The Wait-and-See Approach to Bootstrapping a Business
Founders that plan to bootstrap their startup—whether for some time or indefinitely—are best served by a flexible business structure that allows them to take advantage of the simplicity and tax efficiency of LLCs while preserving the option to convert to a corporation later.
The Bootstrapper’s Approach to Business
Startups begin as ideas. The role of the startup founder is to test the idea in the marketplace. If the idea is good—and if the founding team can execute on it properly—the founders enjoy the satisfaction of watching their idea grow into a successful company.
Different founders follow different paths to success. For some founders—particularly repeat founders—the path inevitably involves seeking outside investment from venture capitalists (VCs) or other institutional investors. Fundraising is a non-negotiable part of their business plan. They plan to raise capital, reinvest it in the business, grow fast, grant equity incentives if needed, and have a successful exit (through being acquired or going public). Either the startup will succeed at that goal or it will cease to exist. There is no middle ground.
But there is another type of founder—a bootstrapper—that thinks about startups differently. Bootstrappers believe that they can succeed without needing to follow VCs in their search for the next unicorn. As Seth Godin quipped:
It’s easiest to define a bootstrapper by what she isn’t: a money-raising bureaucrat who specializes in using other people’s money to take big risks in growing a business.
A bootstrapper uses his or her resources to build a business that will pay for itself every day. They value the freedom to chart their own course over the constraints that come with investor capital. While they want to keep options open, they do not know whether they will want or need to seek investment from VCs or institutional investors. They have a good idea that they believe will succeed. Their immediate focus is on developing their product, finding the right product-market fit, and growing a profitable business from their own resources.
Why Bootstrappers Need Customized Business Planning
As explained in our discussion of LLCs, there is rarely a reason to form a business as a corporation. Compared to corporations, LLCs have several advantages:
- LLCs Provide Better Liability Protection. Unlike corporations, LLCs can use charging order protection to protect against both inside and outside liability.
- LLCs Provide Greater Tax Efficiency. LLCs are the most tax-efficient form of business. Under the default classifications, LLCs avoid the double taxation that applies to C corporations, allow investors to deduct losses, and provide opportunities to save taxes by increasing basis for LLC debt and on sales of LLC equity.
- LLCs Allow Assets Sales. Asset sales are often too expensive for C corporations. LLCs also preserve the ability to structure an exit as an asset sale—which is often more attractive to a buyer—instead of hoping for a tax-free sale of QSBS.
- LLCs can Benefit from the QBI Deduction. The 20-percent qualified business income (QBI) deduction under Internal Revenue Code § 199A is only available to pass-through entities, not to C corporations.
But there is one situation when founders are often pressured to form a corporation to their own disadvantage: Founders of high-growth startups that plan to seek investment from VCs or other institutional investors will often form their startup as a C corporation to meet investor requirements. Although forming a C corporation subjects all earnings to double taxation and prevents the founders from using losses in the early years of the business, it is often a necessary evil when fundraising is involved.
The tension between investor demand and tax efficiency leaves bootstrappers with an uncomfortable dilemma:
- Form the new business as an LLC for the legal and tax benefits, but risk disqualifying the business for venture capital investment; or
- Form the new business as a C corporation to create a fundable structure that may not be needed and will almost always cause them to pay more taxes.
The wait-and-see approach described below relieves this tension. It allows founders to keep options open without introducing unnecessary tax complexity.
The Wait-and-See Approach to Choosing a Business Entity
Ongoing businesses may change from one form of business to another through a process called conversion. As discussed in How to Convert an LLC to a Corporation, converting from an LLC to a C corporation is a relatively straightforward process that can usually be accomplished in a tax-free transaction. (Converting from a successful C corporation to an LLC, on the other hand, almost always results in double taxation.)
The wait-and-see approach involves forming an LLC as the initial company but including conversion provisions in the LLC operating agreement. The conversion provisions provide clear-cut procedures for converting the LLC to a corporation if necessary. Because they are agreed upon in advance, these procedures minimize the risk of future disagreement between the founders about converting to a corporation.
Unless the founders know that they will attract outside investment, starting as an LLC keeps options open. If the company is profitable, it will pay less taxes on its income. And, at least at the initial funding stage, the fact that the company is organized as an LLC should not be a deterrent to angel investors. The LLC would only need to convert to a corporation if required for fundraising. If the company attracts outside investors that require the company to be organized as a C corporation, conversion is relatively easy to do.
Forming as an LLC can help startups get essential documents in place without the expense and hassle of forming a highly taxed corporation they may never need. It allows the business to keep overhead costs and taxes low while spending its resources on developing its core product and attracting its first customers.
Using the Wait-and-See Approach to Benefit from Losses
Many startups operate at a loss for the first few years. The wait-and-see approach also allows the startup to benefit from losses in the early years. If the business is organized as a C corporation from the outset, business losses can only be accumulated to deduct against future income. With an LLC taxed under the default classification, losses can be used immediately to offset current income on the owners’ tax returns.
What About the Cost of Converting to a Corporation?
Some argue that the wait-and-see approach outlined above adds unnecessary legal fees by requiring the business to form as one entity type (an LLC), then convert to another (a corporation). If the founders will end up as a C corporation soon, why not form a C corporation at the outset?
Of course, this argument misses the point. If the founders know that the business will need to be organized as a C corporation soon, then the wait-and-see approach is not the right approach for them. The wait-and-see approach is for founders that may want to seek venture capital investment at some point, but also want to preserve the ability to bootstrap the company without paying unnecessary taxes.
More importantly, though, this argument assumes that the cost of converting to a corporation (the downside) would be greater than the potential tax savings resulting from the wait-and-see approach (the upside). While it may be true that the legal fees and costs may exceed the tax savings, that is not the most likely scenario for a profitable startup. And the downside (legal fees and costs) are limited, while the upside (avoiding double taxation on all business profits) are not.
For the cost of the conversion to outweigh the benefit, two things would need to happen. First, the LLC would need to convert to a corporation—which, as mentioned, is not a given. Second, the cost of conversion would need to exceed the potential tax benefit for operating as an LLC.
To quantify the cost of conversion, we usually charge around $1,500 to $2,000 in attorney fees for converting an LLC to a corporation (and even less if we formed the initial LLC). Using Texas as an example, filing fees for converting a Texas LLC to a Texas corporation are an additional $600. This brings the approximate cost of a simple LLC-to-corporation conversion to under $3,000.
Using these rough numbers, the downside of the wait-and-see approach is the possibility that the business may need to pay an additional $3,000 in legal and filing fees. The upside is that, should the founders bootstrap, they avoid double taxation on all LLC income. If the business has any success, operating as a pass-through entity will save more than $3,000 in taxes in the first year. Any tax savings in excess of $3,000 is extra.
The wait-and-see approach provides a best-of-both-worlds solution for founders that are unsure whether they will need a C corporation to attract outside funding. For these founders, there is relatively little downside to starting as an LLC, and avoiding double taxation can save significant taxes.