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Why Venture Capitalists Hate LLCs

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Business Angel Investors are individual investors, often-successful business owners, who are investing their own personal funds into a potentially rewarding business opportunity often in an early-stage or start-up business. Angel investors have experience and contacts to contribute, and may be willing to be “hands-off”. Whereas Venture Capital is invested by firms or companies that use other people’s money. Venture Capital is seldom invested in early-stage, have many contacts, and often require a seat on the board. They raise that money by offering investors a chance to take part in a fund that is then used to buy shares in a private company. Generally if the business is at an early stage then Business Angels are the most likely source of funding. Venture Capital firms may come on board at a later stage when the concept is proven and initial revenues obtained in order to more quickly expand the company. If your startup is absolutely determined to raise venture capital, there’s only one viable legal entity decision your startup can make–the C- Corporation. Most venture capitalists are unwilling—or unable—to invest in any other business entity.

Why Venture Capitalists don’t like LLC’s:

Limited Liability Companies (LLCs) are a very popular form of organizing small businesses. In essence, they are a hybrid entity that provides the limited liability protection of a C corporation with the tax benefits of a partnership. LLCs are also incredibly easy to set up. One of the main problems with LLCs is the tax implications, which deter—and in some cases even prevent—venture capitalists from investing.

In addition, LLCs are especially problematic because venture capitalists have a strong focus on getting to an exit. To eventually convert ownership into profits for VCs, startups typically need to IPO or be bought be another company. The problem with transferring your LLC to a C-Corporation is that it is rather complicated to transfer or sell partial ownership in an LLC.

Becoming an LLC is fairly easy. First, you must make sure the company name is available. Next, you must file the articles of organization. And now the LLC exists. Many entrepreneurs have not taken further corporate governance steps after filing the LLC articles of organization. This is unfortunate because the most important document for an LLC after it comes into existence is its operating agreement. Many well-intentioned entrepreneurs merely adopt some boilerplate terms for the LLC operating agreement, exposing themselves to major issues when seeking outside investment. Additionally, outside investors are often wary of LLCs because of the limited corporate governance requirements. When an investor is putting money into a new venture, they are not just investing in the idea of the company, but also the people running it. If the investor sees that the original leadership didn’t set up a clear corporate governance structure but just set up an LLC without a detailed operating agreement, that does not bode well for the company.

Why are LLCs not ideal for startups?

Startups that want to raise capital in order to grow their companies find it more challenging to woo investors if their startup is an LLC. Here are four reasons why investors may shy away from an LLC startup:

  • Tax implications of LLCs. C-corporations have no pass-through tax. LLCs and S-Corporations, however, are not taxed as entities, and company income taxes pass-through to its owners. Investors often don’t want to complicate their personal tax situation by becoming a member of an entity (i.e. an LLC) that is taxed as a partnership, because as a partner, they’ll be taxed on the entity’s income even in years when no cash is distributed to them personally. That means investors could be on the hook for a company tax bill, even if they received zero distributions from the startup.
  • Venture capitalists can’t invest in LLCs because of stockholder rules. Some investors, such as venture capital funds, can’t invest in pass-through companies such as LLCs, because the VC fund has tax-exempt partners that can’t receive active trade or business income due to their tax-exempt status. Furthermore, because some VCs manage public funds, they are barred from investing in LLCs. And since most venture capital firms are organized as limited partnerships, they are restricted from investing in S-corporations, which require “natural persons” as investors. S-corps also only allow a maximum of 100 stockholders, which limits growth. Thus, by investing solely in C-corporations, VCs can avoid numerous legal entanglements and complications and it allows the most legal flexibility when it comes to investing.
  • Investors are potentially taxed in other states. If the business has an active trade or business in other states, passive investors may become subject to income tax in those other states. A similar thing happens when non-US persons invest in US LLCs. This is a turn-off for investors.
  • Many investors prefer owning stock in a C-Corp. Investors in early-stage businesses usually just want to make a simple investment, acquire a capital asset (the stock), and avoid any intervening tax complications until the stock is sold and there’s a capital gain or loss event.

The best thing to do is speak with an experienced attorney who can advise you on the best course of action for your business. To speak with experienced lawyers, contact Fisher Stone and we can get started on forming your business.

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