Beyond the Pitch
Company Formation: Corporation or LLC
Selecting the right company formation.
Of the many decisions facing the entrepreneur starting a high-growth business, company structure belongs at the top of the list. Every founder must form a legal business entity; however, that doesn’t mean that the form of that entity can or should be decided on day one.
Don’t be the entrepreneur who hastily opts for the $49 Internet “set up an LLC today.” Instead, take a step back, think about the business you want to build and choose a business structure that matches your vision.
If your vision is to build a high-growth company, one that will eventually require outside investment (specifically venture capital) to initially ramp and then scale, and if the business is made to realize gains for founders and investors through an exit event (typically via acquisition or IPO), the appropriate business structure is a corporation. There are several reasons why.
From an investor’s point of view:
- Venture capital funds and institutional investors prefer the familiarity of Delaware corporations and Delaware law. Delaware offers the most consistent, reliable, and predictable set of corporate laws. That’s why most investment documents are prepared with the assumption that the entity will be Delaware corporation.
- A Limited Liability Company (LLC), on the other hand, doesn’t offer investors the same familiarity or predictability. The case law isn’t as well developed for LLCs. Instead of the comfort and efficiency that comes with Delaware’s corporation statues and precedents, with LLCs, investors can feel like they need to reinvent the wheel with each investment.
- Investors in a startup organized as a corporation can take advantage of the tax benefits of Qualified Small Business Stock (as defined under Section 1202 of the Internal Revenue Code). For these shares, the capital gains can be excluded until future investments are sold.
- LLCs do not qualify for Qualified Small Business Stock treatment and investors are unable to take advantage of this significant benefit.
- Corporations come with fewer uncertainties around management’s legal obligations. Delaware’s robust case law provides a substantial foundation from which board members, officers, and controlling stockholders can make what are often difficult decisions that involve numerous conflicts of interest. This helps directors and officers ensure that they don’t violate any fiduciary duties or other obligations.
- With LLCs, the laws and regulations defer to the individual LLC’s operating agreement to define corporate governance. Therefore, each LLC’s compliance and fiduciary guidelines may be unique, which results in a unique analysis being undertaken on a case-by-case basis. There is more flexibility with LLCs in this regard, but increased flexibility can lead to increased costs and legal expenses.
- LLCs typically are required to comply with certain tax-related requirements. Venture capital funds likely find these requirements cumbersome and/or not worthwhile to endure when investing.
- Converting a startup that began as an LLC to a corporation adds unnecessary complexity, expense, and delay to the deal.
From a team-building point of view:
- Corporations can offer more favorable and more easily understood equity incentives to employees. Many high-growth businesses grant equity to attract talented founding teams. Within an LLC, equity grants can have adverse tax consequences to the recipients and typically come with voting rights that founders don’t intend to provide. Moreover, these recipients go from W-2 employees who generally pay their taxes via a typical withholding process to K-1-receiving partners who are supposed to pay estimated taxes quarterly.
- The tax treatment of appropriately structured employee stock options may be favorable to recipients through the deferral of the gain until the underlying shares are sold. For example, corporations can grant incentive stock options (ISOs) to employees. Employees are not required to recognize income at the time of the grant or when the grant is exercised. Tax is deferred until the underlying shares are sold and, depending on how long the stock was held, could be taxed as capital gains versus ordinary income.
So why do we see so many entrepreneurs structure their company as an LLC?
- Many entrepreneurs don’t know any better. They lack the experience and don’t have a trusted advisor to help them understand why a high-growth business should be formed as a corporation rather than as an LLC.
- Setting up an LLC looks easy. And it doesn’t cost much. Many states now allow for any entrepreneur with a credit card can form an LLC.
This article offers a high-level view of the advantages of forming a high-growth startup as a corporation, rather than an LLC. The idea is to help founders of high-growth companies learn enough about what’s important so that the questions they ask are informed, and they’re properly armed to seek out the appropriate advisors and professional service providers.
In short, if you’re a founder of a high-growth company, you should:
- Resist the urge to “form as an LLC for now.” It might give you some short-term anxiety relief thinking you’ve checked this box, but slightly more effort at the outset will make things far easier going forward.
- Seek experienced counsel before you form your company. In selecting your professional service providers—attorneys and tax advisors—be sure they have lots of experience working with high-growth businesses. Those who do will have the necessary experience to help and should have cost-conscious product offerings for their startup company clients. If you have already previously organized as an LLC, that’s all the more reason to seek counsel from an experienced attorney and tax advisor to determine the best next steps for your company.
- Follow that expert advice. After all, you paid for it!
Even though there’s a lot to be learned about business formation and structure, founders of high-growth companies don’t have to become experts to conclude that for most high-growth businesses, a corporation, not an LLC, is the way to go.
Jonathon H. Vinocur is a partner in Thompson Hine’s Corporate Transactions & Securities practice group. His practice is focused on representing emerging technology companies, angel investors, and venture capital firms. He advises company-side clients from the formation, through funding to exit and has extensive experience in complex, venture-style, corporate finance matters.
Portions of this article were originally published in Thompson Hine’s Spring 2018 Business Law Update: Launching a Startup? Consider Forming a Corporation Instead of a Limited Liability Company, by Kaoru C. Suzuki and Jonathon H. Vincor.
This article is not intended to provide legal counsel or advice. Consult with an experienced attorney. In particular, the tax considerations of equity compensation are far-reaching. Please seek the advice of a qualified tax expert in advance of structuring any equity plan or agreement.
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