Since business is usually about numbers, most business documents contain mathematical formulas of one kind or another. Not surprisingly, formulas are often the most critical part of the document and carry the gravest consequences if misinterpreted or incorrectly drafted. In the linked document, I suggest some strategies for drafting formulas so that they are more accessible to the reader and less likely to be misinterpreted by someone tasked later with implementing the agreement. (I attached the Word document so that you can experiment with the formula editor, which is used in the examples.)
Top 10 reasons lawyers produce hard-to-read documents.
September 17, 2012 by Leave a Comment
The cynical view is that lawyers purposely make legal documents hard-to-read so that lay people have to rely on them to interpret and negotiate the documents. There may be a bit of truth to that, especially in former times, but I don’t think most attorneys intentionally make their documents difficult to read. There are many other valid reasons why legal writing is so obtuse. Here is my List of the Top 10 Reasons Lawyers Produce Hard-to-Read Documents:
Top 10 Reasons Lawyers Produce Hard-to-Read Documents
| 10 | Trade Guild Affectation | Discussed above — I don’t believe most lawyers make things complicated on purpose, but one can see a perverse incentive to do it. |
| 9 | Convention | It’s always been done this way, and lawyers haven’t been exposed to something better. |
| 8 | Esteem of Peers
|
Lawyers want to sound like other lawyers, so they will be respected. This is different from intentionally making the document difficult to read to protect a trade guild’s insularity. I once had a senior attorney reject my draft, not because of its substance, but because he said it sounded “like two people talking on a street corner”. He didn’t mean it as a compliment, but he should have. |
| 7 | Countervailing objectives | Securities disclosure documents and some consumer contracts have countervailing objectives – one purpose is to serve as a marketing document, but the other purpose is to be a record of full disclosure. |
| 6 | Experience | Lawyers get good at parsing long sentences with lots of nested qualifications and with the primary verb well-hidden near the end. (That is to say, they get good at reading bad writing). They also get familiar with the standard provisions in their specialty. |
| 5 | Expense | For efficiency, lawyers rely heavily on prior documents and industry templates as starting points. It would take quite a bit of time to redraft from scratch, and neither they nor their clients want to pay for it. |
| 4 | Fear | A lot of thinking and experience has gone in to prior documents. Lawyers fear that if they re-write a standard document they may miss a detail that matters. |
| 3 | Negotiated document | Because most contracts are negotiated, they are often the work product of multiple authors with different agendas and styles. Lack of coordination and last minute edits all contribute to hard-to-read documents. |
| 2 | Complexity | The subject matter is complicated, full of conditions that are qualified with exceptions that have provisos and further stipulations. |
| 1 | Unit of Truth Problem | The number one cause (in my opinion) of unreadable documents is, as legal drafting Guru Bryan Garner put it, “. . . the fear of qualifying a proposition in a separate sentence, as if an entire idea and all its qualifications had to be fitted into a single sentence.” Another plain English proponent, Howard Darmstadter, calls this the Unit of Truth Problem — lawyers think the unit of truth is the sentence, when in fact it is the whole contract. |
I believe the one thing that would make legal documents more readable is to cure lawyers of the Unit of Truth Problem. As I observed with Reason No. 9, legal matters are full of qualifications and exceptions. I see the following scenario over and over again. After rounds of negotiated changes, another exception or qualification is introduced. The drafter searches for another way to insert a a parenthetical phrase within a long, complicated sentence that already has multiple nested qualifications. It’s poor drafting, and the sentence becomes impossible to read without parsing it carefully. But not putting the exception within the same sentence causes the lawyer real angst. Because in the lawyer’s view, the sentence wouldn’t be true if the qualification doesn’t come before the period. Darmstadter, Garner and other plain English proponents remind us that the “Unit of Truth” is the whole contract. That it is perfectly acceptable for a later sentence to modify an earlier sentence. Of course, it’s poor drafting to bury a qualification in another part of the document, but it is perfectly acceptable to qualify a sentence by the one that immediately follows it, as in this example:
A claim for exemption, which in the case of filers who have reached their 75th birthday may not exceed $4000, must be filed on form AB-34 before July 13th each year.
Rewrite: A claim for exemption must be filed on form AB-34 before July 13th each year. Filers who have reached their 75th birthday may not file a claim for more than $4000.
