Now we’re going to talk a little bit about arguably one of the most important things when you’re setting up a business: fundraising. As a corporate lawyer who represents startup companies and investors in startup companies on a regular basis, I know that fundraising is vitally important for getting a business up and off the ground with working capital that you can use to put your business into motion.
Fundraising for a Corporation
Let’s talk a little bit about the differences between fundraising opportunities for a corporation versus a limited liability company. If you’re a startup corporation that’s looking to take on money from a venture capital firm, virtually all of venture capital and institutional investors favor C corporations because C corporations can issue separate classes of stock, which allows for the creation of various levels of preferences, protections, and share valuations for venture capitalists compared with common stockholders. But also important, venture capital funds aren’t really able to make equity investments in S Corporations because venture capital funds are typically structured as partnerships and they typically want to own preferred stock. With a venture capital fund, equity investment in a limited liability company can cause tax problems for the venture capital funds tax-exempt and foreign partners.
Really a very important point to bear in mind is if you’re an entrepreneur who’s trying to start a business and you really think that your path forward to growth, profitability, and success is raising money from a venture capital firm or a similar type of institutional investor, in all likelihood you’re going to be a Delaware C corporation.
A limited liability company is going to be a difficult choice of entity for you in terms of forming and growing your business. S corporations can issue preferred stock and common stock, just one class of stock to all owners. However, stock with different types of voting rights are permitted. But again, because S corporations can’t issue preferred stock and that’s typically the way that venture capital firms like to hold their ownership interest in a company, you’re typically not going to be able to raise money from venture capital firms typically as an S corporation.
Fundraising for an LLC
Although LLCs may be attractive to businesses and founders who are looking to create a business that’s financed by a small number of corporate investors or individuals, they’re often not suitable for companies that are planning to pursue multiple rounds of financing, issuing multiple classes of equity, or if they’re hoping to issue convertible debt. LLCs from a relative standpoint typically require an operating agreement, which can be fairly complicated and voluminous, and it may render the operation of the LLC undesirably difficult with a high number of members.
LLCs, as I mentioned a little bit earlier, are often unattractive to tax-exempt venture fund investors because their investment in a flow-through entity like a limited liability company can produce unrelated business taxable income. Of course, you can always convert down the road from an LLC to a corporation. Sometimes I have founders who say, “Why don’t we start as an LLC and if we decide that we want to be a corporation later, either because we’re raising venture capital money or for other reasons, we’ll just convert at a later point.” That is true. The entity choice that you choose today is not forever set in stone; however, converting from an LLC to a corporation down the road can be a bit complicated and expensive and so oftentimes it’s better to decide what type of business entity you want to be from the get-go rather than changing midstream.
Familiarity Breeds Investment
Investors can sometimes just be less familiar with LLCs a business entity, and then as a result be less willing to invest in them. LLCs really have only been around since the late 1970s, whereas corporations have a long history and a high degree of familiarity with investors. So if you present an LLC term sheet to some investors, they may be more familiar with the corporation as opposed to a limited liability company, which could be a reason that operating your business as a corporation makes a bit more sense.