“Ask the Business Attorney” – What’s Wrong with an LLC?

by Scott Edward Walker on June 16th, 2010

Introduction

This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  Below is a longer version.  Please shoot me any questions you may have in the comments section.  Many thanks, Scott

Question

I set up an LLC on LegalZoom about a year ago and now my new lawyer is telling me I have to change it to a corporation if I want to get VC funding.  I think he’s just trying to create work for himself.  My accountant told me an LLC is the best structure.  I don’t know what to do, and I don’t have a lot of money.  What do you think?

Answer

As I have previously discussed, each venture is unique and the correct choice of entity depends upon a number of different factors, including the type of venture, whether the venture will be seeking outside investors, the amount of initial capital contributions of the founder(s), etc.

There are three major advantages to utilizing an LLC (or limited liability company).  First, an LLC is a “pass-through” entity for income tax purposes – which means that profits and losses flow directly through the entity to the members (unless the LLC elects otherwise, which is quite rare).  This can be very appealing to avoid the double taxation of profits of a C corporation and to permit the members to write-off certain losses of the company.

Second, an LLC offers extraordinary flexibility, including with respect to the distribution of cash and other assets, the allocation of profits and losses, and management structure (all of which is generally reflected in a written operating agreement).  Indeed, an LLC may be operated like (i) a corporation, with a Board of Managers and officers, (ii) a general partnership, with all members appointed “managers” or (iii) a sole proprietorship, with one member (or outside individual/entity) appointed the manager; and, in certain states (like Delaware), an LLC may even limit the fiduciary obligations of its manager(s).

Third, an LLC is an effective shield against personal liability, subject to one caveat: a few courts have held that the sole owner of an LLC is not protected against personal liability (see my post regarding single-member LLC’s).

There are also three major disadvantages to utilizing an LLC, the most significant of which for entrepreneurs is that VC funds and other institutional investors usually do not invest in pass-through entities such as LLC’s.  Accordingly, if a venture will be seeking VC funding, an LLC is generally not a good choice of entity; and converting an LLC to a C corporation (which is the typical entity in which VC’s invest) can be tricky and expensive.  In fact, a new client of mine ended-up paying tax attorneys close to $15,000 in legal fees to effect such a conversion.

The second disadvantage of an LLC is its complexity, particularly from a tax and accounting perspective (as noted above).  Indeed, LLC’s are subject to complex partnership tax rules, and anyone who has seen a well-drafted operating agreement will notice the pages and pages of tax provisions.

The third disadvantage is the limitation on capital structure; for example, it is difficult and expensive to grant options to employees/consultants in an LLC.  The issuance of other types of securities can be tricky as well, such as “preferred” membership interests.

Conclusion

Based on the foregoing, I would agree with your lawyer that if you’re seeking VC funding it would make sense to convert to a C corporation and otherwise get your house in order before you approach investors.  That being said, you will need input from strong tax counsel to effect the conversion, and if it turns out that you cannot afford to convert, you should go directly to the investors and propose either (i) effecting the conversion as part of the financing (e.g., as a condition to closing) or (ii) setting-up what’s called a blocker corporation, which would permit you to maintain the LLC structure.  Neither alternative, however, is generally appealing to investors.  Good luck!

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2 Responses to ““Ask the Business Attorney” – What’s Wrong with an LLC?”

  1. Natalie says:

    very helpful. thank you!

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