Startups · Fundraising

Do angel investors and venture capitalists prefer investing in LLCs or C-Corps?

Benjamin Bertelsen MSc in Digital Innovation & Management

October 26th, 2016

In the very early stages of the company, you need to make a key decision: What type of business entity to form. Will you be an LLC (a limited liability company), an S Corporation, or a C Corporation? The choice will have an immediate impact on your company, as well as lasting implications for your fundraising ability, especially if you decide to pursue venture capital.

Do VCs prefer one type to the other? In the past I have heard that they prefer C-Corps, and don’t really like LLCs. What is more beneficial to start your company out as?
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Peter Weiss President at American Outlook, Inc.

October 26th, 2016

First the bad news:

- While the conversion from LLC to corporation is simple from a legal perspective and can be simple from a tax perspective, it is not simple from an operational perspective.  You get a new taxpayer identification number, you lose credit history, need to redo all identifying documents and web pages that show you as an LLC, new bank accounts and insurance policies, etc.  Every time I've converted a client and every time I've spoken to CEOs and CFOs who've done it takes about eighteen months before you figure out all the parts and pieces you need to fix.

- There is also potential serious pain if you convert from an LLC to corporation while you have debt or payables on the balance sheet.  If these obligations are assumed by the corporation the owners of the LLC get attributed income from the LLC's debt forgiveness and have to pay income tax at ordinary rates.  This can be very expensive and painful.

- If you are an LLC your start-up losses pass out of the entity and are not available to shelter future earnings from income tax.  In the future you will have to sell more equity to have the same amount of working capital because you will have lower after tax earnings available for business needs.

- In almost every case where I have seen an LLC used for a start-up, the owners have little or no outside income so they do not benefit from the potential tax reduction which can be created by offsetting the start-up losses against other income.  If you convert to a corporation, you will not be able to use these losses until you have non-salary income.  This is tax inefficient for the individual and the company.

-  Finally, most institutional investors and virtually all VCs will not invest in LLCs.  Many angels do not understand them and will not invest.   But, before you despair, keep reading for the good news.

And now, the good news:

- If you really do not expect to seek VC investment LLCs can provide a number of advantages to both founders and investors.

- I have found a number of strategic corporate investors who prefer investing in LLCs, both public and privately held.

- If you believe your business is truly capital efficient and will not need multiple rounds of investment, LLCs are a flexible structure.

- If your investors can use the tax losses you can direct those losses toward the investors, providing financial benefit for them.

- If you expect your business will generate lots of free cash relatively quickly LLCs offer a very tax efficient way to distribute cash because you do eliminate tax at the entity level.  You need to be careful to protect your owners from attributed income without cash distributions but with some care in financial planning and attention to detail when you draft your LLC agreement this can be accomplished.  

-  You can create multiple classes of LLC units with different rights, preferences, etc.  Be careful of how the classes interact for tax, distributions, etc.

-  Until a few years ago you could not have options, convertible debt, warrants or other contingent forms of ownership in an LLC but the IRS changed its rules and those tools are now available.

Bottom line:  LLCs can be very useful but should be used only after careful consideration of many factors.  Do not use one if you think you are likely to convert to a corporation in the foreseeable future.  

Mark Rosenberg Tax, securities and commercial litigation

October 26th, 2016

I am an attorney and specialize in helping startups raise capital. Generally, an LLC is easier to deal with in the initial stages, and many smaller angels and VCs will invest while in that status. For a real "initial round" of funding, it is correct that larger VCs prefer a Delaware Corporation, but it is relatively easy to form that Delaware Corporation and then merge in your LLC. I wouldn't worry much about it at the beginning. You should definitely get legal assistance at the beginning, to make sure that the founders' interests are properly described and agreed to, which will prevent problems later. I am glad to give some informal advice to anyone in this forum. 

Bob Troia Entrepreneur. Builder. Creative Technologist.

October 26th, 2016

If you plan on raising money, pretty much every VC will require the company be set up as a C-corporation:

"Typically, LLC’s are not great for tech startups for a few reasons: (1) VC’s really don’t like pass-through entities; (2) the tax partnership rules are super complicated; (3) it doesn’t allow for stock option plans, convertible notes, etc., (4) it gets more expensive and complicated down the road."

see:

Scott Arpajian CEO, Softonic

October 26th, 2016

Do what's best for you as a founder at this point in time. And I strongly recommend you get legal advice on that one, because the correct answer is highly dependent on your personal situation.

When you get to the stage of VC funding, if they want you to change the corporate structure prior to getting the money, you'll change the corporate structure. It will almost certainly be early enough in your corporate lifecycle that there will not be huge pain in making the switch.

Setting up your company to appease VC investors that don't actually exist yet isn't the right path.

Greg Gerik Growth & Revenue Marketing, Product Marketing, Data Fusion, Speaker

October 26th, 2016

Agree with Scott, and I would add that trying to predict the desires of VCs will be a challenge and almost always require changes to your structure anyway.  More importantly, there can be significant costs to setting up shares early on depending on the valuation and the state of incorporation that are completely unnecessary at an early stage.  I always recommend starting with an LLC and if/when you get funding, walk through the process with your VC group to change the structure together.

David Einzig

October 26th, 2016

My experience is similar to the feedback Bob provided. 

I would add that it is not super complicated to convert from an LLC to a C Corp when the time is right.  KiDCASE, my current start-up was an LLC in it's early stage and then converted to a C Corp upon closing a deal for venture funding. So, if an LLC is easier for you to set up and manage in the early stages, you can rest easy knowing that it is not a permanent decision.  Note that you will, however, need to get all members, including angel investors, to sign off on the transition so be sure to keep everybody informed that it will be a possibility one day.  

Mark Rosenberg Tax, securities and commercial litigation

October 26th, 2016

David--I saw your comment and agree with you entirely. What is KiDCASE?

Martin Omansky Independent Venture Capital & Private Equity Professional

October 26th, 2016

We are neutral on the subject of LLC vs. C corporations, as long as the LLC comes first. It is harder and more expensive to convert from C to LLC. S corporations have some restrictions and disadvantages that make that choice a bad one. LLCs pass through losses to the shareholders personally, which is an advantage from a tax standpoint, and LLCs do not pay a corporate level federal tax, which avoids double taxation. This is good for tax flow and available $ for growth. On the other hand, profits from LLC operations must be distributed each year, and cannot be accumulated. This is a disadvantage. Venture groups have favored C corps because their business models usually include using accumulated profits to fuel growth rather than drawing on new (and dilutive) equity. In recent years, some VCs have invested in LLCs because the conversion to C corps is relatively painless. On a related matter, some angel investors invest in LLCs because they value annual profit distributions. A securities lawyer or CPA can review your situation and make a recommendation. In the end, however, the funding source will probably impose a corporate structure as part of its investment, so whatever you choose may be a short-term decision. Sent from my iPhone

Michael Leeds CEO & Founder

October 26th, 2016

The C Corp allows you to create different classes of stock - most importantly preferred stock (which is what most if not all VCs will require) and common stock. Other corp structures may do this as well (S Corp for example), but I don't know the specific details.

Chris Maeda President & CEO, Brick Street Software, Inc.

October 26th, 2016

Investors generally hate LLCs because of the pass-through treatment of income tax and because share ownership rules are different in every state.

I have seen an LLC used in a pre-seed startup where a wealthy founder wanted to use the losses to reduce his personal tax bill.  Then the LLC converted to a C corp once they were ready for outside capital.