LLCs and Corporations in New Entity Formation

March 20th, 2010

Limited liability companies (LLCs) have been around for 20 years now.  Until somewhat recently the conventional wisdom was that LLCs are useful for businesses whose ownership won’t change frequently (a huge range that covers retail businesses, service companies and investment funds) while corporations are better for businesses that plan to raise money from angel or VC investors.  That is changing fairly quickly and it is becoming more common to see LLCs set up in a way that looks a lot like an investment-driven corporation.

There are still big differences in the way ownership is divided among owners of LLCs and corporations.  This post will offer a quick example of how these differences can manifest themselves.  I need to emphasize that LLC structures are heavily tax-driven, I am not a tax lawyer and I am going to steer clear of tax discussion here as much as possible.  Tax experts reading this are encouraged to set me straight if I oversimplify or inadvertently mis-state tax concepts.

The example is from a situation that a client brought to me somewhat recently.  The client was a new company to be owned by two people.  One was the passive investor who put in $100,000 in seed capital and got 40% of the company.  The other owner was the day-to-day manager who invested nominal cash whose principal contribution was sweat equity and who was to own 60%. The question was whether to form a corporation or an LLC to do this.

As I have described in a couple of prior posts, the core principle behind stock in a corporation is that two people buying the same type of stock at the same time need to pay the same price per share.  If the client formed a corporation, Owner A’s $100,000 might buy her 1,000,000 shares at $0.10 per share.  To get 60% of the company using a single class of stock, Owner B would need to invest $150,000 and receive 1,500,000 shares.  We already know that Owner B is not going to do that, so if we use a corporation the only way to get the percentages to sync up with the amounts invested is to use preferred stock.  Owner B could invest $15,000 at $0.10 to get 150,000 shares while Owner A invests her $100,000 at $1.00 share to get 100,000 shares.  The table below is a simpler way to show how this works.

This gets the desired result but requires a lot of steps, two classes of stock, Owner B still needs to put in $15,000 and there is a 10x difference between the common and preferred stock prices that may or may not work well for accounting, 409A and general capitalization planning purposes.

LLCs are not restricted by this equal-price-per-share requirement.  Instead, one of the structural principles behind LLCs the the concept of a capital account- essentially a ledger of cash (or other assets) invested in the business, profit allocated back to the investor and cash (or other assets) paid out.  This accounting is also separate from voting, so we can easily set up an LLC that gives Owner A a 40% voting interest and a $100,000 capital account, while Owner B has a 60% voting interest with a $15,000 (or $1,500) capital account.  The voting interests and the capital accounts do not need to follow the same ratio.

The part that becomes non-intuitive is that we might want to make our company look like a corporation so that the owners have Units rather than just percentages.  Again, in a corporation we would need two classes of stock to get the desired result, but in an LLC we can provide that Owner A has 100,00 Units and Owner B as 150,000, meeting our desired a 60/40 ratio.  Voting is linked to the Units, while accounting and economic outcomes follow capital accounts.  We end up with a Units structure that looks similar to a corporation, but simpler because we only need one class of Units instead of the common/preferred shares described above.

Which is Better?
We can reach the desired outcome with either a corporation or an LLC.  In this case, the LLC provides a somewhat simpler way to get there and I have seen a number of situations recently where an LLC made more sense for clients with issues like this.  There are a half-dozen or so other factors to consider before deciding for sure which way to go (esp. ability to take tax losses for investment in the LLC and the likelihood that outside investors will be sought and that they will be comfortable with LLCs) so this is definitely not the beginning and end of the analysis.

This was a lot to pack into one post.  Feel free to post any questions or comments in the comment section or contact me directly.

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Why Deferred Salaries Don’t Work for Startup Founders

September 4th, 2008

One of the toughest conversations I have with many startup founders is about salaries.  Founders may come from larger companies that pay them an annual salary and the idea of getting *no* cash for a significant period of time is really hard to wrap one’s mind around.  The argument goes something like this:

“I make $X currently, I know I am worth that much and I really need to get the cash.  I can defer collecting it for a little while, but I need to catch up at some point.”

My humble suggestion is always the same- don’t think about it that way.  You are building equity in a new business.  The equity is your return.  You are unlikely to see your “deferred” salary repaid in that way, so make sure you have enough stock in the business to give the upside you need and work toward making that worth something.

