Selecting a business entity is one of the first things that an entrepreneur has to do when they decide to take their idea and forge ahead to build a business from it. Although there are several different common entity types most founders choose from, we’ve highlighted two of the most popular in this video – the Corporation and the Limited Liability Company.
Let’s get some terminology right first. While “Company” refers generally to any business, a “Corporation” is a specific legal entity type designated by each state. Corporations have owners, called “shareholders”, who have certain minimum statutory rights by law and can have additional rights in the Corporation’s Articles of Incorporation and/or Bylaws. Within corporations, founders can create different tax elections that designate it as either a “C Corporation” or a “S Corporation”.
The C Corporation is the most common entity choice for high-growth businesses that intend to raise outside investment capital. C corporations are also allowed to issue different series and classes of shares. This allows the board to create shares with different sets of rights and preferences, which is almost universally required in angel and venture capital financing transactions. On the other hand, C Corporations are subject to “double taxation”. This means that income taxes are paid both at the corporate level and at the individual level when dividends are paid out.
S corporations are really just an IRS designation. Basically, an S corporation is a legal entity in that is taxed as a partnership but is otherwise generally treated like a “mini” C corporation. An S corporation is limited to 100 shareholders. S corporations are also limited in that they can only issue one class of stock and shareholders must be individual U.S. citizens or permanent residents.
Some businesses elect to be treated as S corporations for as long as possible so that they can have most of the benefits of the C corporation structure without the burden of double taxation, and without the hassle of converting from an LLC to a C corporation at some point in the future.
The limited liability company (LLC) is relatively new form of business entity (new to the legal world, which means it’s about 30 years old in most states). It combines several desirable aspects of the C corporation, but also provides pass-through taxation structure like a partnership. Like a corporation, a limited liability company provides legal protection for founders’ personal assets in the case that a judgment is ever made against the LLC.
Early-stage startup founders will sometimes start their businesses in the LLC form because it is simple and quick to set up, but most will have to convert to a C Corporation when the time comes to raise capital through angel and venture investors. For founders of businesses who know they are not going to raise outside investment capital and who do not plan to compensate their employees with equity, the LLC is often the best choice because of its flexibility and pass-through taxation scheme.
Ultimately, the type of entity that you choose as a founder is an important initial step, but it can always be changed in the future if needed.