By Mark Graffagnini, President, Graffagnini, L.C. Mark is an attorney who represents investors and companies in financing transactions, general corporate matters, M&A deals and public offerings and securities reporting. This post originally appeared on graffagninilaw.com.
Photo: Courtesy Palo Alto Research Center.
If you are an entrepreneur who will be seeking venture or angel capital, you should know that most people, including myself, usually advise against using an LLC as your business entity. Many investors structured as venture or angel capital funds generally prefer corporations to LLCs for startups they invest in.
More and more, however, we see investors who are comfortable with LLCs for early stage companies, and there are several good reasons to use the LLC form at times. If you decide to use the LLC form for your business, here are the top 5 tips to ensure your company remains attractive to investors:
- Use “units” of membership interest instead of percentage interests. Units are like shares of stock in a corporation. A company issues units in exchange for investment capital. LLCs that solely use percentage interests instead of “units” or “shares” have a tendency to be sloppily run. Further, this type of capital structure often gets founders in the mistaken habit of thinking that they sell their own shares or units to investors when they raise money. They tend to look at the ownership percentages as having been bought or sold between the parties, when, in fact, the company should be the issuer of the equity securities of the company. Unfortunately, I also see many advisors such as lawyers and accountants who don’t understand this. In the end, everyone’s ownership is a function of units owned relative to the total units outstanding, but unit based structures are easier to work with and easier to convert into shares later if your investors require that.
- Establish a governance structure. Many startup LLCs are member managed, meaning that all of the members vote on issues. This is rarely appropriate. More often than not, there should be a board who exercises most of the management authority in the company or a single manager (think the CEO). In the absence of a board structure, many startups find it best to have a single person act as the “manager,” approving or disapproving of major decisions for the company. Getting in the habit of operating the company in the manners investors expect is important. Delaying this reality does little to prepare founders for the real world of early stage investing. Management structures which split decision making 50/50 between founders rarely, if ever, work in practice.
- DON’T BE TAXED AS AN S-CORPORATION. I am utterly shocked how many times I come across a tech startup who elected to be taxed as an S-corporation status under the internal revenue code (or, in some cases, even C-corporation status). If you go with an LLC, you should generally elect to be taxed as a partnership. This is the main (possibly only) advantage of an LLC for the startup at the early stage–you can take advantage of losses to your other personal income, or a quick exit will usually be more tax advantageous. If you elect S-corporation status, many investors will question this decision, and you will lose that S-corporation status as soon as an investor who invests through an LLC or a even a non-profit entity. For example, assume that your startup takes investment from a small angel investment fund structured as an LLC. Your company will lose its S-Corporation status the moment it takes investment from that entity. If that happens, you will have an LLC taxed as a corporation and your potential investors will really question the decision. The exception to my position here is if you are purely a service company not looking for outside investment. S-Corporation election status can then make some sense. Generally, if you plan to raise capital from outside investors, S-Corporation status will not be a good choice.
- ROFRs, Vesting, Drag Along, etc. You should consider placing vesting restrictions in your equity documents. These allow the company to buy back co-founder equity for cheap if a co-founder splits. Your new company is not adequately protected without this. Also, all units should be subject to a right of first refusal so that the company and co-founders can buy units back from someone trying to sell them to a third party. A drag along allows the majority owner to drag along minority partners in the event of an exit opportunity. These mechanisms can be as important in the startup LLC as they are in the corporation.
- No 50/50 structures for management. Plain and simple, these often do not work. Remember, management is separate from economic ownership, so evaluate your options there. Many times, I see LLC structures where minority owners have disproportionate decision-making power, and the key founder lacks the ability to make critical decisions and must get approval of absentee, early contributors. This can harm a startup and make potential investors question whether the key founder has essential decision-making power.
While LLCs can bring some advantages to startups seeking capital from outside investor groups like professional VCs or angel groups, people often underestimate the complexity of the form and structure these LLCs in a way that wipes out those advantages. Following these 5 tips can help you maximize the benefit of the LLC structure.
Disclaimer: This post discusses general legal issues, but it does not constitute legal advice in any respect. This post is not a substitute for legal advice and is intended to generate discussion of various issues. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel. Graffagnini, L.C. and the author expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post. The views expressed herein are personal opinion.