If you are like me you had to read the first example twice to get its full meaning.
Here are some other ways to attack the Unit of Truth Problem:
- Condition readers early with sentences qualified by a following sentence.
- Bullet point and tabulate.
- Use “if – then” construction.
- Begin sections with an encompassing sentence that sets the stage for a collection of operative sentences. For example:
The conversion price of the preferred stock will be adjusted for dilutive issuances of new securities according to the rules set forth in this Section.
The whole goal is to produce legal documents that communicate effectively and efficiently. Prose is effective when readers understand the message. It is efficient when readers can understand the message the first time they read it without stopping and re-reading. Efficient writing may sometimes take up more space on the page than less efficient writing.
If legal documents are obtuse, clients simply don’t read them. Or they do their best to plow through them but can’t follow them. The underlying idea of a contract is that both parties reach a “meeting of the minds”. This is less likely to happen if both sides are relying on their lawyers to interpret the contract for them. It also puts the lawyer-client relationship at risk if there is ever a problem.
I aspire to follow the following principals in the documents I draft (you should encourage the same from your lawyer, and consider applying these principals to your writing):
- Keep average sentence length to 20 words, and vary the length (a well-written document should sound like the Gettysburg Address, which adheres to this principle)
- Break up long sentences with bullet points and sub-sentences.
- Use active voice over passive.
- Keep the verb towards the beginning of the sentence.
- Use active, rather than passive, voice.
- Avoid nested modifiers and parentheticals.
- Use if-then construction.
- Use tables if multiple ifs and multiple thens.
- Keep modifiers near the modified word.
- Avoid double negatives.
- Use will, must, and may rather than shall (shall can have at least two, contrary meanings)
- Write numbers one time, not two (2) times. (It seems to be a carryover from the days of handwritten form agreements. It’s not necessary, slows reading way down, and invites error.)
- Minimize definitions, avoid nesting them, and don’t define things away from their common meaning. (Classic example – Rule 506 says you can only sell to 35 “purchasers”. Rule 501(e) excludes “accredited investors,” usually the only purchasers, from the computation of the number of purchasers.)
- Use common language; avoid legalisms and jargon.
- Don’t use any of the following words:
- herein
- therein
- thereof
- such
- provided, however,
- shall
- thereby
- whereas
- therefor (but do use therefore)
Do the documents I produce reflect all of these principals? Unfortunately no, for many of the reasons in my Top 10 List. But I keep trying to improve, and as I get more advanced in my practice I have more control over my starting point when I draft. And I always welcome suggestions for better language in my documents.
So why post this article on a website primarily for clients? Because clients have the power to change legal drafting standards by demanding better from their attorneys. Better documents, faster, more efficient deals with fewer misunderstandings can start with you.
What is indemnification?
September 17, 2012 by Leave a Comment
If you are the indemnified party, an indemnification clause is simply a promise by the other party to cover your losses if they do something that causes you harm or causes a third party to sue you. The key words are “indemnify”, “hold harmless”, and “defend”. Indemnify and hold harmless mean the same thing — to make whole after causing a loss. The word defend relates to responsibility for defending from law suits, and isn’t present in an indemnification provision if the indemnified party prefers to defend its own lawsuits (although the indemnifying party may be required to pay for it).
Often, the indemnified party would ultimately be able to recover on the loss under another legal theory, such as breach of contract or tort. So the primary effect of indemnification in most cases is to shift the cost of defending third party claims to the indemnifying party. Even so, the indemnification provision is very useful for explicitly setting out the responsibilities of the indemnifying party. And if the indemnification clause provides that it is the exclusive way to recover against the indemnifying party, it is very useful for setting parameters around such things as the scope, maximum liability, and time periods when a claim may be brought. Indemnification provisions go hand-in-hand with insurance covenants.
Here is an indemnification clause from an Independent Contractor Agreement, with explanations in bold:
Contractor will, at its expense if Company requests, defend any of the following types of third party claims brought against Company or its directors, officers, or agents (collectively, “Indemnitees”): [If you are sued by anyone for any of the following reasons, the contractor will be responsible for defending you in court.]
(i) any claim that, if true, would constitute a breach of the Agreement by Contractor; [Since the claim is regarded as true, the contractor must defend you based on whether the allegations in the complaint would constitute a breach of the contractor’s agreement.]
