Everyone loves a “Cinderella Story” that begins with a scrappy team of tech-savvy founders and evolves into the next Apple or Google. But that doesn’t happen overnight. A successful technology business starts with a great idea, passion and an entrepreneurial spirit, but ultimately takes planning and strategy beyond the tech side of the business to bring it all together.
Whether you define success as taking your company public through an initial public offering (IPO), scaling your business to sell for a meaningful return on investment, or somewhere in between, you can most effectively set your business up for success by being proactive in a few key areas during the earliest years of operation.
There are various factors to consider when forming a legal entity for your tech business, and all can make a difference in the success of your resulting company. Specifically for a growth-stage company in the process of raising capital, there are pros and cons to keep in mind when evaluating becoming a C corporation, LLC, S corporation or partnership.
Pros
A C corporation is easy to form and provides owners with liability protection. It is the most widely used structure for a company raising institutional capital, primarily because institutional investors generally do not want income or losses passing through to them. Additionally, there are no limitations on the types of shareholders that can exist within a C corporation. It can take years before your company becomes profitable, and C corporation status allows net operating losses to be carried forward and may be available for monetization upon a liquidity event.
Cons
However, be aware of limitations under Section 382 of the Internal Revenue Code, which limits the amount of losses you can deduct for tax purposes. Additionally, if your company was originally structured as an LLC (taxed as a partnership), there are potential tax consequences to be aware of when contemplating a conversion to a C corporation. Some of those consequences include whether or not any outstanding debt is greater than the LLC’s basis in its assets, if any LLC members held unvested capital interest without having filed a Section 83(b) selection, and whether the value of the LLC is greater or less than the defined distribution hurdle associated with any outstanding profits interests at the time of conversion.
Pros
Despite the positive attributes of C corporations, it is not uncommon for founders to establish their businesses as LLCs. An LLC is very easy to form and there are no limitations on the types or number of investors (if taxed as a partnership). The liability protection and pass through of income can be seen as “the best of both worlds.”
Cons
However, when considering pass through of losses, the losses may not be deductible if there is not sufficient basis at risk. Additionally, losses cannot be monetized upon a liquidity event, contrary to a C corporation. Perhaps the biggest con of an LLC structure is the fact that, as mentioned above, institutional investors do not typically like the pass through of income or losses. Therefore, this can significantly limit your company’s ability to raise a meaningful round of equity capital.
Pros
Because S corporations are taxed like partnerships, this structure allows you to avoid the double taxation that you would have with a C corporation, in which the company itself is taxed on earnings and individual shareholders are then also taxed on their dividends received.
Cons
S corporations limit the types and number of investors you can have under this structure. You cannot have more than 100 shareholders and a shareholder cannot be a corporation, partnership or non-resident alien. Additionally, S corporations are only permitted to have one class of stock, and all contributions and distributions must be proportionate to the shareholders’ ownership. These limitations generally preclude companies from using this structure, knowing that capital fundraising — and often numerous investors — is crucial to the growth of the business.
Pros
Similar to S corporations, partnerships pass all earnings on to the partners, thus avoiding double taxation.
Cons
Partnerships generally do not protect or limit liability for owners in a meaningful way. In addition, the complexity of partnership allocations is burdensome. For these reasons, start-up companies typically do not use this structure when fundraising.
In addition to entity structure, building an effective company infrastructure is also important to your success. In particular, focusing on the accounting function — from personnel to software systems and everything in between — is another series of decision points and will evolve with the growth of your business.
At the earliest stages of your company’s existence, namely through a round of Seed funding and perhaps through a Series A round, you likely won’t need to invest in much beyond basic bookkeeping. Most accounting activity will be primarily recording cash activity and relying on outside accounting advisers for any complex activities. Many start-ups outsource this service to a qualified third-party bookkeeper.
By the time your company has reached the growth stage, typically at least a Series A round of funding, it is likely time to invest in hiring an internal controller with more experienced accounting skills. This employee may also perform some CFO-level tasks, such as treasury and capital management. Someone who has background in your company’s industry and experience working with auditors can also be very helpful.
Eventually, you will need to hire a CFO, which may start as a part-time role and grow to full-time as the company experiences sustained revenue growth. Among other tasks, a CFO oversees the controller and other accounting personnel, manages treasury and capital functions, participates in audit and board functions, and eventually helps the company prepare for a liquidity event.
Ultimately, as the company’s founder, it is not advisable to try to perform the accounting function yourself. It takes your time away from the more important value you add to the company’s growth.
Similar to hiring, your accounting software may likely evolve over time as your company scales its growth. Some base level systems include QuickBooks (or QuickBooks Online), Xero and Sage Cloud. Eventually, it may become necessary to upgrade to an Enterprise Resource Planning (ERP) System, such as NetSuite or Microsoft Dynamics GP. Regardless of software choice, there are some additional software products that can be useful to maintain certain schedules, ranging from simple Excel to SaaSOptics. Revenue recognition for Software as a Service (SaaS) companies can be one of the most complex topics to account for, so using an appropriate software to automate revenue recognition schedules can be invaluable.
Overall, when evaluating different accounting software products, some key considerations include cost, ease of use, scalability/complexity, revenue recognition tracking, project time and billing tracking, inventory tracking, budgeting and forecasting, growth and volume projections.
Creating a rigorous control environment begins early, including creating step-by-step process narratives to document the following transaction cycles, as applicable:
When documenting these procedures, it is important to identify the key controls in place and to ensure they are operating effectively throughout the lifecycle of the company. Indicators of a key control include how a transaction is:
Effective controls help deter against fraudulent activity and help identify/prevent errors and omissions. Additionally, this provides both management and investors with confidence in the financial statements and allows for making better financial decisions. Ultimately, when you are ready to take the company through a liquidity event, the internal control environment is a focal point of due diligence and strong controls can help support a higher company valuation upon liquidity.
The considerations above are initial areas to evaluate with your advisers. Once you’ve created the proper structure to set up your company for success and your business begins to scale, you will undoubtedly encounter questions about how to properly account for complex transactions along the way. We’ll cover more of those advanced topics in future articles.
Contact Kaitlin Mansfield at kmansfield@cohenco.com or a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.