Startup founders eat hard decisions for breakfast – and one of their very first snacks is to choose the most suitable legal structure for their company.
Once upon a time, startups planning on raising money from venture capital firms used a C-Corp structure, and it became a standard for US-based startups. But as time went on, we learned they're not really the best course of action for Latin American companies with no operations in the land of the free. At least when we're talking about the very fun chore of paying taxes.
So, investors had no choice but to be flexible in accommodating different sets of circumstances in each startup. Even with that flexibility going on, the way you set up your business from a legal and tax perspective still impacts how likely you are to secure investment.
We all know that building a profitable venture-backed startup requires investors to visualize its true potential, and investors don't want to see the value created going to waste because of a mistake when you structured your startup.
Ok, so you already know what hard decision you'll be having for the next breakfast. The problem is that there's barely any guidance for the specific needs of Latin American startups' when it comes to company formation. Look no further – this comprehensive guide about C-Corps and LLCs is focused on LatAm founders, just like you.
A C Corporation (C-Corp) is a legal entity that serves as an intermediary layer between the business's operators and owners – who may or may not be directly involved in operations.
The C-Corp is notorious for its "double taxation," meaning 1) the owners are responsible for paying personal income taxes on earnings from dividends or the sale of C-Corp shares, and 2) the C-Corp is responsible for paying yearly corporate income taxes.
C-Corps organize their equity in the familiar structure of shares. That's why they allow for liquidation preferences, easy setup of stock option plans (ESOPs), and exits through initial public offerings (IPOs).
A Limited Liability Company (LLC) is a type of organization made up of members, not shareholders. Each of these members pay taxes on a portion of their personal income.
As you might have just noticed, the LLC is fundamentally different from a C-Corp in the way it organizes its equity. Its ownership stakes are divided into membership units instead of shares.
This type of tax structure is also known as a "pass-through" because, in practical terms, the company itself owes no corporate taxes – fiscal responsibility is passed on to the individuals behind the business.
The C-Corp and the LLC structures differ greatly from one another, and they each have their corresponding Internal Revenue Code tax treatment. Here's a quick overview of the differences:
When assessing startups for investment opportunities, prospective angel investors and venture capitalists will pay close attention to the different tax features of C-Corps and LLCs. This can ultimately determine whether or not your startup survives.
When we map all of those differences to reality, a C-Corp’s core advantage revolves primarily around the idea of a very successful company that is either not planning an exit at all or committing to an Initial Public Offering (IPO) as the only viable option. A C-Corp's taxation circumstances operate on the assumption that the business will be very profitable someday, which, while it's good being ambitious, is not necessarily a realistic proposition for every startup.
On the other hand, the most commonly cited disadvantage for an LLC is the different equity structure. But get this: LLCs can still provide equity-based compensation and liquidation preferences even when they lack stock or shares to distribute. Sure, it will demand more effort, but there are several configurable and versatile alternatives for doing so with the help of a trusty lawyer.
Startup founders often use a C-Corp structure to prepare for an IPO. But unless you're planning to go public in the next 12 months, that might be a bit of an overkill at the current stage. An LLC can be easily converted to a corporation later on without necessarily having tax implications, but the opposite conversion would be much more complex in case an IPO is not in the cards for you.
In some cases, you may want to skip the idea of a C-Corp entirely by starting with an LLC and later setting up a tax-optimized corporate structure like the Cayman sandwich, adding a holding company in the Cayman Islands on top. Investors are familiar with the structure, and companies like Nubank used a Cayman entity for their IPO.
What does all of that mean for LatAm founders?
Say you're building a company based in Mexico, but need a United States entity to receive investments. Having a C-Corp as a holding company will make your startup subject to taxes in the US even if you haven't made a single dollar there.
With an LLC as a holding company and a legal entity in your own country, you'll only pay taxes where they're really due: where you're operating, managing payroll, and making profits. A.k.a. in your own corner of Latin America.
Put simply and speaking solely from a tax optimization perspective, an LLC would make more sense over a C-Corp for a LatAm founder with no operations in the US, but in need of a legal entity overseas.
Not all investors would be comfortable with or able to invest in an LLC though, so it's always important to check with yours before committing to a corporate structure.
You will need to consider a few fundamental questions before setting a course, particularly in the case of businesses based and currently operating outside of the US. Questions such as:
Choosing to form a C-Corp or an LLC in the US is all about considering how you can go from point A (your local structure) to point B (the holding company) in the most tax-effective manner. But those aren't the only two options for your business.
The fact is you're just not as good at predicting the future as The Simpsons, and so you should always commit to the Minimum Viable Incorporation for the sake of your peace of mind – and your budget.
For Latin American founders, that can often mean sticking to a basic corporate structure in their own country for as long as they can – think SAS in Colombia, SAPI in Mexico, LTDA in Brazil, etc. You won't really need to worry about setting up legal entities overseas until it's time to get ready to fundraise.
We put together a decision tree to help you understand where you and your business stand and where to go from here.
Don't take this as gospel – it's not here to choose for you, but rather to point you in the right direction.
Ultimately, early-stage startups could benefit from holding on to that LLC status and its tax savings before re-assessing the situation further down the line, when a change in the corporate structure may become the right move – be it because one of your potential investors is putting their foot down, or because your business is ready to go public.
Plenty of LatAm startups are ideal candidates for the flexible and straightforward LLC corporate structure. While owners of both corporations and LLCs have limited personal responsibility, LLC owners also benefit from tax advantages, managerial freedom, and a lack of onerous recordkeeping and reporting obligations.