Beginning stage of every business is termed as "the startup phase", and this term is increasingly being reserved for a narrower category of high-growth ventures. In the digital era, this concept of business is known as "startups". A variety of businesses can be considered startups if they have certain characteristics. Usually, the founder is looking to grow the business quickly. In the meanwhile, they are required to show user growth, revenue growth, or a proof of concept with the help of capital from angel investors or early-stage venture capital firms.
A lean stage of constant growth is also driven by reinvestment before a founder's exit. The venture is kept lean by not taking dividends or a big salary. After a few years, the business plan is to cash out for a heavy return.
A Delaware corporation which is taxed as a C-Corp is sometimes preferable and adaptable to venture capital and angel investing over other forms of business entities. Frequently these Delaware corporations have 10,000,000 shares of common stock authorized with $0.0001 per value and about half of the shares granted to founders.
Additionally, to provide the owners with limited liability, Delaware corporations can be vital to protecting a future investment because they are preferred by angel investors and venture capital corporations.
The main purpose of choosing Delaware Corporation is for its laws which protect investors. As a result, legal professionals and capital investors have always been comfortable with the Delaware laws and procedures governing these entities.
Subchapter-C Corporation is suitable for most startups. That is why most startups have extended times of losses which can be “rolled forward” every year to offset future profits. Most of the startups face years of loses until they reach a tilting point where scale turns into profit. When profits are made, they are reinvested in the business and not distributed as dividends to shareholders. Accordingly, the tax paid is a relatively low corporate tax rate and no personal income tax by the shareholders. Other S-corporation and partnership tax regimes “deem” profits to be distributed and taxed as personal income. The consequence of using an LLC taxed as a partnership or an S-Corporation is a higher effective tax rate than a C-Corporation for a business looking to reinvest in itself.
What will happen if you are not at the point of seeking venture capital investment?
It is the best decision to form a simpler LLC or partnership and then converting it to a C-corp later when you are ready, which will be deemed a tax “reorganization”. It can be helpful for simplicity at the initial stage of the business and can be converted later when funding is sought if the investor does not want the LLC form of business.
In the hypothetical event when you have an LLC taxed as a disregarded entity, partnership, or S-corporation you will give up the benefit of being able to reinvest in the business at a lower and effective tax rate. If you are willing to grow quickly and expect losses and funding from outside angel investors or venture capital, then incorporating a Delaware corporation taxed under Subchapter-C can be your best decision.
When you are going to form a startup, you need to secure your business’s sources of capital and likelihood of losses and possible exit options to come further down the road. Therefore, a careful choice of entity and tax election can be helpful when positioning your startup for growth.