Should A Startup Be A LLC?

Should A Startup Be A LLC?
Legal-Structure-for-Startups

Should A Startup Be A LLC?

Entity formation is intimidating and mysterious to many founders. For most it doesn’t have to be.  Though you’re familiar with Java, C++ and PHP, you’ve yet to wrap your head around the difference between C-corps, S-corps and LLCs.   You know that LLC stands for limited liability company and that sounds pretty good. You also know that Pied Piper became a corporation in episode 3 of HBO’s Silicon Valley.  Shit.  You also just remembered that Pied Piper became a Delaware corporation. So what’s up? Should a startup be a LLC?

Choosing how your company will be organized is important business.  Indeed, the reason so many different choices exist–corporations, limited liability companies, partnerships, sole proprietorships, etc.–is that each comes with unique sets of legal implications.  Although there are a smattering of different organizational structures…and within that smattering a handful of sub-types and hybrid combinations…most founders find themselves choosing between the two most common types of organization, the corporation and the limited liability company (LLC).

As is always the case with these posts, there may be circumstances unique to your business that might warrant a different approach than the one I’ll outline, but the below is a pretty good start on understanding why the LLC might not be the best choice for your company.

Why the LLC is Probably Not For You

You’re right, liability is bad and limiting liability is good.  Despite the LLC being the only entity type with limited liability in its name, though, it is not the only entity type that features a limitation of liability.  In fact, most of the legal entities a startup can choose from (including the corporation) feature some limitation of liability.   While the limited liability feature of an LLC is shared with its corporate counterpart, there are a few features that set the LLC apart, and generally make the LLC a bad choice for startups.  These distinguishing characteristics are flow through tax classification and the inability to issue traditional incentive stock options.

Flow Through Taxation:

Earnings and losses in an LLC “flow through” to the LLC’s individual members and, unlike the corporation, taxation on those earnings and losses are the responsibility of the LLC’s individual members.  So, at the end of the year, rather than the company paying taxes on earnings or offsetting against losses, the LLC’s individual members must do so on their personal tax returns.

The problem is that the members are required to pay taxes on the company’s earnings even if those earnings were not passed on to the member.  So imagine a 4 member LLC makes $1 million in 2014 but takes the entire $1 million and reinvests back into the company….the LLC does not make a distribution to its members.   At the end of the year, each of the 4 members is responsible for their respective pro rata share of the taxes due on the $1 million.  The members aren’t total losers here, as the company grows so does the value of each member’s stake in it, but, nonetheless, each member will have to pay the taxman in cold hard cash even if none was distributed to the member by the company.  Of course, the company could just make a distribution to each member sufficient to cover the costs of any tax the member will incur.

Beyond just being damn costly (if no distribution is made to members) and administratively burdensome (in any case), the flow through taxation feature is particularly unattractive to venture capitalists.  Venture capital funds are often made up of individual investors who enjoy tax-exempt status that may be adversely affected by the receipt of business income from an LLC….making the idea of investing in an LLC less attractive than the notion of investing in a corporation.  A lot of VCs won’t touch an LLC and will require companies to formally reorganize as corporations before closing a round.

Limited and Complicated Equity Compensation:

The preferred equity compensation arrangement in a startup is the stock option.  Basically, a stock option gives its holder (here an employee) the right to purchase shares at a price of X (the strike price) at some specified time in the future.  For example, an option may state that Employee Number 3 has the right to purchase 5,000 shares of Company B at a price of $2.00 per share on a date that is four years from the date of the option’s issuance.  The employee is “in the money” when the value of the company’s shares is above the option’s strike price, thus permitting the employee to purchase shares at a discount.  Staying with our example, if in four years Company B is valued at $3.00 per share, Employee Number 3 is “in the money” by $1 per share.  Employee Number 3 can buy 5,000 shares at a strike price of $2.00 per share, resulting in the purchase of $15,000 worth of shares for $10,000.

The problem in an LLC is that, by definition (and law), there is no “stock” for an LLC to issue to grant stock options.  LLCs have “membership interests” instead of stock and,rather than conveying ownership of a portion of the company (like a stockholder would have by virtue of owning stock), membership interests give the member a right to share in the company’s profits and losses–not ownership of the company.   Granting an option to purchase stock (ownership) at a discount is much easier than granting an option to purchase a share in the profits or losses of company at a discount.  Stock and membership interests confer very distinct rights, and membership interests don’t lend themselves well to the option compensation scheme.

Before I get ahead of myself, there are certain membership interest arrangements in LLCs that can mimic attributes of equity or stock option compensation in a corporation.  They are often complex and costly to set up, though, and may require significant time and attention each time equity compensation is awarded….this is particularly true when attempting to structure an LLC equity compensation arrangement that mimics the benefits of incentive stock options, a statutory and tax efficient stock option scheme only available to corporations.

For startups with growth strategies that will require recruiting top management and technical talent, the ability to match competitors’ equity compensation packages is critical.  Although the LLC membership interest is flexible and creative equity compensation structures are evolving around state LLC law, the corporation may be the best choice for plain vanilla incentive stock options that confer favorable tax treatment.

So If Not The LLC, Then What?

So if flow-through taxation and limited equity compensation arrangements make the LLC a less than ideal choice for most startups, what is the better entity type?  Knocking out the LLC still leaves the partnership, the sole proprietorship, and the corporation—each with different sub-arrangements and hybrids.

Disclaimer: the contents of this article were written and are made available solely as general information and for educational purposes and not to provide specific legal advice of any kind or to establish an attorney-client relationship. This article should not be used as a substitute for competent legal advice from an attorney licensed in your jurisdiction. This article has been written by Bret Stancil in his individual capacity and the views and opinions expressed herein are his own.

This post was originally published on StartupLawHacks.com by Bret Stancil.

[Photo by  Sebastiaan ter Burg / CCBY]

Bret Stancil is a corporate lawyer who focuses on general corporate matters and transactions.  Bret is the creator of StartupLawHacks.com, a site aimed at providing general legal information to entrepreneurs.

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