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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How to Allocate Shares in a Startup When One Founder is Also an Investor

February 5th, 2010

I frequently talk to entrepreneurs starting a company where one founder is putting up seed capital while the others are putting in sweat equity alone.  The founders want to divide the company ownership according to some formula they have figured out, and then ask me how to document it properly.  This are several variables required to do this correctly.  Here is how I think about it:

Percentage Ownership
The founders have figured out an ownership ratio that makes sense to them.  Let’s say there are 3 co-founders, all of whom will be active day-to-day.  One founder will invest $100,000 in seed capital and the others will invest only nominal cash.  The founders have agreed that each of them should get 33.33% of the initial shares.  For simplicity let’s say that each founder gets 1,000,000 shares.

Stock Price
We always want to keep the price of common stock low so that as new employees, co-founders or others come along they can buy stock (or get stock options) at a low price.  I usually like to start with a founder stock price of $0.001 per share.  Stock should always be bought for cash, so we immediately have a problem matching the 1/3-1/3-1/3 ownership ratio with the varying amounts of cash being invested.

Using our hypothetical numbers, Founders A and B are getting 1,000,000 shares at $0.001 per share, which means they need to put in $1,000 each.  If Founder C is buying the same type of stock, also at $0.001, his $100,000 will buy him 100,000,000 shares; he will own 99.99% of the company.

Preferred Stock to the Rescue
My recommendation here is to treat Founder C an investor as well as a sweat equity founder.  By this I mean that we can issue some of his shares as common stock like the other founders, and some of it as preferred stock, which lets us set a higher per share stock price.

Preferred stock is “worth” more because it has rights preferential to common stock.  The rights can vary a lot, and in this case I would provide only a nominal step-up in rights compared to the common stock, so that if our company gets sold Founder C would get his money back before any money is distributed among the common stock holders.  If the company is sold in an extreme fire sale, it is possible that Founder C would be the only one to get any money out, but with luck we will be able to sell this company for more than $100,000.

Stock Repurchase Right
The last important piece here is that all founders should have their sweat equity shares subject to a company repurchase right.  The stock “vests” so that if a founder leaves after a year or two, she only gets to keep the equity she has earned through service.  In my view, all of the common stock should be subject to the repurchase right, but since the preferred stock is purchased for a cash investment, it should not have a repurchase right attached.

In this example, 100% of Founder A and B’s shares are subject to repurchase, but 90% of Founder C’s are not.  This might be the right outcome- or we could adjust the Preferred Stock price and the relative amounts invested for common stock and preferred stock so that Founder C owns more common stock, and has more stock subject to repurchase.  There are a no “right” answers here and it is just a matter of finding the set of conditions that best represents the founders’ relationships.

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