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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