1. S-Corps present the same tax problems for VCs as LLCs do.
Like LLCs, S-Corps are “pass-through” entities, meaning that the S-corp doesn’t pay federal income tax. Rather, the S-Corp’s shareholders pay federal income tax on the company’s taxable income, based on their pro-rated stock ownership. VCs simply don’t want to deal with this sort of complexity.
2. Most VC firms can’t legally be shareholders in an S-Corp.
To legally invest in an S-Corp, shareholders must be U.S. citizens or residents and “natural persons.” Not only does this rule out foreign investors, it also rules out most domestic VC money, which typically comes from VC firms that are set up as partnerships or LLCs. In other words, they are not “natural persons.”
Also, VC firms with tax-exempt partners legally can’t invest in S-Corps because they’re pass-through entities.
3. Only C-Corps can offer preferred stock.
Even if you could find American-based individual venture capitalists who legally could invest in your company, they would likely avoid your S-Corp. Here’s why: S-Corps can only offer common stock, not preferred stock. And preferred stock—which pays higher dividends and puts stockholders first in line to get paid out in a liquidity event—is exactly what VCs expect when they take a significant risk on your company.
4. C-Corps don’t have limitations on growth.
Unlike a C-Corp, an S-Corp is limited to only 100 shareholders. Although this may sound like a lot for a startup that has yet to issue a single stock, this upper limit can be reached rather quickly, especially if a cash-strapped startup offers extra perks in the form of employee stock. VCs are likely to worry about a startup’s inability to grow once the 100 shareholder threshold has been reached. What if you’ve maxed out on shareholders and still need to raise more money to truly scale your company?