(ii) any claim related to injury to or death of any person (e.g., worker claims) or damage to any property arising out of or related to performance of any Work; [If the contractor’s work causes anyone to by physically injured or killed, the contractor must defend the suit.] or
(iii) any claim that otherwise arises from the acts or failures to act of Contractor or its agents (including any claim that the Work Product infringes upon the rights of any third party) [If the contractor copies someone else’s code or the work infringes someone elses IP, and you get sued for it, the contractor would be responsible for defending the suit and making you whole.].
Contractor will indemnify and hold harmless the Indemnitees from any costs, damages, and fees (e.g., attorney fees and the fees of other professionals) reasonably incurred by any of them that are attributable to any such claim. Should the Work Product, in whole or in part, constitute an infringement and any use of it be enjoined or threatened to be enjoined, Contractor will notify Company and, upon Company’s request and at Contractor’s expense: (i) procure for Company the right to continue use of the Work Product, or portion of it, as applicable; or (ii) replace or modify the Work Product, or any portion of it, with a non-infringing version, provided that the replacement or modification meets all Specifications to Company’s satisfaction. If (i) or (ii) of the previous sentence are not available to Contractor, in addition to any damages or other remedies to which Company may be entitled, Contractor will refund to Company all amounts paid to Contractor for the applicable Work Product.
What is the difference between incentive stock options and non-qualified stock options?
September 17, 2012 by 1 Comment
Incentive stock options, or “ISOs”, are options that are entitled to potentially favorable federal tax treatment. Stock options that are not ISOs are usually referred to as nonqualified stock options or “NQOs”. The acronym “NSO” is also used. These do not qualify for special tax treatment. The primary benefit of ISOs to employees is the favorable tax treatment — no recognition of income at the time of exercise, and long-term capital gains versus ordinary income at the time the stock is sold. But in the typical exit by acquisition scenario, employees exercise their stock options and are cashed out at the time of the acquisition. In that scenario, since they sell immediately, they do not qualify for the special tax rates, and their stock options default to NQOs. So in practice, there tends not to be a material difference in the end between NQOs and ISOs. If emplyees are in a situation where it makes sense to exercise and hold (for example, if the company goes public), then the benefits of ISOs may be realized.
The discussion below is not comprehensive. Please consult your own tax adviser for application to your situation.
| Incentive Stock Options | Non-Qualified Stock Options | |
| Who can receive? | Employees only. | Anyone. |
| Requirements: | Must be issued pursuant to a shareholder- and board-approved stock option plan. | Should be approved by the board of directors and pursuant to a written agreement. |
| The exercise price must be no lower than fair market value at the time of grant. | If the exercise price is less than the fair market value of the stock at the time of grant, the employee may be subject to significant penalties under Section 409A, including taxation on vesting. | |
| The option must be nontransferable, and the exercise period (from date of grant) must be no more than 10 years. | ||
| Options must be exercised within three months of termination of employment (extended to one year for disability, no time limit for death). | ||
| For 10% (or more) shareholders, the exercise price must equal 110% or more of the fair market value at time of grant. | ||
| For 10% (or more) shareholders, the value of options received in any one year, cannot yield stock valued at more than $100,000 if exercised (value is determined at the time of the grant). Any amount in excess of the limit will be treated as an NQO. | No limit on value of granted options. | |
| Tax effect to Company: |
The company is generally not entitled to a deduction for federal income tax purposes with respect to the grant unless the employee sells the stock before the end of the requisite holding periods. |
Company receives deduction in year recipient recognizes income, as long as, in the case of an employee, the company satisfies withholding obligations. |
| Tax effect to Employee: | No tax at the time of grant or at exercise. Long term capital gain (or loss) recognized only upon sale of stock if employee holds stock acquired by exercise a year or more from exercise and at least two years from date of grant. | The recipient receives ordinary income (or loss) upon exercise equal to the difference between the exercise price and the fair market value of the stock at date of exercise. |
| But the difference between the value of the stock at exercise and the exercise price is an item of adjustment for purposes of the alternative minimum tax. | The income recognized on exercise is subject to income tax withholding and to employment taxes. | |
| Gain or loss when the stock is sold is long-term capital gain or loss. Gain or loss is the difference between the amount realized from the sale and the tax basis (i.e., the amount paid on exercise). | When the stock is sold, the gain is long term capital gain if held more than one year from exercise. The gain will be the difference between the sales price and tax basis, which is equal to exercise price plus the income recognized at exercise. | |
What is IR Code Section 409A?
