Choice-of-Entity for Funding
Your average start-up guru, entrepreneur blogger, and business lawyer will recommend forming Delaware C-Corporations when seeking to attract VC funding. The theory is VCs refuse to invest in LLCs because operating agreements are often nebulous and legal precedent too uncertain. This “accepted” logic is so circularly cited that it seems impervious to exception. It’s not. There is still a choice of entity.
It’s true that VCs are comfortable funding C-Corporations; and if the corporate structure meets an entrepreneur's needs and desires in all other aspects of the business, then go for it... end of story. But if an LLC provides other strategic or operational advantages, it would be a mistake to presume LLCs are not fundable. Actually, LLCs can be and are funded by VCs – one need not look further than CMEA Capital, Idanta Ventures, and Andreessen to find LLC portfolio companies. There are, however, additional challenges presented by the LLC structure that the entrepreneur should be aware of and prepared to address - keeping in mind that these challenges may require more time and work (i.e. due diligence) on the part of the VC.
Take for example UBTI (unrelated business taxable income) tax. By law VCs, as limited partnerships, cannot invest in “flow through” tax entities like LLCs without triggering UBTI. Once triggered, the tax expense flows back up to the limited partners, who would be liable to pay the additional tax even in instances where the gain is characterized as a capital gain. It is not difficult to imagine the investor’s displeasure with receiving an unexpected tax bill. What’s worse, some limited partners in the VC fund are non-profit entities, which are disallowed from receiving UBTI. In fact, in some circumstances, a non-profit’s status could be revoked upon receiving UBTI. For these reasons, VCs go to great lengths to avoid these occurrences. And C-Corporations offer a safe haven since they are taxed at the corporate level (i.e. C-Corporations are not flow through tax entities) and thus not subject to UBTI.
Of course, there are some fairly painless ways for LLCs and VCs to avoid UBTI. One option is to establish a “blocker corporation” for indirect investment. The blocker corporation is a C-Corporation that stands between the VC and the LLC. In turn, VCs invest in the blocker corporation and the blocker corporation invests in the LLC. This “blocker corp” effectively blocks UBTI from coming into the fund since UBTI will not pass through a corporate-level tax entity. The beauty of this alternative is the LLC founders can still enjoy a flow through tax status. Another option is for the LLC to simply elect to be taxed as a corporation rather than as a partnership or disregarded entity. Since the corporate-tax election will require the LLC to pay tax on a corporation level, there would be no flow through and thus no UBTI. The downside is that the founders would forfeit their flow-through status and there might also be additional tax consequences depending on the State of organization and how that State treats conversion (i.e. assets over merger vs. interest-over, etc…). So there are ways for VCs to invest in LLCs without triggering the dreaded UBTI; it just requires additional steps – again, more work.
It is worth mentioning here that, like LLCs, S-Corporations are also “pass-through” entities. They are then fraught with the same UBTI problem. But in addition, S-Corporations have another limitation: they can only issue one class of stock. And as such, VCs cannot get the benefits of liquidation preferences and other preferred terms innate to preferred shares. In addition, most VC firms are organized as partnerships or LLCs, which are not “natural persons.” Therefore, many VC firms are precluded from investing in an S-Corporation. For these reasons, S-Corporations pose substantial barriers to attracting VC funding – even more so than LLCs. Nevertheless, and S-Corporation can always elect C-Corporation taxation to change its status if it is willing to incur the probable tax penalties associated with such a conversion. Thus, even S-Corporations can find a way if the deal makes sense.
Ultimately, funding a company with outside money is conceptually no different than any other sales process: a pitch is made, a price is set, and the investor either buys a piece of the company or not. It stands to reason then that if the goal is to sell a piece of the company in exchange for capital, the sales process should be streamlined for the buyer. To that end, the fashion in which a business is organized might play a significant role. Then again, if the investment opportunity is good enough, a few obstacles will not stand in a VCs way. Therefore, founders serve themselves well to consider the funding factor along with other factors to guide their choice of entity.