When someone is running a startup company, there are all kinds of pitfalls and potential mistakes. A typical mistake many startups make is incorporating as an LLC, rather than a C corporation. In this post, I will describe why that is often a mistake, and then I will tell you how to fix it.
There is a common perception that it is cheaper to set up an LLC than a C corporation. That really is not true, however. In Ohio, for example, the state filing fee is the same for each: $125. Also, if you go to one of those DIY legal websites (who, like Lord Voldemort, shall not be named), the charge for handling the paperwork and filing is the same.
There is also a misperception that LLC’s are inexpensive to set up and operate. LLC’s are hybrid entities – part partnership, part corporation. The operating agreement for a multi-person LLC can run to 100 pages, with complicated provisions involving capital accounts, allocation of profits and losses, and other tax-driven terms. Also, while LLC’s give you a lot of flexibility in setting up how you want to run the company, if you fail to specify these procedures in the operating agreement, you will be stuck with the state defaults, which may not be what you want. Many people who try to set up an LLC on their own don’t even bother with an operating agreement, or never pay attention to it. That can lead to losing the liability shield that is a big attraction of having an LLC in the first place. Most LLC operating agreements also do not include the vesting and buyout provisions that a startup company needs, to address the situation where one of the cofounders leaves the company.
One justification for LLC’s that I hear all the time is the mantra of avoiding the dreaded “double taxation.” For the typical startup, however, the risk of double taxation is like the risk of being hit by the planet Saturn. First of all, you need profits at the corporate level that will be subject to taxation. Most early stage startups don’t have any profits (and too many don’t even have revenues). Second, you need to make dividends to shareholders, so that you can suffer that second round of taxation. But startups can’t pay dividends if they have no profits, and tech companies traditionally reinvest profits, rather than pay dividends. Microsoft was almost 30 years old before it paid its first dividend. So in truth, double taxation is more urban myth than reality for startups. If pass-through of losses is important – for example, if the founder is keeping his day job and needs to offset employment income – an S-corporation election may be a viable alternative.
Finally, setting up an LLC can be big mistake for any startup seeking venture capital, because venture capital investors do not invest in LLC’s. Venture capital investors will only invest in C corporations, and they will usually require that the company be incorporated in Delaware. While you can set up different membership classes in LLC’s, they are not as easy to create and do not have the body of law supporting them that C corporations have. Coming to a potential VC investor with an LLC, rather than a C corporation, also sends a signal that you are relatively unsophisticated. Surprisingly, there are some attorneys out there who work with startups, and still routinely set them up as LLC’s. I shake my head at this, as I can’t come up with any reasonable justification other than that they want to charge more fees down the road to fix their mistake.
Luckily, if you have made the mistake of setting up an LLC rather than a C corporation, you aren’t doomed. There is a relatively straightforward fix, but it will cost you more money and could delay a Series A closing. The fix is called a “statutory conversion,” and is a mechanism under state law that allows an LLC to convert into a corporation. An LLC formed in one state, for example Ohio, can even use statutory conversion to convert into a corporation in another state, such as Delaware. When you do a statutory conversion, the converting LLC is, by law, the same legal entity after conversion as before, so it avoids transfer taxes and other negative legal and tax consequences that might result from multiple-entity conversions.
To do a statutory conversion from an Ohio LLC into an Ohio corporation, you will have to file a certificate of conversion with the state of Ohio and pay the filing fees. If you are converting an Ohio LLC into a Delaware corporation, you will have to file certificates of conversion in both states, and pay filing fees in both states. Also, you will need to file a certificate of incorporation in Delaware, and pay the filing fee for that. There also may be some accounting and tax issues to deal with, depending on the startup’s assets and liabilities. Of course, there are legal fees involved as well.
As you can see, forming as an LLC isn’t necessarily the best option for a startup that will be seeking venture capital investment at some point, but it can be fixed. The remedy, unfortunately, will end up costing the startup time and money. This is why it is always better to take the time to do things right at the outset.
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