September 10, 2012 by Leave a Comment
Caution: The discussion below is not comprehensive. You need to consult your own attorney as to the specifics of Section 409A and as it applies to your situation.
These days anyone involved with equity compensation will hear a reference to “Section 409A”. It is a reference to Section 409A of the Internal Revenue Code, part of the American Jobs Creation Act of 2004.
Employees and independent contractors participating in a nonqualified deferred compensation arrangement which fails to comply with Section 409A will be subject to:
- income tax on vesting
- an additional excise tax equal to 20% of the amount deferred
- interest on the underpayments if the tax on the deferred amounts is not paid when first includible in income at a rate equal to the underpayment rate at the time of vesting plus 1%.
Incentive stock options (“ISOs”) are exempt from Section 409A. However, one requirement of ISOs is that the exercise price at the time of grant is no higher than the market value of the common stock. So, if it is determined that the fair market value of common stock is greater than the exercise price at the date of grant, the option will not be exempted from 409A. Therefore, the steps necessary for valuing a nonqualified stock option are also applicable to incentive stock options.
The company may protect itself and its option recipients from the negative consequences of Section 409A by doing the following: (1) make sure that the exercise price is no less than fair market value on the date of grant, and (2) insure that the option does not include any other feature for the deferral of compensation other than deferral of recognition until the exercise or disposition of the option or, if the stock received on exercise is restricted, until the vesting of that stock. An example of a deferred compensation feature would be an option that allowed the employee at the time of exercise to elect to take cash amount equal to the option spread as deferred compensation over time. This would render the option subject to Section 409A.
With respect to setting the exercise price at fair market value, it is important to keep in mind that the board’s determination of fair market value must be defendable to the IRS (and in the event the company goes public, to the SEC, as discussed below). A simple board resolution stating the fair market value of the company is insufficient. The fair market value of private company stock or equity unit must be determined, based on the private company’s own facts and circumstances, by the application of a reasonable valuation method. A method will not be considered reasonable if it does not take into consideration all available information material to the valuation of the private company.
The factors to be considered under a reasonable valuation method:
- the value of tangible and intangible assets;
- the present value of future cash-flows;
- market value of similar entities engaged in a substantially similar business; and
- other relevant factors such as control premiums or discounts for lack of marketability.
There is a presumption that the valuation is reasonable if it is based on (a) an independent appraisal prepared no more than 12 months before the transaction date, or (b) a written report by a person “with significant knowledge and experience or training in performing similar valuations”. To rebut the presumption, the IRS must show that either the valuation method, or the application of the method, was “grossly unreasonable.”
These days, boards of directors of many venture-backed companies are relying on periodic formal valuations done by financial firms. That may not be a realistic solution for an early stage company. In such cases, the company can minimize its risk under Section 409A if it can find an adviser, CFO, or someone else who can qualify as someone with “significant knowledge and experience or training in performing similar valuations”. Often very early stage companies have developed some software code but have no sales, sales contracts, or significant value in their trademark. In such cases the reasonable replacement cost of the software code is one metric that might form the primary basis for the valuation.
What is a stock option?
September 8, 2012 by Leave a Comment
A stock option is a commitment from the company to allow the grantee (usually an employee) to purchase a certain amount of stock from the company at a fixed price (called the “exercise price”) for a certain period (typically up to 10 years from the date of grant). Shareholders own a piece of the company. Optionholders are not shareholders (yet). They own the right to purchase the stock at a given price by a certain time. Options are usually intended as an incentive to build the value of the company going forward. The exercise price does not change as the value of the company increases. So (hopefully) as the value of the company increases, the value to the employee will grow. If the value of the company remains dormant while the employee holds the option, then there is no significant benefit to the employee. Employee stock options are usually issued pursuant to a stock option plan approved by the board of directors and the shareholders. This is primarily because “incentive stock options” — stock options that are eligible for certain favorable tax treatment, must be issued pursuant to a shareholder approved plan. See What is the difference between incentive stock options and non-qualified stock options.
