What type of business entity should be formed for a startup company, and which are preferred by investors, angels, or venture capitalists? The common convention is that VCs tend not to like limited liability companies (LLCs) and prefer a C-corp over most other entity types. Some of the reasons for that is because VCs tend to not like pass-through entities, and LLC are for the most part treated as partnership pass-through entities for tax purposes. Further, LLCs do not allow for different classes of stock such as preferred stock (which is what most VCs require), many other instruments of ownership that corporations have.
However, the flip-side of the argument is that it may not really matter during the very early phase of a start-up. Namely, if the start-up is not seeking VC or other substantial money early on, could an LLC be beneficial? LLCs do tend to be easier in the early stages of a company, are flexible, and most smaller angels typically do not have a problem investing in them especially early on in the start-up’s life cycle for some of the following reasons:
- LLCs can beneficial from a tax standpoint considering that LLCs do not have double taxation, namely they do not pay corporate level federal tax, as such they are “pass-through”. (However, the LLC’s operation profits must be distributed each year and cannot be accumulated unlike a corporation, and most VCs favor accumulated profits to fuel growth rather than reaching to new equity.)
- Founders, angels, and/or other investors can offset the tax loss from the LLC against their other income personally which could present a substantial tax advantage.
- Although there are not different classes of stock, it is possible to create different classes of LLC “units” providing different types of rights and preferences attached to those units.
- Given its flexible nature, LLCs could be a good choice if the company has a positive capital flow and will not require additional rounds of investments from others.
So it is not uncommon that the early pre-seed startup will start off as an LLC, and when the time is right, typically in order to close a deal for venturing funding, the company will convert the LLC to a C corporation, usually a Delaware C corporation. For the most part, in regards to the legal formation of converting from the LLC to a corporation is not that difficult. But before determining that LLCs are a good choice for the pre-seed startup, there are some other complications from a practical standpoint:
- The new corporation will have to get a new federal employer identification number (FEIN) and will lose credit history.
- Changes must be made that previously identified the LLC to now identify it as a corporation, such as changes to the bank, web pages, insurance policies, etc. All of which may be extremely time consuming depending upon the history of the LLC.
- If there is existing payables or debt on the balance sheet and those obligations get assumed by the corporation, the owners of the LLC will get attributed income from the LLC’s debt forgiveness and will have to pay income tax at ordinary rates.
So while every scenario is different and while forming an LLC for a preseed start-up has its advantages, if it is clear that the start-up will be seeking additional funding in the near future, careful consideration should be given and a frank discussion with one’s tax advisor to determine if it is more beneficial to start off with a C corporation from the beginning rather than LLC and later converting it.