This is the third and final post in a series that address differences between C corporations, S corporations, and LLCs. The first post focused on taxation differences between the entities. The second post focused on ownership and governance structure differences. This post focuses on fundraising and employee compensation differences.
Fundraising
C Corps.
● Separate Classes of Stock. Most institutional investors favor C corps because they may have separate classes of stock, allowing for the creation of various levels of protections, preferences, and share valuations.
● Easiest for Public Offering. A C corp is also the easiest type of entity to finance in an initial public offering.
LLCs.
● Not Suitable for Venture Capital. LLCs may be attractive to businesses financed by a small number of corporate investors and / or individuals, however, they are often not suitable for companies planning to attract venture capital or pursue multiple rounds of funding.
● Agreements Difficult to Structure with Many Investors. LLCs require complicated operating agreements that may render the operation of the LLC undesirably difficult with a high number of members. An LLC will often have to define the rights of any new class of stock in a financing, and this may involve complex provisions in the LLC agreement and more cumbersome disclosures to prospective investors.
● Unattractive to Tax-Exempt Investors. LLCs may be unattractive to tax-exempt investors because their investment in a flow through entity may produce unrelated business taxable income.
● Customization Breeds Unfamiliarity. Finally, investors simply may be less familiar with LLCs and therefore less willing to invest in them.
S Corps.
● Unattractive to Tax-Exempt Investors. S corps are not a popular entity choice because they present the same challenges to tax-exempt investors as those presented by LLCs.
● Limited to One Class of Stock. S corps are limited to one class of stock (meaning no preferred stock financings) and 100 stockholders. Such inflexible features are typically unattractive to institutional investors.
Employee Compensation
C Corps.
● Easily-Structured Stock Options. Businesses that plan to use equity incentives (e.g. stock options) to attract and retain talent often prefer to operate as C corps.
● Incentive Stock Options. C corps can offer incentive stock option plans that allow employees to defer tax on the equity compensation until they sell the underlying stock.
● Tax-Deductible Fringe Benefits. C corps may offer certain fringe benefits to employees that are tax-deductible to the company and also tax-free to the employee.
LLCs.
● May Reward Membership Interests. An LLC may reward employees by offering them membership interests in the entity, though the equity compensation process is awkward and may be unattractive to employees.
● Limited Compensation Permissible. LLCs are not able to offer certain forms of equity compensation available to C corps such as incentive stock options. It is very complex for LLCs to issue the equivalent of stock options to their employees, and although they can more easily issue the equivalent of cheap stock through the issuance of “profits interests,” the tax accounting for a broadly distributed equity incentive plan in an LLC can be very complex and costly.
S Corps.
● Limitations with Foreign Employees. Although S corps can grant stock options, they should not be granted to non-U.S. residents.
● Limitations with Fringe Benefits. S corps are less flexible than C corps with regard to fringe benefits and must either report the benefits as taxable compensation to the employees or forfeit the fringe benefit deduction available to the company.