Getting a venture-backed company off the ground means dealing with crucial issues nearly every day. While none of these moves guarantees a portfolio company’s success, most could ensure failure if a venture capitalist or an entrepreneur makes the wrong decision. How to structure a company is one of the key early decisions facing founders and VCs.
Structuring a new business as a limited liability company (LLC) initially looks like an attractive option for a number of reasons, says Eileen Smith Ewing, a partner at the Boston office of law firm Kirkpatrick & Lockhartt LLP. “In many states the LLC statute is a whole lot more flexible and less specific than the corporate statute,” she says. “There are certain requirements firmly embedded in corporate law, whereas you can be a lot more creative with an LLC in how you structure it and that could really benefit venture capitalists.”
The structure question essentially comes down to a tax issue, says John Egan III, a corporate partner at the Boston office of law firm McDermott, Will & Emery (MWE). From a tax perspective, the LLC’s other attractive element is that it is a flow-through entity, whose income goes straight through to its shareholders, who pay tax on this income. Thus, LLCs avoid the so called “double tax” corporations pay income tax on their income and then individual shareholders pay tax on any distribution the company makes to them from this already taxed income.
So with greater structural flexibility and tax advantages, VCs should encourage entrepreneurs to structure the companies as LLCs, right?
Actually, no, says Jonathan Axelrad, chairman of the fund services group at Palo Alto, Calif.-based Wilson Sonsini Goodrich & Rosati. The more appropriate approach is for companies to use the C-corporation structure, which are not treated as pass through entities, he adds. “I am a significant advocate of the use of LLCs where appropriate, but an LLC generally is not an appropriate structure for a company seeking venture financing,” he says. The reason for this is that most VCs actually cannot invest in LLCs without breaching the covenants of the partnership agreement they signed with their own investors, he notes.
“VCs raise money from tax exempt entities, like pension funds, and non-U.S. investors who normally are not required to file U.S. tax returns,” Axelrad says. “But if a tax exempt entity or foreign investor incurs unrelated business taxable income (UBTI) or U.S. trade or business income, then they have to file.” Virtually all of the income generated by a private company is UBTI, so if a fund invests in an LLC that UBTI will flow through to the fund’s investors, causing them to have to file tax returns. This could result in some of the investors losing their tax exempt status and some very unhappy offshore investors, who did not want to pay U.S. taxes from the beginning, Axelrad notes. Because of this, these investors usually ask for covenants in a venture fund’s partnership agreements requiring VCs to try to use their best efforts to avoid investing in LLCs, he adds. “Overwhelmingly, VC firms insist that portfolio companies be structured as C-corporations,” he notes.
Laying the Cornerstone
After becoming a corporation, new venture-backed businesses need to decide where to incorporate as legal entities. An increasing number of companies are looking to Nevada because it has laws to protect individuals and their privacy to a great degree, says Cort Christie, founder of Nevada Corporate Headquarters Inc., a corporate structuring and business consulting firm.
“The case for incorporating in Nevada is that there is no state corporate income tax and they have among some of the strongest privacy laws in the nation as regards piercing the corporate veil,” says Kirkpatrick & Lockhartt’s Ewing. However, these advantages do not really help VCs, who divulge their own equity positions to their investors and who, with an eye towards exiting their investments, rather than protecting their assets, at some point would of their own accord give up all the protections afforded by Nevada’s laws anyway, she notes.
Moreover, Delaware corporate code is the most well-developed in the country and the most well known to lawyers, which makes Delaware the choice for incorporating businesses, says Jay Rand, a partner at the New York office of law firm Morrison & Foerster LLP. “VCs often ask for an opinion on the law and firms are comfortable giving a Delaware opinion, because we are all so familiar with Delaware. How comfortable are people going to be giving a Nevada opinion?” he notes.