There are several considerations when deciding between forming a corporation or a limited liability company. The common considerations include taxation, liability exposure, management flexibility, and the need for capital.
In this post, I’ll exclusively focus answering the question “LLC or Corp?” by analyzing the need for additional capital to grow your business, with an emphasis on why you should incorporate if you plan to seek venture capital financing.
It is no mystery businesses need money – especially to grow. It is one question all entrepreneurs think about, or at least should think about, especially in the early stages of the business planning process.
Money can come into a business in several ways. A business can obtain money for growth generally through:
- Sales (customers give you the money for a product or service you sell);
- Sale of ownership interests (offerings stock to investors);
- Owner capital contributions; and
- Debt (Loans).
Depending on which source will dominate the infusion of capital is a major consideration. If a business will receive a significant portion of the capital from outside investors like venture capital funds, forming a corporation is typically the better choice.
Venture capitalist will prefer investing in a corporate entity instead of an LLC for several reasons. Generally, transferability of ownership interest, taxation, established law, and liability protections are the factors considered.
Transferability of Ownership Interest:
While interest in a limited liability can be transferred, it typically involves working around the control of other members. Depending on the operating agreement, members of a LLC may first have to get approvals from non-transferring members. This could be a major turnoff for an investor like a venture capitalist. On the other hand, shares in a corporation can typically be transferred more easily. In particular if the new company’s long-term exit strategy is to offer an IPO, where significant amount of interest will be transferred to investors in exchange for money, forming a corporation is ideal. One must also consider the rights transferred when transferring ownership interest. An interest in a LLC typically comes with rights to be more involved in the management and the day-to-day activities of a business. On the other hand, stock ownership gives the shareholder economic rights but can more easily limit the shareholder involvement in the day-to-day management of the business. Accordingly, if a business owner or venture capital firm wants the flexibility of raising money by distributing rights to the economic gain of the business, but limit the involvement of the party from day-to-day operation, corporate form is favored.
While many business owners favor pass through taxation benefits, it is generally not favored by venture capitalist. Venture capitalist shy away from LLC structures because VCs often partner with tax-exempt organizations like universities and pension funds that are tax exempt. If these tax-exempt entities receive flow through income from the gains of an LLC (known as “Unrelated Business Taxable Income”), they will have to pay taxes at the ordinary income tax rate which is higher than capital gains tax rate. On the other hand when a venture capitalist invest money into a corporation as opposed to a LLC, the gains are received in the form dividends or sale of stock. Under the U.S. tax code, tax exempt organization do not have to pay taxes on these sorts of economic gains (dividends, interest, and capital gains) and venture capitalist by receiving the economic benefit in the form of dividends and capital gains can gain a tax advantage by paying a capital gains tax instead of the higher ordinary income tax.
The corporate entity has been established and used much longer than the more recently established LLC. The LLC is a newer form of business that in Massachusetts only came to life in late 1995. Accordingly, courts have more experience dealing with corporate matters and therefore have more established laws and principles. The laws of corporation offer more governance and defined rights and protections for both the corporate entity and shareholders. For a venture capitalist, the legal certainty that is accompanied by corporate form is comforting and preferred, as it will minimize legal risk.
LLC and corporation offer investors liability protection. While both do offer protection, remember, there is more established law surrounding corporations. This gives liability protection under the corporate form a little advantage over LLC because of the more defined laws and predictability that comes with such an extensive history.
Example: Sergey and Sira – Cure Migraines
Sergey and Sira have a new startup that is the next drug to completely prevent migraine headaches. While the two founders, both scientist, might have the secret formula, before they take the drug to market they will need to conduct research, develop the drug, test it, receive Food & Drug Administration approval, and market it.
The process will likely take several years and will be capital intensive. In this instance, the company can’t sell the new drug until the process is complete, and thus money from sales is not an option. Research grants may help some, but with no real cash flow, obtaining a large loan can be questionable. To stay afloat, Sergei and Sira will likely need an injection of capital from outside investors. This is where the corporate entity comes into play.
A venture capital that decides to invest in Sergey and Sira’s migraine cure will likely prefer the corporate form because of the various benefits discussed above.