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?

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. 

Barry Burr founder, Barry Beams llc, a startup to re-light your night.

October 26th, 2016

My reccemendation based on my experience in receiving an A round, is to start simple with an LLC.
     My investors and I both preferred that, because it avoids the complexity and overly burdensome administrative requirements of corporations, during the phase when you're first launching and growing your business to a sustainable state.
     Many lawyers will shove you into incorporating because now they gotcha by the family jewels, profiting on you now, then profiting later when you need to alter or dissolve the corporation into some other business entity.
At lease in California, LLCs then allow flexibility to incorporate under whatever structure is most favorable at the time when the company does receive VC money and the strings that go along with it.  It may also be better to leave the original LLC as it, with the new corporation acquiring whatever assets, business operations, and intellectual property make the most favorable and least taxable transaction.
Good Luck!

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.

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.

Mike Robinson

October 26th, 2016

In many states, you can start as an S-Corp then convert to C-Corp. This gives you the advantages of pass-through tax treatment to angel investors while you are making losses, and conversion is simply a matter of sending a letter to the IRS. 

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.

Adam Crabtree Founder, Strollbar

October 26th, 2016

Given the informative comments here, I have to piggyback off the original question and ask: which type of formation is better for a 3 person startup that does not intend to bootstrap beyond the friends and family round that helps get a free mobile app product (social/consumer space) off the ground? My intent is to seek seed-round investment following traction, most likely from VCs partnering with an incubator. I’m on the verge of forming a company around the app but only for purposes of liability protection. I have several fleshed out monetization models to possibly implement down the line, and I’ve done a lot of due diligence in this regard, but I just don’t see these models being effective prior to seed funding. And I really think funding through an incubator is our best option. All of this is to say I don’t see an LLC being the best long-term option. If I’m not cranking over revenue in the beginning, and the strategy is to acquire and retain users (about 250K beachhead) as traction, would it be such a pain to convert from an LLC to C-Corp? There are so many unforeseeable contractual nuances demanded by VCs upon forming a C-Corp, I just can’t imagine forming a C at this time and in effect hindering the best possible relations with investors in the future. Suggestions would be much appreciated.

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?