Freelancing for Equity Part 1: Company Types & What They Mean

At Loom, we’re always working on helping entrepreneurs bring ideas to life. We do this by connecting these founders with talented freelancers to make those dreams a reality. And many times, especially with early-stage startups, that involves working for an equity stake in a company.

From both a freelancer and a founder standpoint, the contract hiring process can either be a bit confusing or just a breeze — depending on what you know. The hard reality is, the more you know about the basics of common entity types and their tax implications, the easier it is, and the better you can plan for your financial future.

To help you learn these basics of freelancing for equity, we sat down with José Ancer, an Austin-based startup lawyer who also frequently publishes startup education writings on his blog Silicon Hills Lawyer, to chat about the basics of what you need to know — from either side of the table.

Diving in, let’s talk Equity 101. What are the basic entity structures that Loom users should know about?

The legal entity structure that a business chooses heavily influences the kinds of equity that it can offer to service providers, including outside contractors like software developers and designers. And because the differences between structures can have important tax and stockholder rights implications for the recipients of equity, it’s important that anyone planning to work for equity understand the basics of what they might be dealing with.

The three most common entity structures that you’ll encounter are: C-Corp, LLCs, and S-Corps. Others exist, but they’re so uncommon that we won’t be covering them here.

Got it. So, what’s a C-Corporation? And why do so many companies use them?

A C-Corporation is the most common entity structure for angel and venture capital-backed technology companies. If the company you’re doing work for has already decided that it plans to go the VC-financing route, there’s a very good chance it is a C-Corporation. Early-stage C-Corporations will typically issue stock or options exercisable for stock.

From the perspective of an equity recipient, C-Corporations are the easiest to deal with, because they have a corporate (entity) level of tax that ‘shields’ (in a way) equity recipients from a lot of the hassles that come from owning equity in other legal structures.

In both cases of receiving stock or options, assuming the companies have been properly advised by their lawyers, receipt of equity in a C-Corporation should not require that you pay taxes for receiving the equity grant, and it also should not require that you file annual tax forms for that equity. And most importantly, the annual losses or profits of the company will not affect your personal taxes. C-Corp equity is “low maintenance,” and that’s why it’s favored by high-growth tech companies that heavily use equity as a form of compensation for their employees and contractors.

Let’s talk LLC. If C-Corps are easy for high-growth companies, why would someone go the LLC route to start their company?

Well, while most high-growth tech companies are C-Corps, companies that don’t plan to go the high-growth, VC-backed route will often choose to be Limited Liability Companies (LLCs). Taxes are the main reason companies choose to be LLCs, because they don’t have the corporate level tax that C-Corps have.

However, the absence of that corporate level tax means that for equity recipients, LLCs are higher maintenance. In most cases you will have to make annual tax filings for your equity, and your personal taxes may be affected by the profits or losses of the Company.

There are also more variations, and less standardization, in the types of equity that LLCs can issue. The most common types are “units, or sometimes called membership interests,” “profits interests” and “unit appreciation rights.” Because of how complex LLC equity can be, it’s highly advised that you work with a lawyer and accountant to understand what you may be getting into.

Noted! Then there are also S-Corporations. How is that different from a C-Corp or LLC?

S-Corporations are a kind of hybrid between a C-Corp and an LLC. In terms of paperwork and equity types, they look very much like C-Corps. They issue stock or options exercisable for stock.

However, S-Corps are like LLCs in that they do not have a corporate level of tax. This means that your personal taxes will be more complicated (than a C-Corp) on an annual basis, and may be affected by the profits or losses of the Company.

The reason S-Corps are not more popular is that the IRS rules around the equity that S-Corps can issue are much stricter than they are for C-Corps or LLCs. For example, they can only have one class of equity, all stockholders have to be people (not entities), and they can’t have more than 100 stockholders. This makes it difficult for them to raise outside investment capital, or to grow to a substantial size.

Now that we know those basic company types, let’s talk location. It seems like there are a lot of US-based companies that are remotely based in Delaware. Why is that?

The state of organization of a company affects the rights of equity holders in that company. Whether your company is physically located in New York, California, Texas, or anywhere else, it can choose to take advantage of another state’s corporate laws and organize their if it wants to. In the vast majority of cases, a company will choose either its home state or Delaware.

Delaware is often the default choice for VC-backed companies because, among other reasons, its corporate laws are the most well-known by corporate lawyers. Companies that aren’t VC-backed will often organize in their home state. As an equity holder in a company, your rights will often be determined by the corporate laws of a company’s state of organization.

Thanks, José. Any last thoughts on basics that people should know?

While the above covers the very basics, it definitely should not be seen as a replacement for the advice of tax and legal advisors who can address your specific situation. There’s only so much ground you can cover with broad brush before you have to get into specifics.

Thanks for reading! In our next installment of this blog series, we’ll talk with José to dig deeper into the nuances of receiving equity in C-Corps; the most common legal structure for tech companies.

Stay tuned for the next installment on our blog, and feel free to reach out to us in the meantime about finding top freelance talent to bring your projects to life at Loom.co

About José Ancer: José is a technology-focused corporate and securities partner at Miller, Egan, Molter & Nelson LLP, representing leading startups and emerging companies throughout Texas and various other tech ecosystems across the country. His legal practice focuses on formation, angel and venture capital financings, acquisitions, complex commercial and corporate transactions, and general advisory regarding corporate and financing strategy. While attending Harvard Law School, he was awarded Dean’s Scholar Prizes in Securities Regulation, Startup Company Law & Finance, and Business Strategy.

Additional note: this blog post does not constitute as legal advice and we recommend that you always seek the advice of a licensed lawyer to advise you on your specific situation to plan and protect yourself.