The grant and exercise of of stock options are subject United States and local laws, including tax and securities laws.
What is restricted stock?
September 8, 2012 by Leave a Comment
Restricted stock is stock that is subject to forfeiture to the company for no additional consideration or repurchase by the company at the original price paid, if any, until it vests. The number of shares of stock that are subject to forfeiture or repurchase at the purchase price decreases over time in a way that is similar to the way that options vest over time. Restricted stock is issued pursuant to a Restricted Stock Agreement with the company. Restricted stock is a form of stock award preferable to some recipients for tax reasons usually when a company has only been formed a short time. It is generally not available for most employees. Founders frequently take restricted stock. See Should founders take restricted stock?
What are anti-dilution protective covenants?
September 8, 2012 by 1 Comment
Anti-dilution protective covenants are commonly seen in preferred stock documentation. The purpose of anti-dilution covenants is to protect early investors in the event of a “down round”. A down round is when shares are sold for a lower price than that paid by investors in earlier rounds. Anti-dilution covenants are a contract requiring the company to issue more shares to early investors if the company sells shares to later investors at a price below that paid by the earlier investors. How many shares the earlier investors are entitled to depends on the formula in their anti-dilution covenant.
There are three basic types of anti-dilution formulas: full ratchet, broad-based weighted average, and narrow-based weighted average.
- Full ratchet — Puts shareholders in the same position as if they had made their invest at the new lower price. The conversion price is simply changed to the price of the down round. This formula can result in significant number of shares issued to earlier investors, and make it very difficult to rise capital later on. It was more common in the dot-com era, but not seen often now.
- Broad-based weighted average — See the formula below. This is the most common kind of anti-dilution formula, and is usually not objected to by later shareholders.
- Narrow-based weighted average — Usually yields a larger share adjustment than broad-based weighted average. It is seldom seen now.
Broad-based weighted average formula for preferred stock:
The new conversion price, NCP, for shares with the anti-dilution right in case of a down round, is calculated as follows:
NCP = CP x (CS + AC/CP)/(CS + AS), where
CS = Common stock outstanding before the down round.
AC = Aggregate consideration paid in the down round.
CP = Conversion price before the anti-dilution adjustment.
AS = Number of shares (on as-converted basis) issued in the down round.
To get a sense of how large an adjustment would be, the key term to consider is AC/CP. This is the amount of shares that could be purchased with the new consideration if the new shareholders were buying in at the earlier, higher price. Since CP is higher than that being paid in the down round, the term AC/CP, will be smaller than AS, the number of shares actualy being purchased in the down round. Since the fraction (CS + AC/CP)/(CS + AS) is less than one, NCP, the new conversion price for earlier class of stock, will be lower than CP, what it paid. Lower is good for earlier investors, because they will get more shares when it becomes time to convert their stock into common.
It is called weighted average, because the adjustment that early shareholders are entitled to is a function of shares outstanding and shares issued in the down round. Note that the size of the down round — AS — must be fairly large relative to shares outstanding, and there needs to be both a fairly significant difference between the original price and the down round price for the anti-dilution adjustment to yield a lot of extra shares to the earlier investors.
Narrow-based weighted average formula for preferred stock:
(This is one example, there are variations.)
The basic narrow-based anti-dilution formula is as follows (there are many variations):
The new conversion price, NCP, for shares with the anti-dilution right in case of a down round, is calculated as follows:
NCP = X1 + X2/Y1 + Y2, where
X1 = Aggregate consideration paid for shares in the earlier round.
X2 = Aggregate consideration paid for shares in the down round.
Y1 = Number of issued shares of the earlier round outstanding .
Y2 = Number of shares issued in the down round.
In this formula you can play around with the numbers to see that, holding the price of the down round constant, the adjustment will be relatively greater if the down round is larger.
Take a simple case where there are 10 shares outstanding that were purchased for $10 ($1 per share). Consider a down round for $0.5 per share, in Case 1, 10 shares are purchased for aggregate consideration of $5. In Case 2, 20 shares are purchased for aggregate consideration of $10. Case 1 yields an adjustment ratio of .67 , from [(10 +10)/(10+20)]. Case 2 yields an adjustment ratio of .75, from [(10 +5)/(10+10)].
