|Choice of Entity for a Venture Capital Start-up: The Myth of Incorporation |
Daniel S. Goldberg*
*Professor of Law, University of Maryland School of Law; University of Rochester, A.B., 1968; Harvard Law School, J.D., 1971.
Most tax professionals would advise entrepreneurs to commence their start-up business as a limited liability company (LLC), which, absent an election, is treated as a partnership for federal tax purposes. That advice reflects the notion that tax considerations are among the most important in choosing an entity form, and LLCs offer the advantages of partnership treatment yet provide the limited liability of corporations.
In the high-tech start-up industry, however, entrepreneurs are often advised to begin business as a corporation, albeit sometimes an S corporation if the entity can qualify. This advice is based largely on several perceived operating advantages which are either more easily achieved by or require the corporate form.
Most important of these perceived advantages, perhaps, is the need for the corporate form to achieve the most sought after exit strategies of a public offering or a tax-free acquisition by a public company, sometimes referred to as the "home run" exit strategies. Another perceived advantage of the corporate form is its facility to allow for stock options to employees, giving them additional work incentives through compensation that does not deplete the start-up company's cash resources. Another commonly perceived corporate advantage lies in satisfying the desire of investors to invest in corporations rather than other types of entities. These investors may be early stage investors, sometimes referred to as "angel investors" or simply "angels," or later stage investors, sometimes referred to as "venture capitalists." Venture capitalists sometimes form investment funds with several participating investors, called "venture capital funds." Finally, advisors appear to view the tax advantages of LLCs as more theoretical than real, neither of great magnitude nor importance to any of the participants in the venture.
This article asserts that advisors who advise immediate incorporation are relying largely on myths that the corporation, rather than the LLC, is the more desirable entity for a start-up seeking venture capital funding. This article will review briefly the most important federal tax advantages enjoyed by the LLC over the corporation and then set forth, examine, and debunk the myths of incorporation.
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