Entity Structure: Corporation vs LLC

David Young is a partner at DLA Piper (http://dlapiper.com/). You can watch more content here on Docstoc.

One issue that typically arises when starting a company is determining initial equity structure. This will help you determine whether to register as a corporation or LLC.

  1. What is the nature of your future investors? It is easy to go from LLC to corporation, not the reverse.
  2. Cost considerations. Is it worth paying extra to be an LLC in order to raise more capital? Around five hundred thousand dollars of investment is when you should consider being an LLC.
  3. What is the ultimate exit strategy? Is it a cash flow business? If you have profits that you are planning on distributing out, you may want to start as an LLC.

So the one issue that typically arises when starting a company that’s very important is term initial equity structure. And the two basic alternatives are corporation or limited liability company or LLC.

And a big consideration for any startup in looking at a decision is really, what’s the nature of the future investors, if the company is going to be backed by venture capital investors. Venture capital investors typically will require a corporation structure for a couple of reasons.

One, if they have foreign limited partners or if they have pension from limited partners they are prohibited from having entity investments from past or entities or LLC’s so that’s one consideration.

If you’re on the flip side with someone and they have individual Angel investors early on with a limited liability company, those investors are able to enjoy the benefit of their losses on their personal taxes and so they may prefer starting out as an LLC. It’s very easy to shift from an LLC to a corporation. It’s not easy to go in a reverse. That results in tax issues.

So the key is sort of point is to look at what’s the nature of the initial investors, if they are individuals that would want to have the benefit of the losses, is it worth the extra cost of an LLC, to start as an LLC knowing that if venture capital financing is ever raised, you’ll need to convert to a corporation, which is somewhere in the range of another $7,500 or $10,000 to do that.

And as an LLC, although you enjoy tax advantages, it’s a pass-through entity, there’s no corporate tax, it’s all tax. At the shareholder level, sort of as a startup, everything you do from a legal perspective probably costs 50% more doing -- employee equity is very complicated doing – when you raise money and you raise money do financing, structuring that through an LLC, it can be done, but It’s more complicated. There’s a whole bunch of flexibility on how you do things but that flexibility is good and bad. It also results in having to sort of design everything out and it comes at a cost.

And so, you know, in looking at that, oftentimes, the sort of break point is if it’s going to be at least $500,000 invested by individuals that want the losses, then it’s probably worth it to start as an LLC. If it’s going to be less than that, or where it’s going to be investors that don’t care about the losses just from a cost perspective, cost being a critical consideration for any startup, it’s probably advisable to go ahead and start as a corporation.

The one exception to that might be just what’s the ultimate exit opportunity for the company. If it really is a company that isn’t just are normally technology startups, which is a company that really may end up being just a cash flow business and sort of a lifestyle business that people just have the company and enjoy profits and distribute those out, then it may make sense to be an LLC for the duration, and that would be the one exception.

You know, most startups end up not going that route but there’s a lot of companies in the world that have done that. And if that’s a definite possibility, then it also makes sense to be an LLC either at the beginning or for the duration.