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hey everybody welcome to startup basics it's your host Jason Calacanis you know me as the host of this week in startups and you know one of the things that we like to do on this program is try to help startups like it's kind of the whole mission of the launch festival in this week in startups and I get asked the same questions over and over again so I actually had lunch with my good friend here Todd carpenter from Wilson Sonsini WS gr and we've known each other for a decade or so a long time working with Steiner startups and Rachel you've been at the firm for over a decade over a decade as well Rachel profit and so we just talked about okay what do we do why we do a series where we answer like every question so then we can just send people to that link and at least get them through the basic question so that's what we're doing here at startup basics we're like 10 questions out of 20 that we're going to do and so I asked Rachel and Todd to come and answer one that I have made so many mistakes on in my career and gotten bad advice and now that I'm 20 years into my career I think I know how to do this right but this is the question of what type of corporation should I make should I make an LLC an S corp or a C Corp and now there's even this B Corp thing which I guess we could get into too but let's just start with if I'm starting a company in Silicon Valley like it's a tech startup I'm not talking about building a pizzeria you know or consulting primitive I'm going to start a tech company what should I do S Corp C Corp or LLC easy short answer is C Corp right Delaware C Corp why and what is the difference between these three types so that is the right answer and twice in my career I did an LLC and an S Corp because I had like rank e dank attorney is like mom-and-pop shops or telling me like oh do LLC do s because you can get this savings or that savings but what's the difference between each one well I would say to begin with that they may have given you the right advice for the particular company I think the the point is that it's very company specific so you want to set up the right entity for the right corporation the right company that you're working on for the right business the biggest difference if you look at the LLC of is the escort versus the c-corp the LLC and the escort bar flow through tax entities which means that you can avoid a level of corporate tax escort and a c-corp are largely the same other than the tax treatment and a filing that you need to make with the IRS to elect affirmative ly to be an escort got it and so if you're doing a mom-and-pop shop that's when people tend to do these LLC's or smaller companies like s quiz S Corp stand for small or no it's just an election under the tax code yeah Ashley needs being small it doesn't actually mean small cuz somebody told me it's some way to mean small company I was like really no it doesn't actually mean that no and it doesn't have to be a small business it could be it's just there are restrictions on what types of shareholders in the number of shareholders that you can have in an S corp so it's prohibitive to do that if you're going to be a Silicon Valley company yeah I mean every single company in Silicon Valley is a secret right I'd say for the most part I mean and we end up dealing with a lot of founders that come in and say I've been in S corp I'm an LLC and I have a term sheet but one of the conditions to getting funded is in fact that we go through a conversion process so we spend a lot of time counseling folks who probably got advice similar to yours yeah I want to be like a normal look like everyone else C Corp and what does that process like of like actually changing it it's expensive isn't it can be we're chatting about this today we're going through a couple of these with some clients right now I mean they can be cost per head really expensive sometimes really if you're just running in a seed financing sort of circumstance right you want to raise fifty thousand hundred thousand bucks like you pie don't want to spend exorbitant of money converting yeah the sooner you do it in your corporate lifecycle the easier right there's less contracts to think about less tax consequences to evaluate maybe need less of your accountants time to figure it out and they're not impossible but they can be complicated and expensive now when you want to shut one of these companies down what about that process because that's something I've had happen as an angel investor where I was an angel investor in an LLC or in an S corp or even a C Corp and then nobody shuts it down and I'm getting notices or somebody says they did shut it down and I'm getting notices why is shutting these things down so hard and how does that work well it's largely hard because there if you do it properly there's a lot of statutory procedure that you have to go through to get it done and it's large designed to protect the people the creditors of the company and the the jurisdictions in which the companies do business or are formed because there are franchise taxes owed so you need to jump through all those hoops of making sure you paid all your taxes that you paid all your creditors and so there is a this whole process that you have to go through it's not super challenging it's just a lot of Hoops to jump through so oftentimes because there's the the shield of liability when these companies are early-stage you'll see entrepreneurs that basically just turn the lights off and walk out the problem with that is for years and years to follow you're going to get these notices from the state and if you're the only credible guy that's left standing it may well come to your address and that's really frustrating for folks yeah that has been frustrating for me like literally I had some things where we sold companies to AOL or whatever I'm still getting these things and I'm like can we just shut this down and then I wind up having to pay a small fee or whatever to finally shut them and just to stop getting the mail let's talk about the big work because I invested in one hand up is a great company that we invested in that is helping homeless people by building profiles of them on the web where they can basically communicate and what they need in their life whether it's dentures or a place to live and then get donators and serial donators we give a little bit each month it's really working wonderfully but it's a B corporation and this to me as an investor I had a really hard time trying to figure out what this is because I'm investing but it's not a non-profit so they make a profit but there's a benefit so what is this it's interesting you say that you're probably on the cutting edge of investors willing to entertain this yeah are exactly that reason so it's been around for a little while yeah I think adoption rates have been low for exactly that reason because you know the principle is set out in many jurisdictions to allow a public benefit corporation which basically means companies get to focus on something in addition to just the bottom line right may not necessarily be just to maximize profit we may also want to d
Thanks for your comment Renita Kivett, have a nice day.
