The “C” in VC Doesn’t Stand for Corporation – But Maybe it Should

Travis Stegemoller

October 30, 2012 · 4 minutes read

Uncategorized

* This post is part of an ongoing legal column called “The Legal Pad” here on Technori that digs deeper into the most common mistakes startups make when facing legal issues.  Rather than spell out the basics, this series aims to pull back the curtain and focus on the end results that occur when mistakes are made. *

By now, even the least knowledgeable entrepreneurs know that they need to form some type of business entity in order to protect their personal interests. But, many rush through the decision of choosing which entity fits their business without much thought.  They hear about LLCs and corporations, and often believe that choosing one or the other will lead to the same result. Even worse, they believe those types of business structures are one in the same.

In the startup space, and especially at technology-based startups, a big mistake entrepreneurs make is starting their businesses as LLCs. Why? Put yourself in the shoes of a venture capitalist or institutional investor and consider two fundamental issues: taxes and predictability.

Taxes

Let’s run through the basics. On a very simple level, LLCs allow owners to shield themselves from personal liability while passing their profits through the business and directly to their personal tax returns. This results in the profits of the business being taxed only once—at the owner level. A corporation is taxed at the corporate level and at the shareholder level upon distribution of the profits.  So, every dollar in profit ends up being taxed twice. That fact alone makes an LLC very attractive and is primarily why the LLC structure has rapidly increased in popularity over the last two decades.

Yet, many entrepreneurs don’t consider the practical effect of passing profits through to owners. What if your business nets $20,000 and you want to retain those earnings within the business to fuel growth? Generally, the owner is still liable for his or her share of taxes on the $20,000, even though the owner never received any distributions to use for paying those taxes (complex tax strategies aside).

This becomes a significant issue for investors who have multiple investments across several startups. Imagine the excitement an investor must feel when she realizes 7 of her 10 portfolio startup LLCs have turned a profit. Then, imagine the frustration she will endure when she receives 7 separate K-1 tax forms outlining her aggregated year-end tax liability. Not to mention the administrative headache of tracking these documents.

This is a major reason why many investors prefer startups that are formed as corporations. When a corporation turns a profit, those profits are taxed and paid for out of the corporation’s earnings. The investor does not realize a tax liability until their share of the profits has been distributed. Now the investor has cash on hand to pay the tax liabilities.

Predictability

How hard would it be to win a board game if you did not know the rules?  Really tough! You would probably prefer to read the rule book beforehand.  The same is true with investors.

In an LLC, the rules that regulate an owner’s rights are contained in a unique contract known as an operating agreement. This document is typically customized by the members who own the LLC, and varies from business to business. Investors would have to read a new rule book every time they were pitched an LLC. And, if the operating agreement needs modification, then lawyers are called in and the cost of the deal increases.

On the other hand, all corporations are governed by the same rules: state law. Sure, state law varies from state to state, but the variances are small relative to the boundless creativity of an operating agreement. Additionally, many startups choose Delaware as their state of incorporation, as this state’s laws have been deemed some of the most favorable to corporations. The result is predictability and decreased transactional costs. Thus, in a world where picking successful startups is anything but predictable, having a consistent set of rules is desired.

But What If I Don’t Plan to Seek Institutional or VC Investment?

True, there are scenarios when choosing a corporation over an LLC may not fit the needs of a business.  One example is when the business anticipates limiting the number of investors to a small group for an extended period of time or not seek significant outside investments.  Or, if an entrepreneur plans to bootstrap the operation, then he or she may wish to offset personal income taxes generated by other means with the losses generated by the startup.

Offsetting taxes may also be advantageous to an angel investor who prefers to use the losses of the business against their personal taxes. These cost-versus-benefit scenarios need to be considered immediately after inception of the business.

I Already Filed as a LLC, But I Plan on Pitching to VCs!

Relax, the good news is that this can be fixed.  The bad news is that it does require time spent by lawyers drafting documents and spending money on additional filing fees.   And the more hoops to jump through, the more the business will bear the burden of costs that could have been avoided.

The decision is rather cut and dry:  if an entrepreneur plans to seek investments from venture capitalists or institutional investors, setting the business up as a corporation from the start will prevent unnecessary headaches and legal fees in the future.

 

2 Comments

  1. This is actually bad advice. #1 There are reasons why VCs don’t like LLC structures, but what’s described above is not the full story. For example, traditional “private equity” investors use LLC structures all the time because of the advantages; “venture capital” investors have other issues with LLCs, but those are generally outdated since the IRS’s implementation of the check the box rules; these days is just convention rather than reason. #2 LLC structures are especially valuable to startups with angel investors who want to play games with the tax allocations and get the benefit of the initial losses of a startup, which the founders won’t have any ability to use – this makes an LLC structure more desirable for investors who understand LLCs. #3 LLC law in Delaware is fairly reliable and predictable and a startup using a Delaware LLC with a thoughtful LLC Agreement and knowledgeable lawyer (and accountant) should be fine. #4 Corporations require all sorts of documentation and when investors come in, more documentation; whereas you can handle everything in an LLC Agreement, corporations typically require 3-5 documents to cover the same ground. #5 It’s relatively simple and painless to convert from a Delaware LLC to a Delaware corporation when VCs come in. BOTTOM LINE: Yes, VCs require Delaware corporations, but the decision for a startup is anything but cut and dried and depends on a host of circumstances.

    • Steve – Your comment is fantastic because it reminds readers that choosing a business entity is complicated and should be made on a case-by-case basis with counsel. Let me provide a few responses that address your specific concerns and hopefully reinforce the message of the piece.
      1 & 2) I intentionally left checking the box out to illustrate the results typically
      seen when startups form as LLCs. This is because founders weigh the short term advantages of flow through taxation against the disadvantages of double taxation and tend to select being taxed as an individual. Checking the box is very useful in situations where the number of investors is limited, which was discussed in the paragraph about exceptions for entities that don’t plan on seeking Institutional or VC investment.
      3) Deleware LLC law may be “fairly reliable and predictable,” but the law as it applies to each individual operating agreement is not. Each operating agreement should be individually tailored to the specific company it will govern. This results in a variety of “rules” depending on how the LLC operating agreement was drafted.
      Also, compared to laws that govern corporations, the amount
      of case law available to guide advice concerning a novel issue is much more
      limited (in DE and elsewhere). The
      analogy comparing operating agreements to a rule book in a board game
      highlights the fact that even consistent law may not produce consistent results
      on a case-by-case basis.
      4) The key here is distribution of equity. Once investors are brought on board, assigning shares is a fairly efficient legal process because it can be replicated as
      needed to accommodate future investment or divestment of shares. On the other hand, an LLC operating agreement would have to be modified each time an investment is made and a new member is added. Plus, a new investor could demand that the operating agreement include limitations that he could not otherwise seek if receiving shares in a corporation.
      5) Whether the change from a Delaware LLC to a Delaware C-corp is painless is relative to the bearer of cost and management. Your points seem to back up the
      original assertion: for startups seeking investments from venture capitalists or institutional investors, a corporation is preferred over an LLC.
      Thank you for fleshing out the context in which this decision is made. Great points!

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