Disclaimer: This post discusses general legal issues, but it does not constitute legal advice in any respect. This post is not a substitute for legal advice and is intended to generate discussion of various issues. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel. Cara Stone, LLP and the author expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post. The views expressed herein are personal opinion.

 

 

One of the first decisions a business will make is should they form as a corporation or LLC. There is a big misunderstanding among companies that are looking for venture and angel capital. If a company is seeking institutional investment whether that is from venture or angel investors, 99% of the time, the company should be formed as a Delaware C-Corporation.

Many companies get advice early on that forming their company as an LLC is easier and will save them money. However, companies that begin as LLCs will often need to go through a reorganization process down the line when they start to fundraise. Most venture and angel capital groups will steer clear of LLCs.

Corporations are preferred to LLCs for numerous reason.

Qualified Small Business Stock: The first and most crucial reason that investors prefer corporations is the existence of qualified small business stock. Section 1202 of the Internal Revenue Code allows corporations to issue something called qualified small business stock to founders, investors, etc. Qualified small business stock allows is for an exclusion of up to $10 million of gain upon an exit. This exclusion is not available to any other corporate form. For companies and investors who are looking to grow and ultimately exit, the number one reason for the company to form as a C corporation is to take advantage of this exclusion at exit.

Industry Standard Documents: The second reason corporations are preferred over LLCs is that all of the model legal documents for fundraising, both at the seed level and at the venture capital level, are premised around the idea of a Delaware C corporation.  This idea is important for several reasons. First, this will save time and energy on legal fees. Because the documents are most common, there is less time that needs to be devoted to customizing each form or negotiating over terminology. Second, investors are familiar with these documents. This means there are fewer surprises and fewer risks on the investor side. While there are a few exceptions where it makes sense to be a corporation of another state, Delaware C Corporations are the commonly accepted form type.

Incentive Stock Options: Number three, corporations are allowed to issue incentive stock options. Incentive stock options are the equity incentives that corporations give to their employees to incentivize them to work towards exit. In evaluating other entities, no other entity form permits a company to issue incentive stock options. When an LLC issues employees options, it is issuing non-statutory options or NSOs. These don’t have the same tax incentives and offer a disadvantage to employees.

Best Practice: Number four, the corporate system is just more well developed. Although LLCs have been around for a little while, the body of law that governs how corporations are governed is more advanced in Delaware and has been around longer than other types of forms. This is a leading reason why corporations are the preferred jurisdiction for most investors and others.

Investor Preference Is Seen in the Data

Across almost every industry where we study deal metrics, corporations outperform LLCs on the number of deals raised and the total capital raised. In recent years, the disparity has only gotten more pronounced. For instance, since 2016, 65% of deal volume and 67% of the capital was raised by corporations. In 2019 in Louisiana, 76% of deal volume and 96% of capital being raised by corporations.  (See your market at vc.carastone.com).

Reorganizing From an LLC to a Corporation

Companies that were formed as an LLC but need to reorganize into a corporation should do so as early as possible. Upcoming articles will discuss the steps in the reorganization process, the cost of a reorganization, and how long a reorganization typically takes.

Cara Stone routinely helps companies reorganize. We can help control the cost and ensure the reorganization stays is done quickly.

 

 

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