Last week, I blogged an answer to the question “What’s The Best Corporate Structure For An Early Stage Company?“ A few people responded asking why I didn’t like LLC’s more.
While there are several advantages of an LLC over an S-Corp (ability to issue different classes of securities, ease of set up, informality of operating agreements, lower state taxes, non-US investors), venture funds typically cannot (or don’t want to) invest in LLCs. When a VC invests in an LLC, they risk getting an income tax called UBTI (unrelated business tax income). This type of income is frowned upon by investors in venture funds partnerships and most funds have a provision in their fund agreements that they will use best efforts not to bring UBTI into the partnership. As a result, VC funds shy away from investing in LLCs.
The able minded entrepreneur says “yeah Brad, but I’m not ready for venture capital yet – I’ll just do an LLC now and convert to a C-Corp when I raise VC in a year.” Ok, but in order to “convert” an LLC into a C-Corp, one actually has to go through a complete merger, whereby a new entity is created, which usually drops down a wholly owned subsidiary, that sub is merged into the LLC, leaving the LLC as the sub of the parent. In short, it’s complicated and makes the lawyers and accountants some extra cash. Yuck.
In contrast, converting an S-Corp to a C-Corp is simply a “check the box tax election” (or – actually – “unchecking the box”) – this can be done in a day with a single tax form. No lawyers, no accountants, no money. Therefore, while the LLC has some benefits, the costs of converting the LLC into a fundable entity is substantially higher and usually not worth the additional effort.