Like I said, this formula is not commonly seen these days.
What is dilution? What is a fully-diluted cap table?
September 8, 2012 by Leave a Comment
Dilution refers to a decrease in an owner’s percentage interest in the company. If there are 4 million shares outstanding and you hold 1 million shares, that equates to 25% of the outstanding stock. If the company issues another 1 million shares, your percentage ownership drops to 20%, and you have been diluted 5%. Similarly, when stock options or warrants are exercised, existing shareholder are diluted.
A “fully-diluted” capitalization table shows, in addition to all outstanding shares, the number of shares (or units) issuable upon exercise or conversion of the contingent equity. Sometimes the exact number of shares can not be determined. For example, if the the number of shares issuable upon exercise of a warrant may be based on a formula, such as a percentage of gross sales. In such cases, a properly prepared fully-diluted cap table will have footnotes explaining the assumptions underlying the share numbers shown.
Also, with respect to employee stock options, there should always be a footnote on the cap table indicating which calculation is used, because there three possible meanings of “full-dilution” in the case of employee stock options. The three ways to record the the number of stock option shares, starting from largest to smallest, are: (1) the total number of option shares authorized by the stock option plan, (2) the total number of options currently granted, and (3) the total number of options currently vested. Number (1) is used most often and is the most conservative number for management to use. Number (2) makes sense if additional options are not likely to be granted for some time, but the cap table should clearly indicate that only granted shares are shown. Number (3) is rarely used, since options will continue to vest as long as employees stay employed, but in certain cases, for example when there is a long period before the next options vest, it may make sense to include an additional column in the cap table showing vested only options.
Sometimes the term dilution is used in reference to dilution of value, as opposed to dilution of percentage interest. If new shareholders are paying a fair price for their shares, then the value (as opposed to ownership percentage) of existing shareholders’ interests are not being diluted. In general, I would recommend not using the term dilution (or lack thereof) in this way, but you should be aware when others use it in that sense. See “What are anti-dilution protective covenants?“.
What type of entity should I choose, LLC, C corporation, or S corporation?
September 8, 2012 by Leave a Comment
Deciding whether you should organize as a C corporation, S corporation or limited liability company can soak up a lot of time and resources. Some founders may spend more time on this question than is warranted given the inability to know for sure how quickly your business will grow, how much and which type of outside investment will be required, whether cash will be reinvested or distributed to owners, or whether you will sell the Company or go public – all of which are part of the analysis. Tax rules are the primary source of the complexity, although management and liability issues under state law also make a difference.
Founders tend to fall into two categories when dealing with this issue – those that , with their lawyers and accountants, carefully analyze the various tax rules against their expected growth and exit strategy and try to make the best decision under uncertainty – and those that punt, opting to stick with the format used by most VC-backed technology companies (C corporation) and spend their time and energy on growing their business.
One reason venture capital firms generally will only invest in corporations because they usually have tax exempt investors who do not want to subject to unrelated business income tax (UBIT), which would be an issue with an LLC. Moreover, VC members may not want to file state tax returns, or, in the case of foreign investors, federal tax returns. VCs like some of the other advantages to C-corporations discussed below.
For those that want to dive into the analysis, I discuss the major differences between C corporations, limited liability companies, and S corporations in the second half of this article. Perhaps the best place to start the analysis is to understand why most tech startups are corporations, and to consider what makes your company different, if anything. If not, you may want to follow that model. Since the C corporation is the predominant entity form for tech startups, documentation has become fairly standardized for corporate governance, rights among shareholders, equity compensation, and capital raises.
The top level questions that will affect your choice of entity are these:
- Do you expect to take money from a Venture Capital firm or an institutional investor. In this case, you will need to be a C corporation, although you may be able to start life with an S election while you bootstrap and only convert if it becomes necessary.
- Will you be a typical technology company that will want to issue stock options to employees, raise capital through preferred stock, and expect a typical technology company life-cycle in which all surplus will be reinvested into the company (no distributions to owners) which is grown until the company is acquired or goes public, These factors would push you toward the C corporation form.
- Alternatively, will your company be operated for its cash flows over a long period of time, not necessarily managed for a public exit. In this case, a pass through entity such as an LLC or an S corporation may be preferable.
