C corporation · LLC

Converting a DE LLC to C Corp: need to do a pre-conversion fair-market valuation?

Anonymous

May 25th, 2014

Hi everyone,

Let's you'd like to convert an existing Delaware LLC to a Delaware C-Corp that already generates some revenue.

Is it necessary to do a fair-market valuation before assigning a nominal value for the new C-Corp shares or can the value of those new shares be arbitrary and very low (as is the case for new startups)?

The question is relevant in the case where the new C-Corp would like to give some incentive to pre-seed employees. If the value of the company is already significant (i.e. not close to 0), stock options might not be an effective tool, as the strike price would be too high and have an adverse tax effect on early employees (if they'd like to make the 83-B election, for instance). I would imagine that RSUs would be the way to go in that case and that a stock options pool would be created right after the first seed investment (if any). Of course, those thoughts are moot if it is possible to assign an arbitrary value to the new C-Corp stock. Note that it's not a new C-Corp that acquires the old LLC, but a continuing C-Corp (through a conversion).

Thanks in advance for any feedback from those who've already gone through that process.

Raphael.

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May 25th, 2014

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Michael Barnathan

May 25th, 2014

I believe the existing cost basis of your company carries over from an LLC to a C corporation, so there wouldn't be a gain on the concern as a whole. While the members would realize stock in the new company at a higher cost basis, I suspect that there's no capital gain for them either, because they're "trading" an equivalently valued membership stake in the LLC for that stock. If that's the case, this would probably be considered a "purchase" of RSUs rather than a "grant", assuming everyone makes an 83(b) election.

You'll probably want to consult a tax lawyer; this is my best guess at the scenario and could be totally off-base.

Michael Barnathan

May 25th, 2014

Also keep in mind that the FMV assigned to a company by investors is usually for a "Preferred" class of stock, which often has very little to do with the value of the common stock that you assign to your founders and employees prior to the company achieving a liquidity event.

David Crooke Serial entrepreneur and CTO

May 25th, 2014

Apart from the emotional factor, RSUs are the same as a cash bonus tax wise. if it's a pre-IPO company, it can arguably be worse for the employees than options .... if the options are at parity or appropriately discounted for risk compared to preferred, you can 83(b) them for zero. However I think the company can take a tax hit nowadays for that.

Michael Barnathan

May 25th, 2014

You can't 83(b) options, only stock. RSUs are taxed under 83(a) at vest, or 83(b) at grant, depending on whether you make the election.

Options get taxed only on sale following exercise, so there's no upfront tax liability but the grant usually has worse long-term tax treatment. Stock purchased via exercise of an incentive stock option (ISO) can be taxed as a long-term gain when sold if held for more than 2 years since grant and more than 1 since exercise (but is subject to the AMT), while stock purchased under a nonqualified stock option is treated as ordinary income (like a bonus). ISOs are more favorable overall, but there's a $100k/year limit on ISO compensation.

In a company with little value, RSU compensation with an 83(b) election or early-exercise of options followed by an 83(b) of the resulting RSUs usually ends up favorable. Basically, you want to optimize for the long-term at the expense of taking a tax hit in the present if the company is worth little, since the hit will be small and the long-term upside possibly quite large. If you're buying into a company that already has high value (e.g. your company gets acquired and it's treated as an asset purchase rather than a reorg), particularly if the company is still private and you can't liquidate their stock to repay taxes, options are much more favorable.

This stuff gets pretty complicated pretty quickly, so my advice to consult a tax lawyer still stands :)

Anonymous

May 26th, 2014

Thanks all for your responses. I guess I wasn't really clear about my objectives here, but the concern really isn't for the existing LLC members (and future Corp shareholders), as I indeed believe the conversion to C Corp is a transparent event with no tax consequences.

The issue I have is that one of the members bought his membership interests 2 years ago at an original valuation of $50K. The company is probably worth 10x that now, and though that's still insignificant in itself, it probably isn't if I want to hire and incentivize early non-founder employees.

I would consider stock options if the company was worth, say, $1,000 because the stock options would be appealing to early employees even if the company grows organically without outside funding. If the company valuation is closer to what it really is and the company only grows at, say, 2x per year, then stock options might look pricey for an early employee. Hence the idea of compensating these employees with free stock, i.e. RSUs.

However, my concern is that I have to explain why we're granting RSUs and not stock options, because RSUs are mostly used at large, established companies while stock options are still heavily used at venture-founded startups.

Since my company is neither large (of course) nor venture-founded, I'm wondering which incentive tool looks best (regardless of other factors) for early employees as I'm converting the LLC to a C-Corp (since giving stock incentives in an LLC is rather complex as not well understood, as far as I know).

Assigning an artificially low value to the new C corp would make stock options viable (and hopefully avoid lengthy discussions with potential hires), but I wonder whether that's legally acceptable or not (for existing members, that artificially low value doesn't matter much since they're only concerned with a liquidity event, not a mere valuation - that's not a general statement, just the specific situation with my company).

Michael Barnathan

May 26th, 2014

Ah, it sounds like you have a handle on the differences. I suspect that most early non-founding employees actually don't pay attention to the form of equity comp they receive - I've seen a lot of companies that don't even disclose strike price to their employees when making option grants, and they get away with it. I personally wouldn't discount options out of hand, but might expect slightly more of them than RSUs to compensate for the nonzero strike.

I don't think there are any legal issues, per se, but I'd avoid discounting your stock below a valuation that has already been assigned unless your business truly did shrink. If you or your company does get audited, the question will be what changed to support that lower valuation, whereas it's an easier case to make for growth.