Many early-stage businesses start as LLCs because the costs are so low. However, there may be a time to flip to a C-Corp.
Decisions made for a company early in its existence can become less than optimal as the company grows and evolves. This change is particularly relevant to the entity type, or corporate form, of the company.
Business Entity
A new business often begins operations as a limited liability company (LLC) or an S-corporation. These forms of organization provide early-stage business owners with the advantage of both:
- Limited liability.
- The preferential tax treatment of a partnership or sole-proprietorship, which are pass-through entities not subject to double-taxation like a conventional corporation. (See Practice Note, Taxation of Pass-through Entities).
Once a company is in the market for outside financing it is possible investors are reluctant to invest in a business organized as an LLC or S-corp. Instead, investors are typically looking into companies organized as C-corporations (C-Corp). C-corp is the standard for most major companies. For a comparison of these entity types, see Choosing an Entity Comparison Chart.
Additionally, many newer businesses are organized under the laws of the jurisdiction where they conduct most of their operations. For example, companies with customers and suppliers in New York State are often organized under New York law. Investors in later-stage businesses, however, typically prefer companies they invest in to be organized under the business-friendly, widely known, and well-established laws of Delaware.
Changing Entity Type
If a company decides to reorganize as a Delaware C–corp, it can accomplish this in several ways (usually on a tax-free basis). Typically, the company creates a new Delaware C–corp, which then acquires the existing business assets and operations through either:
- An asset purchase.
- A one-step merger.
- A holding company structure in which the newly-formed Delaware C–corp purchases all the equity in the existing entity and retains it as a subsidiary. The owners of the original entity (and any new equity investors in the business) become stockholders in the new C–corp. This third option typically triggers fewer troublesome provisions in the company’s existing contracts with third parties.
For more information on these types of reorganizations, see Practice Note, Tax-Free Reorganizations: Acquisitive Reorganizations.
Before a company undertakes any type of reorganization, counsel must carefully review all of the company’s contracts, including contracts with suppliers, customers and lenders. These agreements might contain provisions:
- Requiring the company to obtain the consent of, or issue a notice to, the counterparty before reorganizing.
- Allowing the counterparty to terminate the contract if the company experiences a fundamental change such as a reorganization.
Finding these types of provisions in important contracts is usually not cause for alarm. In many cases, contract counterparties will have their concerns allayed and agree to any necessary contract amendments after a conversation in which the company explains why it is changing its legal form. For a further discussion of these types of provisions, see Financing Arrangements.