There are really two alternatives to this, neither of which is feasible: accruing a hypothetical salary to be repaid when some large bundle of cash hits the company’s accounts through financing or sales efforts, and taking stock in lieu of cash.

The Extra Cash Theory

The repayment on filling the coffers approach is based on the false premise that at some point there will be “extra cash” available.  This never happens.  Investors put money into a business in order to build structures that will take the business down the road.  Seeing their cash go straight through a company’s bank account is anathema- except when a founder has actually put in cash without getting stock for it.

The revenue argument is probably even worse.  Revenue is hard to come by and most businesses don’t see enough of it to justify paying back salaries on top of current ones and other business expenses.  The idea of generating enough revenue to cover accrued/deferred salaries is a fantasy in almost all cases.

Stock for Salaries

The stock-for-salary proposal is actually much worse than the extra cash idea.  What many founders don’t realize is that the IRS treats stock in that case exactly the same as cash and taxes it at the same rate.  If a founder accrues $100k in salary and collects it in stock she still has $100k in income to report.

The problem is that she has $100k worth of illiquid stock, a tax bill of $35k or so and no cash to pay the taxes.  This is not a happy situation for anyone.

No Deferral, No Salary, Just Stock

The way out of the dilemma is to give up on the idea of taking much cash out of the business in the early going.  Buy your founder stock (for cash!) at a very low price when you start the business.  That is what you get instead of a salary, so be mindful of unnecessary dilution (no “advisory” options to friends and relatives) and work on making that stock as valuable as you possibly can.  You may not see much cash for a couple of years or more, but if you are lucky the stock will more than compensate for the sacrifices made in the early days.

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Startup Valuation, Preferred Stock and Common Stock Prices

July 17th, 2008

This post may get a bit wonky.  I’ll do my best to keep it straightforward.

I have talked to a lot of people in my career who get confused by the value of shares of stock in a startup company.  A venture-oriented company has two or more different kinds of shares with different values attached.  Here’s how to keep them separate.

Pre-Money, Post-Money and Per-Share Value
When a company does a financing, it sets a value for the entire company- the “pre money” valuation before the new money comes in.  Let’s say the value is $10M.  If the company has 5M shares outstanding, this means that each share is worth $10M/5M = $2.00.  This is the price investors will pay to buy stock in the company.

If the investors are putting in $5M, they are buying $5M/$2 = 2,500,000 shares.  The company now has 7.5M shares outstanding, and the total “post-money” valuation is $15M.  We can see by the numbers that on a per-share basis (2.5M/7.5M) and a dollar-value basis ($5M/$15M) that the investors now own 1/3 of the company.

Common Stock vs. Preferred Stock Pricing
The part that gets tricky is that investors buy preferred stock, but the company also has common stock that it will issue to employees.  Preferred stock has superior rights, especially including a right to get paid first when the company is sold.  By convention and IRS rules, we are allowed to say that the preferred stock is worth more today than the common stock.  Thus, when we sell preferred stock to investors at $2.00/share, we can give options to employees to buy common stock at a much lower price- $0.30 or so.

This works well for the most part.  Investors want certain rights that employees don’t care about and pay extra for them.  Employees would rather get low-priced options than the preferred rights.  Everybody is happy.

But I Thought Each Share Was Worth $2.00?
The place people get tied up is comparing the enterprise valuation with the common/preferred stock differential. We valued the entire company at $10M, which meant that each share was worth $2.  At the same time, we say that common stock is not worth $2 and is only worth $0.30.  Which is true?  Both.  Here is how and when to use each number.

Enterprise Valuation is for the Big Picture and Financings Only
When we value the company for a financing, we put a value on the whole company as though it is about to be sold.  We take into account all of the economic preferences and assume that all stock is converted to common.  Every share is the same at that point.  In other words, if the pre-money valuation is $10M and the company has only common stock outstanding, each share is worth $2.  The valuation is really forward-looking to an eventual exit.

Common Stock Price is For Employees Today
Until that happens, though, we maintain different types of stock with different rights- common and preferred.  The preferred is sold based on the as-converted valuation, but the common has fewer rights and we can issue options at a lower price.  The company’s total valuation continues to be $10M and each share would be worth $2 on a sale of the company, but before that happens each share of common stock is actually worth $0.30.

The Simple Rule
The easiest way to think about this is that preferred stock is for investors and common stock is for employees.  Be aware that pricing is set differently for each.

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