Before raising equity, founders need to know whether the company is organized the way investors expect. For many startups the choice comes down to a C corporation or a limited liability company (LLC). This guide explains how the two differ, why many equity investors prefer one, and when the other can still make sense. It is general information, not legal, tax or investment advice. Entity choice depends on your facts and should be made with an attorney and a CPA.
The basic difference
Both entities separate the business from its owners and generally protect owners from personal liability for company debts. They differ in how they are taxed, how ownership is recorded and how they are governed.
The LLC
By default, an LLC is a pass-through entity for federal income tax purposes. The company generally does not pay federal income tax itself. Profits and losses flow through to the owners, called members, who report their share on their own returns. Ownership is expressed as membership interests or units, and the rules are set out in an operating agreement, which can be written with a great deal of flexibility.
The C corporation
A C corporation is taxed as a separate entity. It pays tax on its profits, and shareholders pay tax again if those profits are distributed as dividends, which is often called double taxation. Ownership is divided into shares of stock, and the company is governed by a board of directors, with a certificate of incorporation and bylaws setting the rules. The structure is more formal, but also highly standardized.
C corp vs. LLC at a glance
- Taxation: an LLC is pass-through by default, while a C corporation is taxed at the company level and again on dividends.
- Ownership: an LLC has membership units, while a C corporation has shares, often split into common and preferred.
- Governance: an LLC runs on an operating agreement, while a C corporation has bylaws and a board of directors.
- Employee equity: an LLC generally uses profits interests, while a C corporation commonly uses a stock option plan.
- Typical investors: LLCs are common in closely held businesses and real estate, while venture funds usually expect a C corporation.
Why many equity investors prefer C corporations
Venture funds and many angel investors are used to C corporations, and much of early-stage financing is built around them.
- Preferred stock is the standard instrument of an equity round, carrying rights such as a liquidation preference. Corporations issue separate classes of stock in a familiar, well-tested way. An LLC can create similar rights in its operating agreement, but each one is drafted differently and takes longer to review.
- Stock option plans are routine for corporations, including incentive stock options, which are generally available only to corporations. LLC alternatives such as profits interests are often more complex to administer and less familiar to employees.
- Common early-stage documents, such as SAFEs and convertible notes, are generally written with corporations in mind, so less time goes to negotiating structure.
- Some fund investors avoid pass-through income. A fund's own investors may include tax-exempt organizations and foreign investors, for whom income from an operating LLC can create tax or filing complications. Many funds prefer not to hold pass-through interests, and some fund agreements restrict it.
There is also a cash issue. LLC members can owe tax on their share of profits even when the company distributes no cash to cover it. Investors who expect a company to reinvest everything for growth often prefer to avoid that.
Why Delaware is common
Many companies planning to raise from institutional investors incorporate in Delaware, even when the team is based elsewhere. Delaware has a well-developed body of corporate law, a specialized business court known as the Court of Chancery, and a long record of decisions that lawyers and investors know well. That predictability can make review faster and documents more familiar.
Delaware is common, not required. A Delaware company operating in another state generally must also register in its home state, which means filings, fees and taxes in more than one place. Companies not planning an institutional raise often find their home state works well.
When an LLC can still make sense
The preference for C corporations is strongest among venture-backed companies. Many other businesses raise capital as LLCs, and for some the LLC is the more natural fit.
- Closely held businesses that expect to distribute profits to a small group of owners, where avoiding a second layer of tax can matter more than investor familiarity.
- Real estate ventures, where pass-through treatment and flexible allocations of income and losses are standard, and investors often expect an LLC or a limited partnership.
- Companies whose investors want pass-through treatment, so that income or losses flow to their own returns, subject to the tax rules that apply to them.
- Businesses that do not plan to raise from venture funds or grant options broadly, where the flexibility of an operating agreement is an advantage.
The useful test is who your likely investors are and what they are used to.
Converting later, and why timing matters
Many companies start as LLCs and convert to C corporations before a priced equity round. This is a common step, and there is more than one way to do it, such as a statutory conversion or a merger into a new corporation. The right method depends on your state and tax position, and is a choice for your attorney and CPA.
Timing matters. A conversion takes time and legal work, and doing it in the middle of a raise adds one more task to a full schedule. Membership units become shares, any profits interests have to be addressed, and the cap table has to be rebuilt to match. Some tax outcomes can also depend on when the conversion happens and what the company is worth at that point, which is one reason many advisors prefer to address it early.
Founders also hear about the qualified small business stock rules in Section 1202 of the Internal Revenue Code, which can provide favorable federal tax treatment for gains on certain C corporation stock that meets specific requirements. Whether they apply to you is a question for a tax advisor.
Moving in the other direction is harder. Converting a C corporation into an LLC taxed as a partnership is generally treated as a liquidation for tax purposes, which can create tax at both the company and the shareholder level.
Making the decision with your advisors
Entity choice touches tax, governance, employee equity and the investors you can approach, so it belongs with an attorney and a CPA working from your actual facts. It helps to arrive with clear answers to a few questions.
- Who you expect to raise from, such as venture funds, angel investors, lenders or a small group of private investors.
- Whether you plan to offer equity to employees and advisors, and how broadly.
- Whether the business will distribute profits to its owners or reinvest them for growth.
- What has already been issued, including units, profits interests, SAFEs or convertible notes, and what documents exist for each.
Formation documents, the operating agreement or bylaws, and records of every equity grant are also items investors typically review in diligence. Our guide to the documents to prepare before you raise covers that list in more detail.
Preparing for your raise
If you are preparing for a raise and are unsure whether your company is set up the way investors expect, SugarTime can help you get the pitch deck, data room and company structure ready before you meet investors. Start your application.