Why High-Growth Startups Need Customized Business Planning
High-growth startups usually have some combination of the following characteristics, identified by Peter Thiel in Zero to One:
- Proprietary Technology. Proprietary technology makes it difficult for competitors to replicate the product.
- Network Effects. The product becomes more useful as more people use it.
- Economies of Scale. The business gets stronger as it grows. The potential for scale is built into the business design.
- Branding. The business creates a strong, powerful brand.
The business plan for a high-growth startup involves raising capital, reinvesting heavily in the business, growing fast, granting equity incentives if needed, and cashing in on the investment through a successful exit (through being acquired or going public). This business plan distinguishes high-growth startups from other businesses that plan to become profitable early, earn money over time, and distribute surplus profits to owners.
A high-growth startup may—at least theoretically—bootstrap its way to success without seeking outside funding. But most high-growth startup founders are more interested in accelerating growth and capturing market share quickly. These founders almost always look to VCs to provide the financial backing needed to quickly and successfully validate and scale the business.
Because high-growth startup founders will eventually share business equity with VCs, they must consider VC requirements when deciding whether to form a corporation or LLC. Although VCs are gradually warming up to the LLC form, most VCs require startups to be organized as C corporations.
Why VCs Prefer to Invest in C Corporations
Absent VC requirements, most founders would form LLCs to provide enhanced liability protection, avoid double taxation, and provide operational simplicity. But although pass-through entities like LLCs provide the most legal protection and tax efficiency for the founders, most VCs will not invest in startups that are structured as pass-through entities.
VCs think of the choice-of-entity decision differently than founders. VCs look for big wins—high-growth startups with market validation that need capital to scale. They tend to focus on the big payday—the liquidity event that allows them to cash out on winning investments—not the legal and tax structure of the business during its initial growth phase.
Because VCs are focused on the exit strategy, they are less concerned with the tax and legal consequences to founders of startups that fail to yield the returns they are seeking. In other words, VCs are more interested in choosing an ideal structure for their winning investments than optimizing the business structure to provide better legal or tax planning for the founders. This focus on the exit strategy is reflected in explanations that VCs and their attorneys offer to explain their preference for C corporations over pass-through entities.
Pass-Through of Income Causes Problems for Certain VC Investors
LLCs that are taxed as partnerships pass income through to the investors. The pass-through of income can cause tax problems for two types of investors:
- Foreign Investors. Foreign investors are not generally subject to U.S. income tax, as long as they do not conduct a trade or business within the United States. Although receiving dividends from a C corporation is not an issue, a pass-through of income from an LLC can result in effectively connected income that treats the foreign investor as engaged in a U.S. trade or business, subjecting them to U.S. taxes that they would not otherwise pay.
- Tax-Exempt Investors. Although tax-exempt investors do not pay income tax on income relating to their exempt purpose, they are taxed on income that is unrelated to their purpose. This income is called unrelated business taxable income or UBTI. Dividends from C corporations are not considered UBTI, but a pass-through of ordinary income of an unrelated trade or business is taxable UBTI for tax-exempt investors.
To avoid triggering unnecessary taxes and reporting obligations for these investors, many venture capital fund agreements prohibit investment in entities that pass income through to the investors.
Angel investors may also object to pass-through tax treatment. Many affluent investors in high tax brackets want to control the timing of their receipt of income so that they can plan out their taxable year. The ability to time the receipt of income is lost with a pass-through entity, which automatically passes income through to the owners in the year it is earned.
Double Taxation Is Not Really a Concern for High-Growth Startups
Many VCs believe that the perils of double taxation are overblown. They often cite three factors that mitigate the risk of double taxation in the early years of the startup:
- C corporations are only taxed if they earn income. VCs expect their investments to produce a loss in early years—and perhaps even beyond—so the threat of taxable income is not a significant factor.
- Because the corporation will produce a loss in the early years, there are no surplus earnings to distribute. Taxes on shareholder distributions are not a big concern.
- Once the startup becomes profitable, net operating losses from earlier years can offset the taxable income. Any profits above the carried-over losses are taxed at a low 21-percent rate.
These three factors provide relief from double taxation for early-stage startups. Once the startup is successful, most VCs plan to sell their stock to cash out on the investment. In the ideal scenario—which we describe in the C Corp Startup Strategy—the liquidation event will be a tax-free sale of qualified small business stock. In that scenario, the ability to cash in on the investment through a tax-free sale outweighs any potential double taxation during the startup’s early years.
The Loss Pass-Through Benefit of LLCs Do Not Interest Venture Capitalists
Most startups operate at a loss in the early years. Pass-through entities pass losses through to their owners, who can then use the losses to offset other income. While the ability to deduct business losses may appeal to many owners, VCs tend to discount the value of loss pass-throughs. There are a few reasons for this:
- VCs tend to be optimists that expect their investments to perform well. They are less concerned with benefiting from losses from poorly performing investments.
- As a practical matter, the passive-activity loss rules of Internal Revenue Code § 469 prevent many investors from benefiting from loss pass-throughs.
- Because C corporations can carry losses forward and deduct them against future income, the tax benefit of the loss is not eliminated, only deferred until the corporation becomes profitable.
- Reporting losses on their tax returns could open VCs up to reporting requirements in multiple states.
Instead of looking for losses to report on their tax returns, VCs prefer to allow the losses to accumulate within the corporation and deduct them later, once the corporation earns a profit. This preference may conflict with the goals of founders, many of whom would prefer to use pass-through losses to reduce taxes on their current income.
The Corporate Form Provides More Familiarity and Predictability
While VCs may not be risk-averse when it comes to investments, many are less adventurous when it comes to choosing a form of business. Choosing a Delaware C corporation provides VCs with a familiar body of law that has been tested in the courts, a set of organizational documents that have largely been standardized, and access to a pool of attorneys and tax advisors familiar with the corporate business model.
Although LLCs can be structured to provide many of the same benefits as corporations, some VCs view this flexibility as a two-edged sword. LLCs allow novel organizational structures, but they also require significant legal expertise to draft an operating agreement to support those structures. The standard corporate documents provide less flexibility but also less complexity. Many VCs prefer the familiarity of using the same basic deal documents across their investments.
C Corporations Have Better Equity Incentive Options
Many high-growth startups depend on incentive equity to attract qualified talent and grow the business. Although LLCs taxed as partnerships may issue profits interests as incentive equity, profits interests do not cleanly match the corporate-style incentive model that VCs are familiar with. Many VCs prefer to rely on stock options and other corporate forms of incentive compensation.
The Wait-and-See Approach to Entity Formation
If seeking outside investment is a nonnegotiable part of the startup’s business strategy, forming as a C corporation can help with fundraising. But that would require a firm decision. Due to the high tax cost of operating as a C corporation, founders should not form as a C corporation just in case they need to attract outside funding. They should only form a C corporation if they know they will look for funding from outside investors.
In the early stages of a company, the founders may not know whether they will need to seek outside funding. Many prefer to keep their equity by bootstrapping the business to success. Others may want to operate for some time to validate the idea before deciding. The wait-and-see approach to entity formation provides an attractive alternative for many founders. It allows founders to start as an LLC with the option to convert to a corporation later. Starting as an LLC provides a more flexible entry point for these founders, allowing them to choose their tax structure as their needs evolve. It preserves the option to bootstrap the company to success and ultimately distribute operating profits to themselves. If the need arises to convert to a C corporation, LLC-to-corporation conversion can be done at a relatively low legal and tax cost.