You are an entrepreneur with a hot new technology, and believe that investors will love it. Never mind that the venture capital market is soft just now: You have built the better mousetrap, and the world will come knocking. You know the competitive marketplace, but there is one thing you don’t know: the best business vehicle to use out of the starting gate. Decisions, decisions…
The first observation – entirely accurate, but largely unhelpful – is that if a business founder can forecast exactly how the business will develop, then I can easily identify the right startup vehicle. However, this observation is solipsistic: essentially, my offer is that if you give the right answer to me, I will give it back to you. This is not the reason you hire a lawyer.
The fact is that neither you, nor I, nor anyone else can predict the future. A new technology may gain immediate traction, the business may take off like a drag racer, and investors may beat a path to the door. But a new business more often journeys down a road filled with bumps and potholes – not to mention cliffs, boulders and U-turn tax law changes. Therefore, you need a startup vehicle that can operate on all terrains — at least until you are well down the road to success.
Don’t Start At “C”
Although it cuts against the conventional wisdom, I never, if I can avoid it, let a startup begin as a so-called “C” corporation (i.e. a corporation that pays its own taxes). Instead, I opt for a so-called pass-through entity – either a limited liability company (LLC), which is taxable as a partnership, or a so-called “S” corporation, which has a corporate form but passes corporate income through to shareholders on a Form K-1.
The received wisdom is that venture capitalists always want to invest into a C corporation, and therefore a startup should be a C corporation from the outset. Nonsense. You can always become a C corporation later, and, while converting to C status may entail some complications, the obstacles are not insuperable. In the meantime, starting as an LLC provides a more efficient tax structure and greater flexibility to modify the business deal if the real world refuses to conform to the initial business plan.
Assume you start as a C corporation, and obtain some seed funding from family, friends or individual angel investors. Unfortunately, the marketplace does not buy into your new technology, and the business loses all its money and fails. Because the business was a C corporation, all those losses will be trapped inside the corporation and can’t be used — or at least not easily, soon, or in any great quantity (see Code 382). The investors, who probably could have used those losses against other sources of income, will be stuck with a long-term capital loss, which, under the current rules, is deductible against capital gains plus $3,000 per year of ordinary income. Granted, no one invests in a company expecting to write-off the entire bet, but it happens – in fact, it happens a lot. Therefore, anticipating this possibility in a no brainer.
In the case of an LLC, the early investors can be allocated the startup losses directly. If the investors are not actively involved in the LLC business, the losses will be subject to the passive activity loss rules. This means that the losses can be used currently to offset passive income from other sources, or else suspended and deducted in full when the passive investment is terminated – either by sale or by failure. If the investor has a different investment that generates current passive income (called a “passive income generator” or “PIG”) the passive losses can be used immediately. In the worst-case scenario of complete business failure, the passive losses at least become ordinary losses, which are much more useful than capital losses
The LLC is also a great vehicle when things go well. For example, a new technology may, after investment and development, spawn several distinct market opportunities, which may appeal to different investment constituencies. Being able to separate these ideas quickly, easily – and above all without tax consequences – is very desirable. In general, corporations have been described as “lobster traps” (this is a popular analogy in Boston) because it is easy to put assets into a corporation but hard to get them out. An LLC, by contrast, is amenable to easy spin-offs, distributions, separations and re-combinations of business assets.
An LLC passes income through to members, thus causing profits to be taxed a single time at the individual level instead of the brutal double tax that currently applies to C corporations. An LLC can also issue “sweat equity” to employees in the form of a “profits interest,” which is not taxable on receipt; this can be a big advantage compared to restricted stock or stock options in a corporation, which are taxable when the restrictions lift of when the options are exercised.
If the business receives an early cash buyout offer the LLC structure is golden because it allows the owners to sell the assets OR the equity (i.e. LLC interests) at a single level of capital gains tax, while allowing the purchaser a step-up in tax basis. A C corporation, by contrast, is subject to double taxation on a sale of assets, or, in the case of a stock sale, offers limited tax benefits to the purchaser (a stock purchase does not allow basis step-up in underlying corporate assets), which usually reduces the offer price substantially.
Now for the conventional wisdom, especially from those sitting in the investment seat. Venture capitalists often insist on structuring the investment target as a C corporation, for a variety of reasons:
2) The VC group may include foreign non-resident investors who do not want to be subject to U.S. income taxation, which would be the case of an LLC conducting business in the United States.
3) VC investors often don’t want the hassle of reporting taxable income from the investment, either because it involves filing returns in a variety of states, or because the income is not accompanied by the cash to pay the tax. (Although an LLC can promise to distribute enough cash to cover the tax liabilities, this can be an administrative hassle, and there is always a risk that the K-1 may arrive but the tax payment check may not.) Some VCs don’t like to report losses, either it can make the investment performance look bad.
Ultimately, and at the most fundamental level, VCs understand and are comfortable with a C corporation issuing preferred stock, with the corresponding predictability concerning control of the business, distribution preferences, and other legal rights that have been long established and, in some respects, have the inertia of tradition.
On the securities law side, LLCs can raise problems with the holding period under Rule 144. In particular, if an LLC “converts” to a C corporation at the time the VCs invest, the holding period of pre-existing investors for Rule 144 purposes begins at the time the C corporation is formed and does not relate back to the formation of the original LLC.
Another criticism of starting with an LLC is that it is sometimes difficult to negotiate a new round of investment, either in the LLC or into a newly formed C corporation. All deals, of course, are unique, but as a general matter I find that it often makes sense to keep the LLC group intact (all the complicated prior negotiations are reflected in the LLC), and instead have the LLC contribute its business assets to a newly formed C corporation (in exchange for stock now owned by the LLC) and, at the same time, have the VCs invest directly into the new C corporation. This approach has the enormous virtue of not trying to convert the often-complicated relationships within an LLC into the very different format of the C corporation’s capital structure. Among other virtues, the LLC remains in existence and any profits interests issued by the LLC to service providers (a very common situation in startups) remain intact; by contrast, a conversion of profits interest into stock may trigger income taxation on the conversion date.
Venture investments are always governed by the golden rule, namely those who have the gold make the rules. Quite appropriately, the VCs call the shots on corporate structure: it is the prerogative of providing the money. On the other hand, I counsel startups to wait until VCs make the proverbial offer they can’t refuse – don’t convert to C status prematurely. I have seen startup companies convert to C status in expectation of investment, only to have the investors walk, leaving behind a wholly inappropriate early-stage operating vehicle.
Conversely, the one situation where I found an LLC startup to be a true impediment was when the LLC was approached by a publicly traded corporation hoping to acquire the business solely in exchange for its stock. In that instance, it would have been better if the LLC had been a corporation and thus eligible to participate in a tax-free merger. However, I will also point out that this was wonderful “problem” to have: namely a large, early cash-out at a huge premium. This situation basically produced a triple instead of a home run. However, for every home run, there are a far greater number of startup businesses that strike out, and the issue is how best to balance all the possible outcomes. The only sure way to get it right is to gaze into your crystal ball – and then be skeptical. And, in most cases, the LLC is tailor-made for skeptics.
Joseph “Jay” Darby is a partner in the Boston office of law firm Greenberg Traurig (www.gtlaw.com). He specializes in three areas: tax, corporate/securities and intellectual property. He received his law degree from Harvard Law School in 1978 and a bachelor’s in mathematics from the University of Illinois in 1974. Darby is the author of several books and has written more than 500 articles for magazines and newspapers, including Hemispheres and Worth.