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Don’t Startup with an LLC Structure

Trying to figure out whether a Limited Liability Company (LLC) or Corporation is the right legal structure for your business?

There is a lot of information on the Internet about which type of legal structure is best for Startups whether it’s an LLC or a corporation. And there is no shortage of opinions when you talk to accountants, attorneys, and business contacts. You ultimately will need to determine what is best for you and your business, but I wanted to provide some practical perspective based on what I see with actual Startups and their experiences.

I recently was introduced to two Startup companies and both Founders had realized that they no longer could advance the legal entity formation work that they had started on their own. They both had invested a significant amount of time working on the legal aspects of their new companies, spent money on online legal services and paid related filing fees.

In both cases, the Founders had set up Limited Liability Companies to structure their businesses and I asked them why they had done so. They both replied that they had heard that the LLC structure was less complicated and easier to manage than a Corporation. When pressed further regarding their decision, they could not remember how they had reached that conclusion. Both Founders believed, however, that they had moved their companies forward, probably because they had spent time and money working on legal documents and had received an official looking, stamped document from the Secretary of State where they had filed their LLC paperwork.

The problem is that, for most operating companies, the LLC structure is not the best way to structure your business. In fact, the LLC often times will be more complicated and costly to set up and maintain over time, especially if you want to seek funding from outside Investors and add more owners (members) to the LLC structure. Unless you have structured a company before and are willing to invest additional time and effort to set up your new company properly, there is a good chance that you will miss some key legal issues at the beginning, which you will need to clean up later (if possible) at greater expense.

I understand that many Entrepreneurs do not want to admit that they may have made a mistake, especially after they have spent time and money on the attempted legal work that they have handled. Money typically is tight for many Startup companies and I understand that Founders may be reluctant to introduce delays or negativity (“we didn’t do this right”) when the new company is now rolling and gaining momentum.

It turns out that only one of the two recent Startup companies was willing to shift gears and convert its LLC structure to a Corporation. Not surprisingly, the company willing to change has a very innovative technology with big commercial opportunities and the Founders quickly realized that there were significant operational and execution risks if they failed to structure their company properly.

In order to help you figure out the Corporation vs. LLC decision, below are 4 additional reasons why you should stay away from the LLC as the legal structure for your new business:

1. Operating Agreements are long, complicated and expensive.

These documents typically range in length from 30 to 100+ pages, depending on their complexity, including the number of owners and additional legal bells and whistles that the Founders and Investors might require. Operating Agreements also contain extensive tax-related provisions, so you definitely will need to have an experienced tax professional on the team for proper structural and compliance advice. Alternatively, you can set up a well-structured Corporation that you can more quickly use to hire employees, engage consultants, set up a Stock Option Plan to provide them with equity incentives and take in funding from Investors.

2. Investors are less familiar with the LLC structure.

If your company grows and becomes successful, then you may need to seek funding from outside Investors. Whether Friends and Family, Angel Investors or Venture Capitalists, Investors typically understand and are more familiar with Corporations and their stock ownership and management structures (e.g., Board of Directors, Corporate Officers, etc.). The negotiation of the financing terms and the preparation of the related legal documents will go more smoothly and be less costly with a Corporation. Lastly, Venture Capitalists typically do not invest in LLCs given the adverse tax consequences for their fund investors.

3. Stock Options are not the same with LLCs.

Stock Option Plans work best when employees and consultants understand how their activities and performance will affect their future stock ownership and potential economic upside. Your employees and consultants will better understand how their stock options work with a Corporation. Also, an LLC cannot grant Incentive Stock Options (ISOs) with their related tax-favorable features.

4. Qualified Small Business Stock is not available with LLCs.

If the Capital Stock of your Corporation qualifies as Qualified Small Business Stock, then there can be significant tax advantages if you sell your shares of Capital Stock after holding them for at least five years. These tax advantages are not available for ownership interests in an LLC. If you really are creating your great business, then you will need to make sure that you have the right legal structure for your company and its goals. If you already have set up an LLC, don’t worry–experienced corporate legal counsel can help you convert the LLC to a Corporation and it is easier and less costly to do so sooner rather than later.

Your Turn:

What type of legal structure (LLC vs. Corporation) are you using for your new company and why? Please share the most important reason for your decision, so that other Entrepreneurs can learn from your experience. We look forward to hearing from you.

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