Thursday, February 5, 2009

Why Don't Venture Capitalists Like Investing in LLC's?

When an entrepreneur hopes to raise venture financing, a very common mistake he can make is to form the wrong type of entity or to form it in the wrong state. Choosing what type of entity you should form -- that is, choosing between a basic "C" corporation, a limited liability company, a limited partnership, an "S" corporation or a general partnership -- can be a very complex choice and I am not going to go into all of the legal and tax ramifications here. However, venture capitalists have very distinct and particular opinions on this decision. By making the wrong choice you will hamper your ability to raise venture capital and/or create costs and complexity down the road when your prospective VC request you "do things over." More after the break.

Potential venture capital investors have clear preferences and expectations as to how their transactions will be structured. Generally, in order to get a venture capital investment, you will need to be organized as a "C" corporation and it is preferable that you be incorporated in Delaware.

VCs will almost never invest in limited liability corporations and will rarely invest in corporations formed in states other than Delaware. VCs will virtually never invest in a partnership and are forbidden from investing in an "S" corporation. In many ways, by forming the wrong type of entity in the wrong state, you will demonstrate your inexperience with and ignorance of the venture capital process. This is the last thing you want to do when you are trying to show off your entrepreneurial savvy to a potential investor.

This is not to say that there are not advantages to be had with different entity types. However, the venture capital process is form driven and the corporate form is tried and tested. Folks just know it works. Every VC has its own set of forms that it basically uses for all investments on which it is lead. The VCs and their attorneys know the forms inside and out and are comfortable quickly making adjustments and changing deal points that will flow across multiple forms and multiple sections within a form. Further, the rights, preferences and privileges of preferred stock are fairly standard and will not vary too much in a particular region and time period. Also, corporations are easily able to issue tax favorable stock options to incentivize their employees. Finally, VCs are comfortable with how to realize liquidity in a corporation -- through IPOs, liquidation events and dividends -- and they understand the various tax treatments.

To make a VC investment in an LLC would require an entirely new set of forms developed from scratch. The classic rights, preferences and privileges of a VC preferred stock investment do not translate easily or comfortably into the LLC format (although, admittedly it can be done). Developing these scratch documents is a costly endeavor (and obtaining venture capital is not cheap anyway) -- it is unlikely at best that a VC will want to bear these additional costs. In addition, an LLC is not able to issue stock options to its employees with the same tax advantages as a corporation. Also, the manners of obtaining liquidity in an LLC (through distributions or liquidation) do not translate easily into the VC world and have potentially different tax treatment. For example, the flow-through tax treatment of an LLC could potentially cause problems for the limited partners of the VC. Finally, and perhaps most importantly, it is not possible to do an IPO with an LLC. Any LLC that wanted to go public would be required to first convert to a corporation anyway with potentially very adverse tax consequences.

This is not to say that an LLC is not an excellent choice for joint ventures or small businesses which will never need to raise money from a VC. LLCs are very flexible entities that can provide favorable tax treatment for individual investors. It is just exceptionally rare to find a VC that is willing to invest in an LLC.

The choice of state question is not as clear cut. However, most venture capitalists have a clear preference to invest in a Delaware corporation. This is because Delaware is still the most common state of incorporation and, consequently, the statute is well thought out and practical and the courts in Delaware are very experienced with corporate law. Delaware law is also very flexible in providing indemnification for officers and directors and for protecting officers and directors from claims of a breach of their fiduciary duties. Nevada law is not a viable alternative, despite the claims of internet incorporation firms to the contrary. It may have similar laws, but it does not have the same experienced judges. On the other hand, it is common for a local venture capitalist to be willing to invest in a corporation formed under the laws of its home state (Virginia for a Virginia VC, California for a California VC), but why limit yourself to local VCs by choosing the local jurisdiction?

In sum, if you are considering starting a business that plans to seek venture capital at some point, you should strongly consider starting out as a Delaware corporation. It happens too often that an entity is ready to start or receive fundraising but first has to re-do its charter documents at great expense and with adverse tax consequences. Venture capitalists simply do not like investing in LLCs.

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Dividends and Preferences by Hank Heyming is licensed under a Creative Commons Attribution 3.0 United States License.