Life Sciences Articles
Choice of Entity Critical to Later Success for Biotech Companies
By James A. DeLeo, CPA/MST
Gray, Gray & Gray, LLP
With all the things an entrepreneur must think about in the course of starting a new business venture - securing patents, gaining FDA approval, negotiating licensing agreements, hiring personnel and gaining traction in an ultra-competitive industry - it only stands to reason that some important areas will get overlooked.
One commonly disregarded area that is actually critical to the ultimate success of a start-up business is the choice of tax entity. What type of business will you be?
This is a decision that must be made early in the start-up process, usually at the time of incorporation. Often this decision is made quickly in the rush to incorporate. As a result, the repercussions are not felt until years later when these hasty decisions come back to haunt the founders at the most inopportune times.
The questions surrounding choice of entity are many. Should the newly created entity incorporate? S-corporation or C-corporation? Should consideration be given to a Limited Liability Company (LLC) or Partnership (LLP)? What if the venture intends to seek venture capital (VC) funding or an IPO? Does the choice of entity make a difference?
The first step in the decision-making process is to review the business plan and its stated objectives. It is important to ascertain where the start-up venture is looking to position itself in the future. The choice of entity will be different depending on whether a company plans on going public, intends to solicit VC funding as a source of capital; if it intends to sell to a much larger competitor, or remain closely held. It is also important to be aware that entity type can change such as from a Subchapter S corporation to a C corporation as well as from a Limited Liability Company (LLC)/partnership to a corporation under certain circumstances. However it is easier to change certain entity types than others which result in adverse tax effects if undertaken.
Once determined, the next step is to engage qualified professionals such as accountants and attorneys to work together in drafting the documents and making the appropriate tax elections for the entity. All too often these decisions are made solely by the founder or an attorney in the rush to incorporate, without full knowledge of the long-term ramifications. That is why it is important to emphasize a team approach to this process.
Other items that also require attention at the time of incorporation relate to whether the entity intends to be taxed on a cash basis or accrual basis of accounting, what year-end does the company intend to use as a cut-off to its yearly operations, and the inventory valuation method the company intends to use. These are all important decisions which require the appropriate amount of time and consideration in order for the best choices to be made.
If the founders plan to take the company public the entity choices are narrowed. Because a Limited Liability Company issues "members interests" in an entity and not stock, this type of entity would be difficult - if not impossible - to take public in its existing form. Most VC firms do not deal with LLC's for this very reason. In planning for an eventual IPO or the initial and hopefully subsequent round of VC funding, the choice comes down to C-corporation or S-corporation.
The basic difference between the two entity forms is entity level taxation versus pass-through taxation, the type and number of shareholders allowed as well as single versus numerous classes of stock. A C-corporation is the tax form adopted by publicly held companies primarily because there is no limit to the number of stockholders. However, the C-corporation also carries with it the burden of double-taxation when selling corporate assets. So this form of entity would not be beneficial to a venture whose goal is to sell to a larger company. In such a situation, not only will the entity be taxed on any gain associated with such a transaction but the stockholders would be taxed again on the distribution of the sale proceeds, leaving less after-tax cash for the stockholders. It is also very important to these types of entities to be able to use losses generated in the development stage as well as various state credits which the company may qualify for.
An S-corporation "passes through" income and expenses to its shareholders so that all transactions are subject to tax only once, at the individual level. This avoids double-taxation. It is a preferred vehicle for those start-up entities concerned about the type of shareholders allowed, as well as the use of a single class of stock, and those that may be involved in a potential sale in the future. An S-corporation can also be easily converted to a C-corporation down the road by simply ensuring that the company no longer meets some of the S-corporation requirements, such as the maximum number of shareholders.
C-corporations are generally accepted by venture capital firms since most venture capital firms are partnerships and would not be qualified Subchapter S corporation shareholders. In general, neither form of entity would significantly inhibit venture funding at any stage of growth.
Keep in mind that, although the entrepreneur cannot expect to address every obstacle in the way during the course of ramping-up operations of a start-up, there are some decisions that carry a great deal of weight if they are not addressed properly. If these decisions are addressed at the appropriate time and in sufficient detail they can have a very positive impact on future growth.
James DeLeo, CPA is a partner with Gray, Gray & Gray, LLP, Certified Public Accountants, Westwood, MA. Gray, Gray & Gray serves the tax and accounting needs of businesses in the life sciences industry. Mr. DeLeo can be reached at (781) 407-0300, or via e-mail to: jdeleo@gggcpas.com