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3 Reasons Why Your Startup Shouldn’t Be An LLC

One of the earliest legal decisions you’ll need to make as the owner of a startup is deciding what type of entity your new company is going to be. Will you choose a C-Corp? An LLC? Something a bit more eccentric, like a B-Corp? There are a number of options out there, and picking the wrong one can spell disaster for someone hoping for a high growth rate fueled by venture funding.

For most startups, there are three different corporate structures to consider: the C-Corp, the S-Corp, and the LLC. The three are primarily differentiated by their tax treatment, but that’s a story for another article, and I have posted an introduction to LLCs and a primer on Corporations before, so check them out if you want to learn more about those entities, how the differ, and what they’re best suited for. Spoiler: the C-Corp is the best entity for a startup.

Now onto the matter at hand. Why are LLCs are terrible for tech startups? There are tons of reasons, but I’ve distilled them down into three.

  1. Investors Don’t Like LLCs. Venture capitalists can be a funny bunch. On the one hand, they’re always trying to discover the next great thing that’s going to turn into a huge success. On the other hand, they’re ultra-conservative (as much as possible, anyway) with their investments. And they have good reason to be—especially those who are investing other peoples’ money. As a result, investors don’t like LLCs because they’re different than the standard C-Corps they’re used to investing in, which means more money must be spent on due diligence, including evaluating each LLC’s unique operating agreement and drafting the often complex LLC documents; the partnership style taxation of most LLCs means some tax-exempt investors can’t invest in LLCs and all investors can still be taxed on the LLC’s income even if they’re not getting a cut of it in any given year (due to reinvestment, etc.); and investors living in other states may have to declare income, and subsequently be taxed on it, in not only the state where they live, but they state where they’ve invested in the LLC. The upshot of this is that because most investors have issues with LLCs, it makes it much more difficult to find investors for your new startup.
  2. Unlike Corporations, LLCs Are Difficult to Manage the Larger They Get. With a C-Corp, where stocks are issued instead of membership interest when someone acquires an equity stake in the business, a corporation can easily manage how its stocks are being distributed. Stocks are simple and easy to manage no matter how many shares are being issued. Instead, with an LLC, the company is left trying to cut the pie into smaller and smaller parts with each new investor, leading to all kinds of tax complications. Also, LLCs are predominantly governed by their individual contracts, and as more investors get on board, the contracts will become longer and more complex, leading to higher legal fees with each new transaction (except for those lawyers who help startups for flat fees).
  3. Taxes, Taxes, Taxes. I’ve already touched on some of the major tax issues, including taxation in states where passive investors reside and where the LLC is located, but tax problems can also arise each and every time a new investor comes in, depending on how they want their preferential treatment structured (liquidation preference, etc.). The tax code also doesn’t recognize LLC membership interest for reduction in capital gains taxes under Section 1202. And to top it all off, when it comes time to sell your company, you’re going to be stuck with taxes and, unlike with a corporation where you can swap the stock of your company for that of the acquirer in certain circumstances in order to help defray those taxes, with an LLC, you’re left hanging out to dry by the tax code with no option but to pony up the cash to pay the tax bill.

So, as the founder of a new startup, what are you to do? The common solution to the problem with LLCs is to just not use them for startups. While ease of operation and need to not follow any of the traditional corporate formalities may seem like a boon for founders in the early stages, the problems with LLCs escalate as they grow. As a result, if you’re bootstrapping your company, you can freely choose any entity you like (though I recommend doing so at the suggestion of your startup attorney and your accountant). But, if you have any desire to raise funding on a large scale down the road, you’re going to want to consider an alternative structure.

