If you’re thinking about starting a tech startup you already know — there are a lot of things to consider. The legal structure for business formation is one of those critical factors, and it has a significant impact on whether you will succeed or not.
Most SaaS, AI, and IoT enterprises are corporations. But what if a tech startup uses the LLC structure? Why should a founder entertain this idea? That’s not to deny the numerous advantages that a corporation offers, though.
This article examines all the major business structures and highlights the significant benefits of each, and particularly LLCs.
LLCs vs Sole Proprietorships and General Partnerships
SaaS, AI, and IoT companies are capital-intensive startups; it is almost impossible to get your startup off the ground if you run it as a sole proprietorship or a general partnership.
And this is not only due to lack of liability protection, though it is a significant factor attracting investors. As a sole proprietorship, your investment sources are minimal, often limited to only family members and a few close friends.
Even when you have family and friends investing in your business — the investment amount is generally quite small. Most sole proprietorships remain small businesses. If your goal is a tech business that has plans to scale — significant investment is required.
Not to mention that sole proprietorships are less reliable, from an investor’s point of view, and credibility is a significant factor driving investments. In essence, forming LLC positions you to attract investors. Business setup platforms like IncFile have also made this process easier and more efficient for businesses.
Investors are driven by a need to minimize risks 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. In addition, they can neither issue stocks nor bonds.
LLCs vs Corporations
In comparison to corporations, LLCs can be more flexible with investors and investments. As members, investors can choose to become part owners of the company or only directors.
More so, 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 to members (owners and investors) in proportion to their contribution to the company.
And even though an LLC is legally required to report its revenues, profits, and losses, it does not have to pay corporate income taxes on profits.
When you contrast this with corporations, where investors are doubly taxed (first, the corporation is taxed, then the shareholders are taxed too when they receive dividends), you find that LLCs are much more flexible.
Although, it is worth pointing out that some corporations (S-Corps; the others are called C-Corps) may get a special status that exempts them from corporate taxes. Lower tax rates allow an LLC to be more flexible with finances.
However, most institutional investors (venture capital groups, for instance) don’t mind this structure, and they, in fact, prefer to invest in corporations due to protections from issuing stocks.
While LLCs cannot issue stocks, they can sell bonds to investors. Bonds, which are technically a type of loan, can help the business raise required funds for business growth.
No founder wants to start a business that would only survive for one or two years. One primary consideration in creating a tech startup is the long-term strategy, per the owner/founder’s goals, especially regarding exit.
If a founder’s goal is to grow the business for some time and exit by selling the company, through merger/acquisition, or through IPO, then the corporation (C-Corp) structure might be the best. Corporations perform better on their IPO openings, and they alone can receive tax benefits via Qualified Small Business Stock (QSBS).
However, like every founder would admit, the path of a startup’s success is never clear from the beginning. So, an early exit might not be on the table initially. Many founders do like to retain significant control over their business.
However, as a corporation, the business is effectively in the hands of the investors, and the founder may even be sidelined in crucial decision-making. 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 wish.
As such, it might not be too bold an idea to start your company as an LLC and then transform it into a corporation later as the company grows.
Note, though, that it shouldn’t be a hard rule that all tech startups in SaaS, AI, IoT, and the likes must start as corporations. Definitely not.
Instead, founders should carefully examine their unique contexts and use the business structure that best supports the company’s growth.
This article has simply shown that LLCs help you gain many benefits and can supercharge your startup growth journey as a founder.
LLCs are often regarded as a hybrid of sole proprietorships and corporations, and that’s for a good reason. As a founder, explore all your options to play your cards right.