- Kareen Keitsock, Staff Member
the great thing about an llc particularly one that elects to be taxed as a partnership which is what they generally elect to be taxed as is there something called a pass-through entity so cheers yeah so a pass-through entity means it's a tax issue and it means that the entity itself doesn't really exist as a tax paying entity i'm oversimplifying it but nothing happens it doesn't pay taxes it doesn't pay taxes it just all trickles up too it all triggers right okay and so this one as a founder as soon as it's like this is not only legal but it's also tax oriented i think my eyes start to glaze totally oh no this totally yeah and and the reason why you know people would hear that and say okay wait a minute so the entity isn't paying taxes or isn't involved in this sort of tax scheme instead it all gets pushed back to the owners okay that sounds bad why would the owners want to pay tax this seems like a bad thing well the reason why this is actually a good thing is that in the early days the company's probably losing money and so instead of those losses belonging to the company the losses come back to the united states if you made money it goes against the money you made that's right that's exactly right and you can use it to be highly beneficial and it is it can be very attractive from that perspective to be an llc particularly in the early years when you're losing money some of these companies always lose money until they sell you know losing losing losing and so and then you personally never have to pay taxes exactly that's pretty cool yeah i mean it so that can be that can be really attractive with the corporation it doesn't work like that okay the c corporation is that the distinguishing feature between the c corp and the it is a it's a big distinguishing feature between the two um c corporations have what's called double taxation that doesn't sound good at all it doesn't sound good at all so this isn't an issue so much for the losses part but on the profits part it can come into play where the corporation has to pay taxes and then whatever's left it pushes out to the owners and then the owners have to pay taxes so the company makes money and it gets taxed for that profit yep and then it wants to distribute that profit to the investors or to the individuals and then we get taxed again that's right and that doesn't sound very good at all that's right so my default would be i'd like to rather just have the llc and have it just come straight out and get the text one time yeah why is that not always the case no and we can and and that sort of generalization of pass-through taxation versus double taxation is you know at a high level works and so you hear that and you're like give me the pass-through piece yeah as an llc i get losses and then even when we start to get to a profitable place or maybe when we sell the company it's only one level of taxation rather than the c-corp thing where i don't get to use losses and it's two levels of taxation why would i ever want to be a c corporation um given that the other piece to layer on this that people tend to talk about with llc's is there's a notion that llcs are more flexible that c corporations have you know they have officers they have a board they have stockholders you're supposed to have meetings there's a sense that there's more formality there llcs don't have to have that okay um they're what we call creatures of contract whatever you and i want it to be we can make a video yeah it's a whiteboard and you can design the governance structure to fit what you wanted to design or what you want it to fit and that can be attracted to a lot of people so that's the llc archimonde okay and a lot of people will come to the table and say that um passive taxation good double taxation bad right flexibility good not flexibility bad no-brainer right and a lot of us work that way for a long time in fact you know um believing believing that logic a couple things have happened um one thing with c corporations that's really attractive and not to get too deep into this tax well but there's something called section 1202 don't drink too deeply qualified small business stock oh no what okay yeah acronym qsbs oh no yep i'm gonna need some more simplified if you hold qualified small business stock which virtually every startup company's stock is okay if you hold it for over five years you pay no tax when you sell that stuff it's a huge incentive for investors incentives yeah and that's not the case with ls and for founders okay oh for founders too interesting yes so yes for five years older for five years okay now if you're an investor or a founder in a in a c corp correct then you don't have to pay taxes after five years um that's a big deal that's a big deal and that doesn't apply to llcs okay and the one point for c corp that's right and a lot of people will argue that that tax benefit outweighs those other issues we discussed earlier yeah pass through nice um single layer of taxation nice oh look at that see the benefits of a founding team that's why you don't want to be a solo family that's great right you need someone else yes um but there are a lot of people who will say if you do the math that 1202 savings is profound yeah and i mean from a complexity standpoint is it a lot harder to make a c corp than another no why do people team i guess the reason not anymore not anymore it's not and the reason is is it more expensive no it's not it feels like it was like a hundred a couple hundred dollars for a delaware sequel so versus like 70 so that's and that's a fair point so founder's achievement most people right and that's it's a very good point most people will push you to be a delaware corporation whereas with llcs there's not as much of a bias towards a certain state that's fine right and people do that all the time and and i think that generally holds true so that's right you can be an llc in ohio or kentucky or michigan or you know missouri or wherever for a hundred bucks for 200 bucks to be a delaware c corporation you got to pay delaware probably 500 yep and you have to pay something to the state where you live okay so you know instead of paying a hundred dollars maybe it's 700 but then it's 30 taxes that's right on five years of profits that's right it's a pretty it seems like from an roi standpoint it seems like it's worth it that's exactly right interesting so the 1202 piece is big um another another piece that's it's really important to keep in mind is there is a cultural element at play here okay you know and you've seen this which is the bias that institutional venture capital in particular has for c-corporations why is that part of it is they themselves and when you say institutional you're saying a venture capitalist venture capitalists vcs vc from a force that's right they like c-corps because they are passive entities you know they themselves are okay and because of that they have certain challenges in investing in other pass-through entities so it's hard for vc to invest in an llc okay because stuff keeps passing through and without getting into the details of it it creates they get stuff
Thanks Coy your participation is very much appreciated
- Kareen Keitsock
About the author
I've studied sociology of gender at Birmingham-Southern College in Birmingham and I am an expert in positive psychology. I usually feel annoyed. My previous job was radiologic technologist I held this position for 22 years, I love talking about golfing and electric guitar. Huge fan of Forrest Fenn I practice vault and collect non-sports trading cards.
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