Why Your Startup Shouldn’t Be an LLC

Every now and then, I see the unthinkable: an LLC trying to raise venture capital.

You want to give your startup every chance of success. So don’t shut yourself out from venture capital with this rookie mistake!

Repeat this mantra every night before bed: “investors want a Delaware C Corp.”

Why Don’t Investors Like LLC’s?

Here are a few reasons:

1) Issuing stock options to employees is difficult and expensive.

Almost all startups use options to recruit and retain employees. You don’t want your legal structure to make that nigh impossible.

2) Investor taxes become a nightmare.

3) The venture fund’s own investors won’t have it.

These limited partners (LP’s) who put their money in the venture fund don’t want to deal with the tax complexity of LLC’s.

What’s more, many LP’s are tax exempt foundations and endowments. They don’t want the taxable income an LLC will pass through to them.

4) LLC’s don’t qualify for a big tax loophole.

Qualified Small Business Stock (QSBS) can shelter up to $10 million in capital gains from any taxation whatsoever. Pretty sweet, eh?

But LLC’s don’t qualify. C Corp’s do.

LLC’s Advantages Are an Illusion

I know, I know, C corp’s cause double taxation of profits, both at the corporate level and the individual level. But given that most startups make bupkus for years, you don’t need to worry about that.

And yes, LLC’s are very simple to form. But if you’re issuing options and raising capital, the LLC soon becomes far more complex than the C Corp.

From Harvard-trained attorney Jose Ancer:

The amount of tax and legal analysis that has to be done to issue equity compensation and/or raise capital in an LLC is (without exaggerating) 10x that of a corporation.

What’s the Obsession with Delaware?

Simply put, it’s the standard. Delaware has well-established corporate case law and investors are used to dealing with Delaware companies.

Delaware also has some sweet tax advantages.

What If I Already Screwed Up?

I’m sending you to bed with no dinner!

Just kidding. If you initially formed an LLC and now realize you need to be a C corp, it’s okay! Just make sure to convert before raising any money.

Once you’ve raised money, converting becomes a lot harder and more expensive.

Here’s Becki DeGraw, a partner at top tech law firm Wilson Sonsini, explaining the conversion process on This Week in Startups:

How Do I Make a Delaware C Corp?

You’re in luck! It’s much easier than it once was.

There are online services that can handle the whole thing for you. Stripe Atlas is one popular choice.

Another is Capbase, which can not just form the company but manage your cap table (list of company owners) and a lot more. Full disclosure: I’m an investor in Capbase.

Whichever method of incorporation you choose for your tech startup, just be sure it’s a C Corp registered in Delaware and you’re off to a great start!

Happy building!

More on tech:

Why I Just Invested in Capbase, The Startup in a Box

How Startups Can Dominate the Elevator Pitch

The Lean Startup

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