Those are the primary considerations. For those that want to dig deeper into the minutiae, what follows is a more detailed discussion of the differences between C corporations, S corporations, and LLCs (taxed as partnerships).
C Corporations. The biggest downside of corporations is that they are subject to double taxation. (The corporation itself is taxed on its profits, and shareholders are taxed when earnings are distributed to them.) However, the downside is diminished if the company intends to reinvest most of its surplus cash for growth. Moreover, the C corporation can accumulate net operating losses, which may offset profits in the future or have value to an acquiring corporation. C corporations can qualify for Section 1202 qualified small business stock, and for Section 368 tax-free reorganizations.
Limited Liability Companies. Technically, LLCs are disregarded entities in the eyes of the IRS. Under the Code, LLCs may elect to be taxed as a partnership, as a C corporation, or as an S corporation. When people refer to the tax treatment of LLCs, they usually mean an LLC that has elected to be taxed as a partnership. Taxed as a partnership, the LLC is a “pass-through entity” that is not taxed. The members are taxed according to the amount of profits that are allocated to them per the terms of the operating agreement. Allocations of profits and losses need not necessarily follow ownership percentages, they can be specially allocated per the terms of the operating agreement, although accounting and compliance gets more complicated when it does not. Investors can offset their other income from their share of LLC losses. Another advantage of partnership taxation is that appreciated assets can generally be distributed to partners/members tax free. (This can allow tax-free spin-offs of subsidiaries and other assets to the members.) Appreciated property (such as developed software, for instance) can be contributed to the LLC tax-free (without a “control requirement”). Lastly, redemptions of membership interests are a deductible expense to the LLC.
S-Corporations. Technically an S corporation is an election filed with the IRS, not a form of entity. LLCs, as well as corporations can be taxed as an “S corporation”. An LLC that makes an S election will be an S corporation in the eyes of the SEC, but it’s corporate governance matters will still be controlled by state law and the LLC operating agreement. Like an LLC taxed as a partnership, an S corporation is a flow though entity with a single layer of tax. S corporations convert easily to a C corporation. (Actually they convert automatically to a corporation if the company does anything to blow its S election, such as exceed 100 shareholders, accept a foreign shareholder, or issue preferred stock.) As with C corporations, Section 368 tax-free reorganizations are available.
An S corporation structure may result in the reduction in the overall employment tax burden. One difference between S corporation taxation and partnership taxation is that owners of LLCs can not be employees of the company. All member draws are subject to self-employment tax. With S corporations, owners may be reduce employment taxes by taking part of their income in salary (and paying employment taxes on that) and taking the rest of their income as a distribution. S corporation shareholders who are employees are taxed as employees and receive a Form W-2, not a Form K-1. As long as the salary is reasonable in the eyes of the IRS, the income taken as a distribution is not be subject to employment tax withholding.
Traditional stock options are available for S corporations, as long as the exercise price is a fair market value and doesn’t have any unusual terms that would cause it to be characterized as a another class of stock.
In summary , here are reasons you may choose one entity form over another:
C corporation because:
- Predominant model for tech start-ups (equity offerings and IPOs)
- VCs usually won’t invest in LLCs
- You will have foreign, corporate, or non-profit investors
- Retention of earnings/reinvestment of capital
- Qualified small business stock (Section 1202)
- Section 368 tax free reorganizations available
LLC (taxed as partnership) because:
- Single level of tax
- Flow through entity that allows: multiple classes of units, foreign members, over 100 members
- Investors can use operating losses
- Business will be operated for cash flows
- Tax-free distributions of appreciated assets
- Tax-free contribution of appreciated property without “control requirement”
- Special allocation of tax attributes (such as specific gain, loss, income or deductions)
- Redemption of partnership interests are deductible expenses of the LLC
S corporation because:
- Simple flow through entity with single level of tax
- Easy to convert to C Corporation
- Can minimize employment taxes
- Investors can use operating losses
- Business will be operated for cash flows
- Traditional stock options are available (as long as exercise price is at market value)
- Section 368 reorganizations available
But, S corporations are limited to 100, domestic, non-corporate shareholders, one class of stock. Shareholder redemptions are not deductible. Lack of ability to allocate profits, losses, attributes other than pro rata.