So, you developed the next great start-up idea and you are looking to organize your company… Initially, the entrepreneur will have to decide what type of entity to use and under what state to form the company. Various legal factors will influence the selection of the entity’s jurisdiction. Typically, the company will be formed under Delaware law or in the entrepreneur’s state of residence. Most states provide a wide variety of operating entities. The three most popular start-up entity types (in rough order of frequency) are C-Corporations, Limited Liability Companies (“LLC”), and S-Corporations. In part one of a multiple part series regarding entity selection, this article will discuss the potential benefits of an LLC.
When selecting an operating entity for your business venture, an entrepreneur should be mindful of the following legal benefits and notable operating complexities of an LLC:
Relatively Simple to Organize
Forming an LLC, especially initially where there will only be one equity holder, can be a fairly simple and cost effective process. Depending on each state’s nomenclature, an organizer files a certificate of organization with the state. If the LLC only has a handful of initial members, the operating agreement can be fairly simple.
The laws governing LLCs do not require the formalized governance and operating approach required for corporations, which are required to observe many formalities even if they only have one stockholder. LLCs on the other hand can be managed by a member, but are flexible enough that they can mirror the structure of a corporation (which can be useful if the LLC has 3rd party investors).
LLCs’ provide a liability shield to protect members and managers from personal liability for the debts and obligations of the company, similar to the benefits of a corporation. The personal assets of each member or manager will not be subject to any legal claim or judgment. However, there are some exceptions to the limited liability concept.
When structuring an LLC, an entrepreneur must decide whether the LLC will be a member-managed or a manager-managed entity. The LLC allows for a flexible structure dependent upon the company’s governance needs. Most businesses seeking outside investment will structure their LLC to be manager-managed in order to closely mimic the shareholder-director structure of a corporation. The manager-managed structure allows for the delegation of managing powers to be held by a board of managers (that can act essentially as a board of directors) and for the members, acting as owners, to provide investment. Most aspects of an LLC are based on the principle of freedom of contract. This principle allows the LLC’s members to define their roles and business relationships among each other, the managers, and third parties. That said, LLCs at their core are more akin to partnerships, and thus there is some risk in a member-managed LLC of members binding the company (which shareholders in a corporation do not have the power to do). Thus, many startups selecting to use an LLC will use a manager-managed LLC.
The operating agreement establishes the organic rules of the company, and essentially covers the same ground for the LLC that the charter, bylaws and stockholder agreement do for a corporation. An operating agreement will confirm material matters, such as the management structure and responsibilities (for instance, including officers for day to day management), voting rights, financial allocations, issuing and/or transferring ownership interests, tax matters, fiduciary relationships, indemnity, dissolution and liquidation of the LLC.
Similar to corporations, an LLC does not restrict the type of owners nor the number of owners. Unlike corporations, LLC ownership interests are envisioned as containing both a financial interest and a governance interest. By statutory default, most LLC laws limit the transferability of governance interests, unless the other members agree to the transfer or set forth a process of transferability in the operating agreement that allows the transferee to be admitted as a member. LLCs’ allow ownership interest to be expressed simply as a percentage of ownership (like a partnership) or as a number of units (a version of shares in a corporation). LLC interests are still securities in the same way that corporate securities are, so the company has to comply with federal and state securities laws.
Similar to any other entity, an LLC may hire employees, and the company can structure equity incentives for employees and service providers, though LLC equity incentive plans need special attention because of the unique tax treatment of LLCs (which are by and large taxed as partnerships rather than corporations) and incentive stock options (ISOs) are not available to LLCs. LLC incentive plans may offer certain unit options, restricted units, and instruments similar to stock appreciation rights and phantom stock or incentives through structuring a profits interests plan.
LLCs are generally taxed like a partnership (unless the LLC elects with the Internal Revenue Service to be taxed otherwise). If the LLC elects to be taxed as a partnership, no taxes are levied on the entity at the federal level and profits flow through to the members. To the extent the company generates significant operating income, this partnership tax treatment is the primary reason why LLCs are chosen. To an extent, this pass-through treatment is also one of the reasons why many institutional investors strongly resist investing in LLCs. Further, partnership accounting rules are complex, and LLCs have some reporting obligations, with respect to the members, that must be factored into the initial operating costs of doing business as an LLC.