In short, I would say that being structured as an LLC rather than a corporation will never turn a venture capitalist or angel investor away from a great investment opportunity. That being said, I believe that venture capitalists still prefer to invest in a corporate entity rather than a limited liability company. If you intend to raise capital at some point from outside sources, I think you will save yourself considerable time and money resources by choosing a corporate entity (of course, consult your accountant as part of this process). If you’d like some background information on the basic differences between S-corps, C-corps and LLCs, see my earlier post.
So, why are limited liability companies notthe preferred entity structure for a VC-backed company? First, the flow-through-tax status of LLCs can wreak havoc on a venture fund’s limited partners as it may subject them to UBTI (Unrelated Business Taxable Income). They may be forced to recognize income from the investment even though they have not received a distribution to pay for the resulting tax. Some VC funds have employed unique blocker entities to avoid these taxes but these methods are not surefire. Once an entity like a VC fund invests in a corporation, it will take on C-corp status, thus eliminating any flow-through-tax issues for limited partners in the fund.
Second, LLCs cannot issue certain types of stock options nor can they adopt a stock option plan (often the source of non-cash incentives for founders and other early members of management). Corporations don’t have this problem. They can issue restricted stock options, incentive stock options, non-qualified stock options and so on, all through a stock option plan adopted by the company.
Third, to the extent IPOs ever return as a possible venture backed company exit strategy, people perceive that trading shares in a corporation is easier than trading membership interests in a limited liability company.
Fourth, corporate law (particularly in Delaware) is well established. There is substantial caselaw on all sorts of issues which makes outcomes more predictable. Predictability helps eliminate risk, which VCs like. It’s a comfort factor.
Lastly, LLC Operating Agreements that have multiples series of preferred membership units (like you would have in a VC-backed LLC) can get extremely unwieldy. I can attest to the difficult drafting that is required to make all of the LLC provisions flow consistently and work together, particularly with multiple series of preferred membership units (LLC vernacular for shares). Creating series of preferred stock in a corporation is much simpler.
I would suggest that LLCs are a better entity for mom-and-pop type businesses, lifestyle companies, professional service companies and as subsidiaries of larger companies. Interestingly, many VC funds use LLCs as the preferred structure for their general partner entities.
What to do if you’ve already formed as a limited liability company and intend on seeking outside sources of capital from the likes of venture capitalists? Most likely, a VC that is interested in investing in your company will make it a condition to closing that you convert your LLC into a corporation. It gets more complicated if you’ve already got multiple series of preferred membership units in the existing LLC, but such a conversion can be done with some added time and cost. You simply merge the LLC into the new corporate entity. Some VC funds may even require that as part of this conversion you re-incorporate the entity in Delaware (a preferred state of incorporation). I’d suggest you save yourself the time and cost of conversion by going with the corporate entity from the beginning.