Will investors put money into an LLC?

QUESTION:

Does my startup have to be a Delaware corporation, or will investors put money into an LLC?

ANSWER:

Ethan Stone

Ethan Stone

by Ethan Stone, Stone Business Law

First, a quick but important clarification: I’m not your lawyer and this answer doesn’t establish a lawyer-client relationship. I’m giving a generic answer to a generic question to educate the users of this site. The information below is general in nature and should not be understood as a substitute for personal legal advice.

Generally speaking, professional investors either require or strongly prefer to invest in a Delaware C-corporation. There are several reasons for this. The tax laws that govern non-profits (such as pension funds) that often invest in VC funds make it difficult for those funds to invest in LLCs. Professional investors also generally want to see you giving stock options to employees which is much easier to do with a C-corporation (more about that below). Finally, professional investors are looking primarily to a sale of the company or an IPO as their investment “exit.” Companies that go public are, almost without exception, C-corporations.

Not all professional investors require a C-corporation. Individual angel investors who don’t have to worry about pension fund investors can be more flexible. For example, take a look at John Frankel’s answer to a similar question: http://www.foundersspace.com/fund-raising/is-it-easy-to-switch-from-an-llc-to-a-c-corp-once-im-ready-for-investment.

The fact that professional investors will want you to have a C-corporation does not mean that you need to form as a C-corporation initially. Under some circumstances, it might make sense to form as an LLC and convert to a C-corporation when you raise capital from investors who want that. The advantage, generally speaking, is that you an your co-founders may be able to deduct your initial business expenses on your personal income tax returns. If you’re not going to be able to do much until you raise professional capital, however, this is often more trouble than it’s worth.

As noted above, another disadvantage of forming initially as an LLC is that it will make it very difficult for you to issue stock options. You can get away with much lower strike prices if you issue your options well before you close on a round of professional investment. So if you think you’re going to have a team on-board before you raise capital and your business plan requires you to raise professional capital, forming an LLC is usually not a good idea. Your team will not thank you for jacking up their exercise prices to get a few thousand dollars of deductions.

As you can tell from this discussion, a lot depends on your and your co-founders’ specific plans and personal tax situations. So you’ll want to go to a competent adviser to help you think things through if you think forming as an LLC and converting might be an attractive option.

There have been a number of related questions on this site. I referenced one above, but I thought it might be helpful to provide links to some more:

1. Considering the Alternatives to Angel and Venture Financing. See my short article here: http://www.foundersspace.com/news-announcements/considering-the-alternatives-to-angel-and-venture-funding.

2. Does it make sense to set up an LLC or S-Corp for my startup? Antone Johnson’s answer is here: http://www.foundersspace.com/company-formation/llc.

3. Why do VCs prefer Delaware corporations? An anonymous answer and my comment are here:
http://www.foundersspace.com/fund-raising/why-do-vcs-prefer-delaware-corporations/.

4. What are the advantages & disadvantages of incorporating in Delaware? An anonymous answer and my comment are here: http://www.foundersspace.com/company-formation/delaware-incorporation-advantages-and-disadvantages/.

5. Is an LLC or a Corporation better when starting a new services business? An anonymous answer is here:
http://www.foundersspace.com/company-formation/is-an-llc-or-corporation-better-if-youre-a-freelancer-starting-a-business-in-california.

Founders Tip: Consider using a filing service such as Legal Zoom where they file all the documents with the state, get your record book, and more.

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Comments & Advice:
  1. Good answer. Thanks for the link to my own answer to a related question here at Founders Space. I've listed some other resources that can help with choice of entity and other structural considerations at http://bll.la/9n .

  2. over at the LLC Investors post on LLCInvestor.com you can find some more valuable info on Limited Liability Company Investment.

  3. Anon says:

    Why is it hard to issue options as a LLC? It’s totally possible and quite simple. You issue Unit Options as LLCs have units instead of shares. Done.

    LLCs also offer a step-up in basis to the buyer which is highly advantageous to buyers and leads to buyers paying higher prices due to the tax writeoffs they get.

    LLCs are a no brainer and institutional investors need to get with the program and start creating blocker LLCs to invest into LLCs to get around LP pass-through issues.

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