If you’re thinking about starting a tech startup that you already know – there are many things to consider. The legal structure is one of those important factors for building a business, and it has a significant impact on whether or not you will be successful.
Most SaaS, AI and IoT enterprises are corporations. But what if a tech startup uses the LLC structure? Why should a founder entertain the idea? However, there is no denying the many benefits a corporation offers.
This article examines all the major business structures and highlights the significant benefits of each, and that of LLCs in particular.
LLC vs Sole Proprietorship and General Partnership.
SaaS, AI and IoT companies are capital-intensive startups; It’s nearly impossible to get your startup off the ground if you run it as a sole proprietorship or general partnership.
And it’s not just because of the lack of liability protection, though it’s an important factor in attracting investors. As a sole proprietorship, your sources of investment are minimal, often limited to only family members and a few close friends.
Even when your family and friends are investing in your business – the investment amount is usually quite small. Most sole proprietorships remain small businesses. If your goal is a tech business with massive plans – significant investments are required.
Not to mention that sole proprietorships are less reliable from an investor’s point of view, and reliability is an important factor driving investments. In short, forming an LLC gives you a position to attract investors. Business setup platforms like IncFile have also made this process easier and more efficient for businesses.
Investors are driven by the need to minimize risk and maximize returns. But sole proprietorships and general partnerships do not have the requisite structure to allow this. For one, they have no liability protection. Furthermore, they can issue neither stocks nor bonds.
LLC vs Corporation
Compared to corporations, LLCs can be more flexible with investors and investments. As members, investors can choose to be part owners or only directors of the company.
In addition, investors are attracted to LLCs because they can enjoy a flexible tax regime. Unless the LLC itself specifies otherwise, the company’s profits and losses are passed on to the members (owners and investors) in proportion to their contributions to the company.
And even though the LLC is legally required to report its revenue, profits and losses, it does not have to pay corporate income tax on the profits.
When you compare this with corporations, where investors are taxed twice as much (first, the corporation is taxed, then shareholders receiving dividends are also taxed), you find that LLCs are much more are flexible.
However, it is worth noting that some corporations (S-corps; others are called C-corps) may have a special status that exempts them from corporate taxes. Lower tax rates allow LLCs to be more flexible with finances.
However, most institutional investors (for example, venture capital groups) ignore this structure, and in fact, prefer to invest in corporations because of the protection from issuance of stock.
While LLCs cannot issue stocks, they can sell bonds to investors. Bonds, which are technically a type of loan, can help a business raise the funds needed to grow the business.
long term strategy
No founder wants to start a business that only lasts a year or two. A primary consideration in building a tech startup is long-term strategy in accordance with the owner/founder’s goals, especially with regard to exit.
If a founder’s goal is to grow the business for a period of time and exit the company either by selling, through merger/acquisition, or through an IPO, a corporation (C-corp) structure may be best. Corporations tend to perform better at the opening of their IPOs, and they can receive tax benefits through Qualified Small Business Stocks (QSBS) alone.
However, as every founder agrees, the path to startup success is never clear from the start. Therefore, early exit may not be on the table in the beginning. Many founders prefer to maintain significant control over their business.
However, as a corporation, the business is effectively in the hands of the investors, and the founder can also be sidelined in making important decisions. Even if you have a long-term exit strategy, keeping your business as an LLC protects your interest as a founder for as long as you want.
Thus, starting your company as an LLC and then later converting it into a corporation as the company grows may not be a bold idea.
Conclusion
Note, however, that it shouldn’t be a hard rule that all tech startups in SaaS, AI, IoT, and the like must start as corporations.