Debunking Blocker C-Corps

December 4, 2015

Douglas BaldasareDouglas Baldasare is the founder and CEO of ChargeItSpot. ChargeItSpot saves consumers from their dying phone batteries while driving consumer into retail stores, increasing shopper dwell and driving sales for retailers. The company has built a proprietary engagement platform to connect one-to-one with each consumer who charges their phone.

Our startup, ChargeItSpot, has raised $4.5+ million in funding over the last three years, all while keeping our status as an LLC. Common knowledge dictates that VCs won’t invest directly in an LLC, so what’s the secret? The Blocker C-Corp, an underappreciated and underused entity that I think benefits both founders and venture capitalists.

Choosing your legal entity (LLC, C-Corp, S-Corp?) can be a confusing decision for founders. More often than not, ambitious founders establish their startups as C-corporations because they operate under the assumption that VCs will require them to convert into a corporation before receiving any VC funding. It’s a common mistake that costs entrepreneurs upwards of 30 percent of the after-tax proceeds from an exit from an asset sale.

Imagine your startup is on the path to success and you sell your company for $100M. Assume the founders own 50 percent of the company and the transaction is a sale of the company’s assets — not stock — which is fairly common for deals of this size. Now, as founders, what do you take home after tax?

  • Scenario A: Your company is a C-Corp. When you sell your company, you pay federal ordinary income tax of 39.6 percent. For the founders, the after-tax proceeds from the sale of the company are $30.2M (50 percent x $100M, minus 39.6 percent tax).4

  • Scenario B: Your company is an LLC. Your exit is taxed at a long-term capital gains rate of 20 percent, which yields after-tax proceeds of $40.0M (50 percent x $100M, minus 20 percent tax).

    (Note: I have ignored state and local tax, which varies by location and is typically even higher for a C-Corp than the rate on flow-through income for an LLC.)

    So what does this mean? As an LLC, the founders walk away with $9.8M more cash in their pocket than if they were formed as a C-Corp. That’s a whopping 32 percent difference! In other words, for a founder of a C-Corp to achieve the same payout, they’d have to have owned over 66 percent of the business (compared to 50 percent under the LLC entity).

The Blocker C-Corp Solution

When VCs invest in a startup, they can elect to form a C-Corp investment vehicle around the LLC operating company, which is aptly named a Blocker C-Corp. If the investors were going to own 20 percent of the company, now the Blocker C-Corp owns 20 percent of the company. All of the different investors own their proportionate share of the Blocker C-Corp.

We’ve established that LLCs benefit the founder, but what about the VCs? Why aren’t they investing in LLCs? I’ve broken down the 5 most common reasons VCs have given startups for not investing in their LLC, along with why I think they don’t matter:

1. “W