Why Do VCs Prefer C-Corporations?

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Life Science Startup Funding: Why VCs Prefer C-corps

It’s common knowledge that some angel investors, venture capitalists, and venture capital firms prefer to invest in businesses organized under Subchapter C of the Internal Revenue Code, or C-corporations, commonly referred to as C-corps. Why is that?

In this article, we’ll explore these preferences and why raising capital from VCs and other investors can be “easier” as a C-corp. But first!

A Brief Review About Business Entities & Incorporating

In the early stages of company formation, you make a decision, as an entrepreneur and founder, about which type of business entity you will form. This choice of entity has an immediate and lasting impact on you and the business, especially concerning the pursuit of venture capital (VC) and your exit strategy (whether you plan on going public through an initial public offering, being acquired through a merger and acquisition, or being bought-out).

Many companies choose to form a limited liability company (LLC). Or, they decide to form a corporation and elect S-corporation status. Both of these business structures are treated as pass-through tax entities, meaning the business does not pay income taxes. Instead, the income taxes pass through to its shareholders, or owners, who then pay the tax. LLCs can elect to be taxed as a corporation, however, which changes the way in which they are taxed.

On the other hand, C-corps are subject to double taxation, where the business is taxed once at the corporate level and again at the shareholder (owner) level. This double taxation is seen as disadvantageous to some business owners.

However, this business entity is much more organizationally attractive to potential VC and angel investors, whose limited partners are often 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.

C-Corps are “Easier” to Invest In

Because of these various factors, most VCs are unwilling—or possibly unable to—invest in any other type of business entity other than a C-corp.

As a life sciences startup founder, securing investments from outside investors—particularly venture capitalists—can be challenging if you choose the “wrong” business entity. And if your goal is to operate as a high-growth startup, getting others to invest in your business is perhaps the best way to achieve it.

So, startups beware: if it’s at all likely you will want to secure investments from a prospective venture capitalist (also VC) forming a C-corporation is encouraged. That said, if you don’t choose to organize your business this way initially, you can—through a somewhat difficult and potentially expensive process—make the switch. 

This article is informative. It is not meant to represent legal advice. Before forming a business entity, it is best practice to speak with a lawyer or law firm who has a track record in startup and venture capital.

Why Do VCs Prefer C-Corps over LLCs and S-Corps?

Why do VCs invest in C-corps rather than LLCs or S-corps, or any other business entity for that matter? 

C Corps and LLCs shield members and shareholders from liability, and LLCs aren’t themselves subject to the federal corporate tax rate. So, why do the vast majority of new businesses intending to seek venture-funding form as C Corporations?

There are a number of reasons, three of which stand out:

Preferred Stocks

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.

Legal Flexibility

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.

Taxes

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

Should You Form a C-Corporation or Make the Switch?

Starting a life sciences company and immediately organizing the business as a C-corporation is typically recommended for founders who wish to use fundraising to fuel fast growth, using the money secured venture capital investments to expand operations and scale up. Further, you most likely will have a general exit plan in mind, whether it be to IPO or get acquired. The corporate structure of C-corps is simply more ideal for this type of strategy.

The many founders who don’t initially choose to go that route, instead forming an LLC or electing to be categorized as an S-corp? They 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, initially choosing to form a C-corp has numerous benefits, and saves you from a serious headache later on. And 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.

At Excedr, we aim to bring you high-level information regarding the life sciences and the intersection of science and business. However, before making any legal or financial business decisions, you should consult with a professional who can advise you based on your individual situation.