Tag Archives: LLC

Accountants Heart LLCs

I’ve never had a client’s accountant recommend any legal form besides the LLC for a new startup. Even though I heart corporations, I still believe the LLC can be an appropriate legal entity for some companies and ventures. But when it comes to a startup looking to (i) raise capital, and/or (ii) issue incentive equity compensation, the corporation is the proper choice.

LLCs are great because they are “simple.” But eventually the startup will have complex legal needs and the startup LLC will end up having to draft corporation-like provisions into its documents. It ends up being much easier to convert to a corporation at that point rather than adapting the LLC to operate like a corporation.

Skip the LLC

“My startup will start out as an LLC and then change to a corporation when/if…” This quote, or similar derivation, is a common fact pattern I hear from new clients or general inquiries. I think most entrepreneurs are attracted to the LLC because they hear it is “simple” or “easily-managed” or “flexible.”

Sure, LLCs are all of those. But remember that the LLC was created for tax reasons, and not for typical startup company legal maneuvers like raising capital or employee incentive compensation.

Thus, if there is any possibility that your startup will raise capital, I would skip the LLC and proceed straight to the corporation. Additionally, if you plan on giving your current or future employees incentive compensation, skip the LLC as well.

Of course, you can convert your LLC to a corporation when it is time to raise capital or grant stock options. Just keep in mind that converting from an LLC to a corporation later will be another round of filing fees with the secretary of state and legal fees (if you hire counsel).

If you really want pass-through taxation, file form 2553 with the IRS and elect to be a S-Corporation. And if you still want to be an LLC, check out my article on LLCs.

A Primer on LLCs

The limited liability company (LLC) is a relatively new legal entity which got its start in the late 1980s. As the name implies, an LLC provides limited liability to its participants called “members” while containing the assets and operations of the business enterprise. Please keep in mind that LLCs are regulated at the state level, therefore management and formation matters may vary from state to state.

How to Form an LLC

LLCs are formed by filing an articles of organization (or other similarly titled document) and submitting a filing fee with the Secretary of State.

You’ll have to make sure the LLC’s name complies with applicable state rules or else the Secretary of State will reject the filing. The most common reason a name is rejected is that the proposed LLC’s name is too similar to that of an existing entity, whether the existing entity is an LLC, corporation, limited partnership, etc. Some states can be very laid back with regards what constitutes a similar name, while others are hyper-sensitive sticklers (hello Texas!).

You will also have to appoint a registered agent for your LLC. A registered agent is a business or individual designated to get served when your LLC is a party to a legal action such as a lawsuit or summons. Failure to maintain a registered agent or keep your registered agent’s address updated can produce undesirable effects for your LLC.

The Management and Operations of an LLC

An operating agreement typically determines the management and operational functions of the LLC. This agreement is made between the LLC’s members (the owners of the LLC) and the LLC. The operating agreement will also determine the allocation of income and tax liabilities. These documents can be extremely short or extremely long.

In the typical default management structure, the management of the LLC is vested in the members in proportion to their ownership interest in the LLC. However, the members can agree, either in the articles of organization or operating agreement, to vest management in a “manager” rather than each of the members.

Tax Basics

Thanks to a 1998 Internal Revenue Service ruling, LLCs are a hybrid vehicle which provides the liability protection of a corporation with the pass through taxation benefits of a partnership or S corporation. Pass through taxation means that the members of the LLC pay the taxes of the LLC on their individual 1040 tax return via a Schedule K-1. Thus, the income (or loss) is “passed through” to the members. This allows for the avoidance of double taxation on the LLC’s income.

I highly recommend seeking guidance from your CPA, as there will be tax issues–both personal and for the entity–that may influence your entity decision.

When is the LLC the best choice of legal entity?

Unfortunately, I don’t have a bright-line rule for when to be an LLC. The LLC is a very flexible legal entity combining the advantages of corporations such as limited liability and continuity of life with the advantages of partnerships such as pass through taxation and corporate informality.

Thus, if you are looking for a simple way to enjoy limited liability and you are not too concerned with raising capital or establishing a more traditional management system, the LLC is probably for you. But if you are looking to use various corporate-like methods, whether options or raising capital, the LLC may not be your best option. You can still create some corporate-like incentives for your employees, but I find that most employees have a hard time comprehending what a “membership unit” is as opposed to a share of stock.

Why Startups are a Corporation for Venture Capital

Choosing a startup’s legal entity can be a frustrating experience for the entrepreneur. Who has time to deal with the LLC, S-Corp, C-Corp, LP, GP, LLP & LLLP when you’re already buried with things like CSS, RoR, AJAX, PYTHON, PHP & ASP? Thankfully, if your startup is absolutely determined to raise venture capital, there’s only one viable legal entity decision your startup can make–the Corporation. Here’s why your startup will be structured as a corporation for venture capital investment:

Does this include S Corporations?

No. While the S Corporation structure is a popular choice for entrepreneurs and other small businesses, it comes with regulatory limitations that do not make it a feasible vehicle for raising venture capital. The three main regulatory limitations are:

  • S Corporations may only have one class of stock;
  • S Corporation stockholders must be natural persons (except for some extremely limited circumstances); and
  • S Corporations can not have more than 100 stockholders.

The one class of stock requirement is fatal to a venture capital investment since venture capital firms will demand preferred stock in return for their investment. Also, most venture capital firms are organized as limited partnerships and less frequently as LLCs–but both legal entity types aren’t “natural persons.” And finally, as your startup grows, the 100 stockholder maximum comes into play once your startup begins issuing stock and stock options to employees.

Thus, the only type of viable corporation for venture capital investment is the C corporation.

Why not an LLC?

While the LLC is also a common startup vehicle, the C Corporation wins hands down when it comes to raising venture capital. The following 4 reasons explain why the LLC is suboptimal compared to the corporation for venture capital:

1. Pass Through Entity

While the pass through feature (income/losses are passed down to the shareholders rather than dealt with at the entity level) of LLCs are desirable to most entrepreneurs, venture capital funds do not find pass through taxation to be a similarly desirable feature. The venture capital firm does not want the accounting and tax matters of a funded venture to be passed down to the firm, and thereby be attributed to the venture capital firm’s tax exempt and foreign limited partners. Such a scenario could create unrelated business taxable income (UBTI) issues or have their foreign investors be deemed “doing business” in the United States and thus have to file a U.S. tax return.

2. Transferability

The membership interests of an LLC are typically not freely transferable by state statute. This makes the LLC a lousy entity for one of venture capital’s exit strategies: the IPO. (Not that IPOs for venture backed companies are hot at the moment.)

3. Predictability

Started in the late 1980s and only made more popular in the last decade or so, LLCs are a relatively new type of legal entity. Thus, there just isn’t a well developed set of laws and regulations for LLCs. Corporations, on the other hand, provide a larger degree of predictability with regards to corporate governance and stockholder rights.

4. The Venture Capital Firm’s Organizational Documents

Primarily due to the reasons outlined above, many venture capital funds will have specific provisions in their own organizational documents that prohibit them from making a venture capital investment in an LLC, or any other legal structure than a C Corporation. Thus, if your startup is absolutely against being a C Corporation, you could be declined by the venture capital firm regardless of how spectacular your startup is.

The Conclusion

The C Corporation is a venture capital firm’s clear-cut choice for the type of entity in which to place their investment. When the to-be-venture-funded startup is a C Corporation, various administrative and other burdens are minimized for the venture capital firm, which allows them (and their capital) to focus on developing the startup company’s business. You startup should be structured as a corporation for venture capital.