For some reason, those who have navigated away from an LLC tend to be drawn towards the S-Corp. Maybe it’s because someone told them they were a great way to protect themselves from taxes and “all the rich people use them” as tax shields, or something like that. And while an S-Corp is certainly better than an LLC in terms of running a startup driven by investor financing, there are still some problems you can run into. Namely, foreign investors and corporations cannot invest in the S-Corp, and as far as growth goes, you’re stuck at a maximum of 75 investors—so much for rapid growth with lots of investors. As a result, if you’re starting out and planning to bootstrap your operation entirely, an S-Corp is a solid choice for your business structure. But if you’re hoping to build the next great startup with a shower of VC money coming your way, think again.

Which leaves us with the C-Corp. The ideal structure upon which your startup should be based. Investors (and their lawyers) are used to them, they’re easy to deal with, there’s a ton of law about how they work, and it just makes sense.

Now, which state should you incorporate in? Delaware? California? Nevada? Your home state?

Choosing Corporation or LLC: The Legal Side of iOS App Development Part III

At this point, you’ve read through Apple’s developer contracts and you’ve decided on an amazing name for your iOS app. But what’s the next step, aside from actually designing and coding your app, of course?

While it is definitely possible to have a single individual, also known in the business world as a sole proprietor, post an app to Apple’s App Store, you’re going to be much better off if you form some kind of business entity before you submit your app. Why? Several reasons—most of which revolve around liability and growth.

But before we get too far ahead of ourselves, we need to ask what is a business entity? It’s kind of a strange phrase, but it’s simply a general term for corporations (both C-Corps and S-Corps), limited liability companies, and partnerships. Which one is right for you is going to be a judgment call you should make after you discuss your situation with other iOS entrepreneurs and a knowledgable business lawyer.

With the general nomenclature out of the way, let’s talk about some specifics. Most small developers like to form LLCs. People talk a lot about the benefits of an LLC (liability protection, electable S-Corp taxation status, lack of corporate formalities). However, there are a number of very significant drawbacks. For example, I’ve discussed this on our site before, but if you’re forming a single-member LLC, you’d better be sure you know what you’re doing—or you could find yourself liable for the debts of your company. And that’s not a position anyone wants to be in. Further, LLCs often have a problem scaling, which is something even the smallest app developer should be concerned with since app development can sometimes be an expensive undertaking and you may want to take on extra investors in exchange for a percentage interest in the company. That said, LLCs are great for a small number of shareholders (called “Members” in the LLC context), but trying to add more members and investors down the road can lead to some major problems. After all, corporations are much better suited to taking on investors than LLCs are.

And that brings us to the corporation. Compared to LLCs, corporations are slightly more costly to set up and require more effort to keep running (in terms of required meetings, corporate minutes, resolutions, etc.). However, if you’re looking for a way to scale your business at some point, setting up your entity as a corporation is the way to go. With the ability to issue a range of stock types to investors, you’ll be in a position to grow in ways you never thought possible.

But what if you’re looking for something in between? You’ve started out and you’re developing your first app, after all. What do you do? Well, we sometimes recommend setting up the LLC first and then converting it to a corporation later. That way you don’t have to worry about all of the corporate formalities at the beginning and you can focus on what you do best—developing your app. Then, after your app is finished and selling like hotcakes on the App Store, you can convert the LLC to a corporation. And to top it all off, you’ll have saved some money to boot.

Next time we’ll discuss the legal ramifications of using third party resources and code in your app—what it means for your development now and in the future.

Photo Courtesy: Thomas Leuthard

Understanding the Difference Between Common Stock and Preferred Stock Equity Financing for Startups

Financing your startup is easily one of the most important steps in the process of developing your company—but is it also one of the most despised. When it comes to financing, you’re looking at several rounds, ranging from the very beginning when you’re just getting money from friends and family members who want to help you out from the kindness of their hearts all the way to the IPO and taking your company public. Through it all, though, there are three main ways to structure your company’s financing. Common Stock, Preferred Stork, and Convertible Notes. While this article is limited to a discussion of common stock and preferred stock, each type of equity financing has its own benefits and drawbacks, and hopefully this article will help you understand exactly what the differences are between the two stock classes and how each is used.

