It seems like every year I see more and more companies that are trying to raise money and are structured as LLCs. It feels like lawyers across the country are recommending an LLC structure for early stage startups. But they’re not asking one important question: “Are you planning on raising professional investment?”
If there were, then there would be more companies avoiding the LLC structure and setting things up as Delaware S corporations that eventually drop their S elections and become C corps. If you are serious about raising money, my advice is usually not to set up an LLC. Set up a Delaware S or C corp.
Of course anything can be fixed, so it’s far from fatal if you do set up an LLC. You can set up a C corp and have it buy the assets of the LLC. It just costs money and time. You end up with less money and the lawyers end up with more.
Occasionally, angels will invest in LLCs, but it’s basically unheard of for VCs. Techstars is an interesting case – we greatly prefer to invest in S or C corporations, but we’ll also invest in LLCs only because it’s not practical to pay to dump the LLC and incorporate the company at a very early stage. But man, can it be a headache. Those LLCs all have to provide K-1s to their investors. This ends up happening at the last minute and delaying personal tax returns for those investors. This sounds like a small problem, but investors who play with LLCs end up spending a bunch of extra time running around at tax time. I’m particularly sensitive to it right now because it’s that time of year. There are other reasons investors don’t like LLCs too. One big example is that they may end up creating tax bills before generating any liquidity.
Bottom line: Assuming you’re not ready for a C corp, create your decision tree based on whether or not you feel that raising professional investment is desired/likely. If so, consider a Delaware S corp for now. This is very easy to change to a C corp. If you don’t plan to raise money, you can get away with an LLC and it may have very real tax advantages for you to do so. As always, consult your (ideally, venture experienced) accountant and/or legal counsel before taking any specific advice, especially from me.
As for why I’m suggesting Delaware, that’s for another post.
UPDATE: I posted More on LLCs two days later as a follow up.
I've never personally set up any of these, however I was talking to a friend the other day and he was talking about avoiding S Corp and LLC and going towards some kind of estate something or the other (sorry can't remember exactly what it was). Basically, it creates a "shell" company out of a company. It's designed to protect the company in the event of a lawsuit, divorce, etc. Do you know anything about this?
Quite frankly, I don't understand investor resistance to the LLC structure which has significant tax advantages on certain types of businesses; for a startup, those tax advantages can translate to positive cash flow, never a bad thing. It seems to me that professional investors insist on corporate structures from the standpoint of consistency and clarity of ownership. I don't think that LLCs should be dismissed out of hand nor do I think that professional investors should insist on incorporation without some dialogue on the matter.
They shouldn't be dismissed out of hand, you're right. That's why I said you should consult your accountant/attorney. I'd like to learn more (which is why I blog). What sorts of businesses do you normally recommend set up an LLC?
Let your accountant be your guide on that one. My takeway from a discussion with another CEO is that if you business expects high margin transactions of 50% on your product / service, then the LLC structure saves big on taxes. Two business "types" that come to mind are subscription services and car washes. 😀
In my experience — the key to this question is whether the start-up expects/wants to raise VC.
To make a VC investment in an LLC requires an entirely new set of forms developed from scratch. The classic rights, preferences and privileges of a VC preferred stock investment do not translate easily or comfortably into the LLC format (although, admittedly it can be done). Developing these scratch documents is a costly endeavor (and obtaining venture capital is not cheap anyway) — it is unlikely at best that a VC will want to bear these additional costs.
Also, an LLC is not able to issue stock options to its employees with the same tax advantages as a corporation. And the manners of obtaining liquidity in an LLC (through distributions or liquidation) do not translate easily into the VC world and have potentially different tax treatment. For example, the flow-through tax treatment of an LLC could potentially cause problems for the limited partners of the VC. Finally, and perhaps most importantly, it is not possible to do an IPO with an LLC. Any LLC that wanted to go public would be required to first convert to a corporation anyway with potentially very adverse tax consequences.
This is not to say that an LLC is not an excellent choice for joint ventures or small businesses which will never need to raise money from a VC. LLCs are very flexible entities that can provide favorable tax treatment for individual investors. It is just exceptionally rare to find a VC that is willing to invest in an LLC.
One last thing, S Corps are prohibited from having shareholders that are not natural persons (or certain trusts) so an S Corp could never take institutional money. Also, I have seen people experience real pain (as in tax pain) when converting from an S to a C — all in all it is a tricky question that bears some real thought before answering — need to tailor the answer to the recipient.
I did a blog post on this in more detail a little bit ago here – http://dividendsandpreferences.blogspot.com/2009/…
If a company hopes to make any real money (that will be distributed to the members) isnt an LLC the best choice to avoid double taxation?
Also, I am not an accountant, but if a a number of people create a C corp and incur a ton of expenses trying to create a product prior to getting VC they wont be able to pass through those expenses to themselves. They remain stuck in the original corp. I ran into that once before when I created my first corp while trying to get something going back 10 years ago.
Hank, are you sure about the IPO rules? I don't believe that Blackstone Group converted; E*Trade and Seagate remain LLCs. It may be more difficult to do an IPO as an LLC, but I don't believe it's not possible.
With all the scrutiny of the last few years on options, I have to think that they've lost their attractiveness, and I hear of companies that are now using restricted stock as bonuses.
One attractive aspect of the LLC structure is that companies have more flexibility in how they claim income to the IRS and in that case, they can avoid higher taxation on certain types of income such as capital gains.
While there is a lot of ink about how much VCs dislike LLCs, I think the more interesting story is on companies that remained LLCs despite VC pressure. Segway, LLC was financed by Kleiner Perkins, and I'm sure there are others.
I'm very anti S-Corps in the early stage, since it prevents the company from having anyone as a shareholder who is not a "natural person". I'd estimate that more than half of the angel investors I know invest through some kind of entity (typically an LLC), thus you immediately force a conversion from S-Corp to C-Corp in an angel round, which adds a ton of overhead and expense. Starting as an LLC, you can convert at the time of institutional investment much more easily, and you'll have the capital to support the legal fees…
Huh? Going for s to c is a simple change. Going from LLC to c is a total reorg!
Sorry I was referring to operating overhead and expense. C-corps require an added level of reporting, taxation and structural administration that can be PITA in a seed stage company. I agree that LLC to C is more of a reorg than S to C, but what I'm suggesting makes the timing appropriate to the stage of the company.
I know there is the issue of "C" corps being double taxed on retained earnings (if they take those earnings out as profit later). On the other hand, the ability to retain earnings is what kept my "C" corp alive last year. We had enough cash stored up that we could weather a downturn in the economy and still be cash positive by the end of the year. That's something that becomes much more difficult if you must push all the profit out to your shareholders each year. Retaining earnings is what allows a company to weather not only the upturn growth but the downturn economy without risking personal funds to do so. With the new stimulus allowing us to write down losses this year against past profitable years, that only increases the value of having those earnings around to keep your cash rich position during hard times. Run in the black – it only makes sense 🙂
Remember – Cash is King!
thanks a lot for this
Thanks for the insights. These things really do need careful consideration when starting a business, no matter how small. In the long run, it would be for the benefit of the startup or the small business owner to consider each aspect of an LLC structure with the consultation of law office that has a specialization in business law to ensure that everything that is worth considering is indeed carefully considered.