- Forms. The holy grail of cheap legal fees is standardized forms. VCs have their own contract forms for investments in C-Corporations and they want to keep it that way. It is more efficient for them to use their own forms: their lawyers can get through them and the VCs can review them quicker than if they used some unknown forms. Using a different entity would force them to rewrite their forms, which would cost them money. And, VCs are notoriously cheap and demanding of their lawyers. (Not that that has been my experience, of course; every VC I’ve dealt with has been a peach.)
- Standards. Preferred stock preferences, dividends and tax treatment issues are knowable, known and standardized.
- ISOs. Corporations can issue stock options with tax advantages, like incentive stock options. Other entities can’t issue incentive stock options.
- K-1s. If VCs bought equity in LLCs, they would have to deal with all the K-1s. K-1s are the tax year reports issued to owners of pass through entities. People who get K-1s have to integrate them into their tax returns, which costs headaches and tax preparation fees. But, ownership of stock in a
C-Corporation has no impact on the owner’s personal tax return until there is a sale or dividend, which, let’s be honest, the VC controls. - Exit. A C-Corporation is primed for the IPO. And the VC’s entire business model is built around smooth exits out of the investment.
Anyone disagree or have something to add?
July 20, 2011
@profitandlaws
5 Reasons Venture Capitalists Demand a C-Corp http://dlvr.it/bvrGX
July 20, 2011
Dan White
VC’s usually cite these reasons. If the fund has tax-exempt or foreign investors, the VCs also don’t want to invest in an LLC because it causes the fund to incur income that the fund is typically contractually obligated to avoid (unrelated business taxable income (UBTI) and effectively connected income (ECI)).
To the VC, I do have a response to items 3 and 5 as relates to the typical exit strategy.
ISOs usually arent exercised until liquidated in an exit. [If exercised earlier, its by former employees anyway] In our experience, the vast majority of exits are taxable sales to a strategic or private equity buyer. In that case, there’s minimal tax benefit to the employees for having ISOs over any other kind of corporate equity compensation.
If the company were an entity taxed as a partnership (LLC), you can grant profits interests in the LLC, which have many of the benefits of ISOs and more (which I think you discuss elsewhere). Because of implementation complexities, profits interests may not be the best solution for rank-and-file equity compensation plans.
The other advantage is that in a taxable exit, a buyer may be willing to pay more for an LLC than a corporation. This is because the buyer generally is able to amortize the purchase price (e.g., “step-up” the assets to their fair market value) in an LLC purchase but typically not in a stock purchase. If the buyer anticipates sufficient taxable income and the target’s sole valuable asset are intangibles (goodwill, patents, and the like), the present value of this tax benefit could be up to 20% of purchase price. I’ve seen academic studies that indicate that sellers successfully bargain for more than half of this amortization benefit.
Just one tax lawyers view on this topic.
July 21, 2011
Dan White
Another thought on item #5. A very popular trend in IPOs these days is to make the IPO a taxable asset sale and then share the tax benefits of that basis step up with the selling shareholders. The economics generally only work if the company going public is a pass-through entity like a partnership (LLC), S corporation, or the 80%+ owned subsidiary of another corporation. It can also work if the IPO company has big net operating losses but there sure needs to be a lot of them relative to the valuation.