiving too much of unrelated business taxable income (UBTI) in order to retain their tax-exempt status.
Thus, venture capital firms and angel investors (any investor looking for equity in exchange for their money) will prefer to invest in a C-corp, making things on their end much more organized. In some cases, it’s too difficult to even invest in a company that isn’t a C-corp. Essentially, this is because the distribution of profits and losses can become untenable when there are too many limited partners involved.
Let’s review C-corps in more detail. This type of business entity is a type of corporation that’s considered separate from its owner(s). This means it has its own legal rights that are treated as independent of its owners. The corporation can sue, be sued, own and sell property, and sell the rights of ownership in the form of stocks.
Unlike sole proprietorships and partnerships, certain types of corporations have to pay income tax on their profits. Owners of the corporations pay taxes on corporate income distributed to them as dividends. This is called double taxation, and mostly affects C-corporations.
While double taxation and the corporate tax rate are seen as downsides, corporations can, unlike other types of legal entities, raise funds through the sale of stock. There are several variations of corporations, including:
C-corporations can have an unlimited number of owners as well as multiple classes of stock, known as common and preferred stock. C-corps will also include a formal board of directors, an a company’s governing body made up of elected board members depending on the corporation’s bylaws.
As stated, C-corps are a good option for small business owners looking to attract venture capital and other types of equity financing.
Learn more about LLCs vs. S-Corps vs. C-Corps.
As mentioned, VCs are unwilling—or possibly even unable to—invest in any other type of business entity other than a C-corp.
Even without considering business entities, a biotech startup founder will already face challenges securing investments from outside investors—particularly venture capitalists. Choosing the “wrong” business entity can make it even worse.
But thankfully, this is a type of “low hanging fruit” you can “pick” to increase your chances of securing funding. If your goal is to operate as a high-growth startup, getting others to invest in your business is generally perceived as the best way to achieve that growth, and forming a C-corporation is encouraged.
Below are a few reasons why C-corps are easier to invest in than other business entities:
There are two types of stocks: common and preferred. C-corps, unlike partnerships, are allowed to issue preferred stocks in order to raise financing. Preferred stockholders have a higher claim to asset distribution or dividends than common stockholders. Furthermore, preferred stocks can yield more than a common stock, while also being paid out monthly or quarterly.
This class of stock gives special rights—anti-dilution protection, conversion rights, liquidation preferences, etc.—to a company’s investors, as well as the ability to pick board members.
Compared to LLCs and S-corps, C-corps offer VC investors more flexibility when it comes to investing. Not only is there more flexibility investing in a corporation, some VCs are actually barred from investing in any other type of entity. This is because many firms manage public funds. Additionally, when a VC firm invests capital from a fund, things can get tricky. More on that in a second.
Furthermore, because venture capital firms are recognized as limited partnerships, the firms are not allowed to invest in an S-corp either, as these entities require “natural persons” as investors.
In addition to this requirement, S-corps are also only allowed to have a maximum of 100 stockholders, limiting growth. Investing in a C-corp ultimately offers the most legal flexibility to VC firms, as they can avoid complications more easily.
S-corps and LLCs are not taxed as entities, the business’s income tax passes through to the shareholders (owners). However, C-corps are not organized as a pass-through entity. Therefore, no pass-through tax occurs. This means investors aren’t “on the hook” for debts and obligations like a company’s tax bill, even if they receive zero distribution or dividends payments from the company.
Now, when a VC invests in a company using a public fund, Because S-corps and LLCs generate gains that pass-through to the ’fund’s investors
Launching a biotech startup and choosing to form a C-corporation is generally recommended for founders who wish to access fundraising to fuel research and development and facilitate faster growth. It can help you with your exit plan as well, whether you want to IPO or get acquired. This is because a C-corporation’s corporate structure is simply more ideal for a growth strategy like this.
That said, founders who don’t initially choose to go that route and form an LLC or elect to be categorized as an S-corp can make the switch to a C-corp if it turns out they’re interested in taking on venture capital dollars.
The fact is, very few businesses remain LLCs all the way through an exit. And there is a lot of pressure from VC firms to incorporate as a C-corp. It makes both investing and going public or being acquired less complicated. However, if you’re at a crossroads and are considering how you will try to fund your life sciences company, this is exactly where you need to step back and weigh your options. Just how much will it cost you, in terms of time and money, to incorporate or make the switch if you didn’t choose to initially incorporate? And what will the tax implications be? Will it ultimately be worthwhile for a shot at a significant influx of cash?
For many startups, choosing to form a C-corp offers lots of benefits, and can save you from a serious headache later on. Although it can cost you to make the switch, it may be worth it to take on serious financial backing from a well-established VC company that specializes in the life sciences. Now, where you should incorporate is an entirely separate conversation. Learn about why VCs often prefer to invest in startups that have incorporated in Delaware.
This article is informative and does not represent legal advice. Before making any legal or financial business decisions, you should consult with a professional who can advise you based on your individual situation.