Common Stock for Startups

Of the three types of equity financing discussed in this article, common stock is probably the one you’re most likely familiar with. When you form a corporation at the beginning of a venture, this is most likely the stock you’re issuing to yourself and your cofounders. This type of stock is used throughout the early stages of fundraising, and is mostly given to the friends and family members who have helped you out when you’re just getting started.

From your perspective, this is the best type of equity to give to investors. It keeps everyone on the same playing field in terms of voting rights and special privileges, and you don’t have to worry (as much) about running afoul of some securities law by issuing something other than the common stock you started with. It’s the perfect way to get smaller investments from a larger number of individuals in a Kickstarter, crowdfunded kind of way. In short, if all investors are given common stock, everyone has the same rights, and that usually means the founders get to keep control over the company they built.

However, investors do not share the same perspective you do as the founder of your company. Investors are putting large amounts of their money on the line in hopes they’ll see some big profits in the future—and that’s why they hate common stock. When an investor comes calling, they want to have more control over the way the company is run, and common stock simply doesn’t grant them the ability to run the business in a way they’ve determined is the most prudent manner. Ultimately, because the investor will be negotiating with you at a time when your company needs the money, they’re going to have all of the leverage and you’re going to have to give up and accept you’re going to have to give them a class of stock better than common.

Preferred Stock for Startups

And that’s where preferred stock comes in. Preferred stock doesn’t really do much for the company itself, but means the world to the investors because of all of the additional bells and whistles that come attached to the stock to help increase investors’ reward while decreasing their risk. The main factor is that most of the preferences and rights associated with preferred stock go into effect at the time of a liquidation event—often purchase of the company, merger, public offering, or closure.

When it comes to preferred stock, all are not created equal. There are a number of different features that separate one class of preferred stock from another. It is important to keep in mind that a company’s preferred stock may have one of the following additional rights or all of the following rights—it really just depends on how well negotiations went and who the company has as its investors.

Conversion Rights: These are rights given to an investor designed to protect that investor from having her shares diluted by future financing rounds. After all, as more shares are issued, the fixed number of shares an early investor purchased becomes a lower overall percentage of the company’s equity. Generally, what happens with conversion rights is the investor is given the right to convert each share of their preferred stock into a larger number of shares of common stock.

Dividend Preference: While finding a dividend-paying startup is like discovering a dodo on your front lawn, dividend rights ensure a preferred stockholder gets their dividends before anyone else does—even if they have to wait years. The key here is some investors require dividends accrue even if they’ve not been officially declared by the board of directors. If this is the case, the dividends, which should have been paid out on a regular basis, grow in the background and are then paid to the preferred stockholder at the time of a liquidation event, thereby increasing the money made by the investor beyond just an increase in value of her stock.

Liquidation Preference: What happens with a liquidation preference is the investor gets her investment back before any of the common stockholders get a dime. These are triggered by any liquidation event (liquidity event). Something to look out for are liquidation preferences that provide a return on 1x the amount invested, though that’s a topic for another post.

Redemption Rights: The redemption right gives the preferred stockholder the right to force the company to repurchase its preferred shares. Generally, these are only activated after a specified amount of time and, for the most part, most redemption rights go completely unused—particularly in early investment rounds.

Voting Rights: Now here’s a big right for preferred stockholders that can mean a lot of different things. Voting rights can range from the ability to have the investor installed on the board of directors. They can also mean that each vote from a preferred share is worth more than that of a common share. Or, there can be protective provisions in place that give the investor the right to veto certain decisions made on the company’s behalf. Needless to say, the voting rights of a preferred stockholder are far beyond those of a common stockholder.

And those are the most common preferences and rights of preferred stock. Whenever you seek investor financing, always, and I mean always, consult with a startup lawyer to read the terms provided by the investor and help negotiate the deal.

Photo courtesy: Robert S. Donovan