Debunking Blocker C-Corps

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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. “We can’t have flow income because of our LPs.”

VCs have steered away from investing in LLCs because LLCs generate gains and losses that would pass through to a fund’s investors (Limited Partners or “LPs”). Many LPs are 501(c)(3) nonprofits (e.g., university endowments or pensions). For these LPs, the flow-through income creates what’s called “unrelated business taxable income” or UBTI, which can trigger significant tax penalties for the LPs. But when a VC elects to form a Blocker C-Corp, it shields the LPs from flow-through income and completely eliminates any tax consequences typically generated from UBTI.

2. “It costs too much money and is a pain to administer.”

The average cost to set up a Blocker C-Corp is roughly $5,000. Compared to how much the VC is investing (typically, millions) and the difference at time of exit (many millions), this cost is negligible. And it’s not a pain to administer. Under either a C-Corp or a Blocker C-Corp, the company must record minutes at board meetings – so we’re indifferent on that point. In my estimation, there are an additional five hours per year in administrative accounting time for the VC to manage a Blocker C-Corp. At a healthy accountant rate of $300/hour, this totals $1500. Again, negligible. Heck, most founders would even be willing to foot this bill.

3. “With a Blocker C-Corp, there is less oversight over the startup.”

This is just false. In the same way that investors would hold a board seat in a C-Corp, investors hold board seats in the LLC’s Board of Managers. The only difference is the wording. Both boards have the exact same flexibility and can be structured identically.

4. “You have to be a C-Corp to go public.”

Not entirely true. Even if it becomes a requirement, the LLC can convert into a C-Corp on the eve of the IPO. Sure, it would be an expense but a minor one given the financial scale of an IPO. Also, with IPOs at a historic low in our country (from 2001 to 2011, the total number of small businesses going public plummeted 80 percent according to several sources, according to Inc.), this excuse is simply no longer relevant.

5. “Shareholding employees of LLCs know too much.”

This is a very minor concern. VCs are often worried that employee shareholders will know too much because, as “LLC members,” employee shareholders would be required to receive regular shareholder updates that contain sensitive company information. Even so, if the company structures employee ownership as options, the employees do not become members until they exercise those options and therefore are not privy to such sensitive company information. In my experience, 95 percent of employees do not exercise options until the time of a company sale.Unfortunately, the predominant reason that VCs resist Blocker C-Corps is simply because of inertia. Others in their industry do not do it, and so the status quo perpetuates. Since when is it a good idea to resist logical progress and financial gain because of status quo? Entrepreneurship is all about embracing change. Should we stay nestled in our C-Corp corner of comfort? One thing you always hear VCs say is that they see themselves as value-add partners for founders and that they want the founders to be incentivized with enough of a stake in the company. What better way to add value and incentivize founders than with direct, incremental cash in the pocket of the ambitious entrepreneurs?

(This article by Douglas Baldasare was originally published on Huffington Business)