As a founder, you may have a fresh company concept and be prepared to commit your time and money in its development. Now the time has come to register it to the authorities in order to comply with all the necessary requirements before massive growth beggins.
The founder’s objective is to select the one that fits the business strategy, but in most cases any entity can work fine and there is no one correct answer to this question.
The most important reason why you need to get this right is because of your investors: different types of entities mean they’ll receive a different kind of legal and fiscal treatment in the eyes of the IRS, or their local tax and revenue offices. As it is important to them, it should also be important for you.
Every business entity, when registered, exists as its own “person”, separate from the founders, and can do things like purchase and sell items, hire people, engage into contracts, acquire debt, own property, and so on. The company’s rights and obligations are confined to its own assets and liabilities, and the shareholders are not responsible for them (except in extraordinary circumstances).
If you are reading this at the Lazo website, it means that your interest is definitely in VC. So we’ll focus on the two most attractive types of companies for you: LLCs and Corporations.
An LLC is an agile and simple corporate vehicle. Startups who have their operative company in LATAM tend to choose it especially as a Holding Company when they are raising money outside the US, due to some fiscal facilities that investors find attractive.
From the legal point of view, LLCs and Corporations are not too different: An LLC may issue Preferred Membership Units with similar rights and advantages as preferred stock (issued by Corporations) and both can be held (owned) by people, corporations and other business organizations.
The big difference begins here: on the fiscal side, many businesses are founded as LLCs because they are “pass-through” organizations. What does this mean? That the company is not taxed individually. Instead, the owners must pay the company’s tax directly on their personal income tax return. This is particularly important to understand for your investors.
This is the reason why, while an LLC may be appropriate for many Private Equity investors, US Venture Capital firms sometimes avoid them. This “pass-through” mechanism may oblige them to declare the company’s losses to the fund’s investors and it will also require foreing investors to file a US tax return. As all these may cause some discomfort and mistrust, and flash a yellow light in your due diligence.
Also, there are certain additional costs connected with LLCs that should be addressed as part of your entity selection choice.
If you are looking for Venture Capital investment in the United States, a Corporation may be the ideal option for you. As they appeal to a bigger range of investors, many firms (and most large organizations) are established in this way.
Corporations can be structured under two different kinds: C-Corps, listed in the IRS code under section C, and S-Corps, listed under section S.
C-Corps are often favored by US Venture Capital funds since they can issue Preferred Stock and have other corporations as shareholders or investors. Also, as they are more formal, they meet higher requirements and regulations, like the ones necessary to be a publicly traded company. They may also be more expensive to run than other types of business organizations, but if you aim to exit through an IPO, you should know that creating a C-Corp will be a necessary step along the way.
Their major disadvantage is the possibility of an adverse tax treatment. Corporations pay taxes on their profits at the end of the year (reported on the company’s income tax return), and when dividends are distributed to the shareholders, they may also have to pay taxes on the distributed amount on their personal filings. This is often referred to as “double taxation”.
There are ways to minimize the “double taxation” exposure for a while, but as the company expands, the shareholders may find it unavoidable.
In fiscal terms, an S-Corporation, like an LLC, is a “pass-through” company. However, they are somewhat restricted since the number of shareholders they may have at any given time is limited, and there are certain types of institutions that are not allowed to own S-Corps. Furthermore, they may only have one type of share, known as common shares. These characteristics may be acceptable for a Friends and Family round of financing, but they are usually not advantageous for other kinds of VC or Private Equity rounds.
Finally a very important thing to note is that S-Corps can only be held by US residents.
Broadly speaking, if you have your operative company in Latam and are considering fundraising outside the US, you may consider an LLC as your most convenient type of entity. And if along the way you decide (or an investor insists) that you change to a Corporation, the procedure is quite simple and often not prohibitively expensive. On the other hand, if you think you’ll be fundraising in the US, you should most probably consider a C-Corp.
But, as mentioned above, there is no correct answer. So we advise you to consider all options and talk to an expert before you make a decision. If you are thinking about incorporating in the US, contact us so we can tell you more about how to do it!