“New Internet” LLCs

Some “New Internet” entrepreneurs who don’t foresee needing a ton of capital are now organizing new ventures as limited liability companies (“LLCs”).  The fact that this is happening may be related, in a way, to the economic depression, and probably reflects some of the ways entrepreneurs are re-thinking how best to capitalize and run startups.

The LLC form of entity has been around in Washington nearly as long as I have been practicing law.  It’s used frequently in real estate, from financing, to development, to management of income-producing properties.  But, by and large, the LLC has not been a suitable vehicle for tech startups that utilize venture capital.  Reasons for this are many, including the lack of settled law; and the disadvantages are only compounded when you cross state lines, as states treat LLCs inconsistently.  Not so with corporations (not really). 

I used LLCs first in the 1990s to form small, company-specific early stage investment funds.  The LLC form was amenable to the management of very specific investments.  For instance, you could set up capital call provisions to deal with the funding of potential exercises of warrants, and you could provide for separate classes or accounts to deal with follow-on investments that might occur in proportions different from the first round.  (These days, I and my colleague, Bob Muraski, sometimes use a Delaware series LLC to accomplish similar ends.)  In certain situations, you did not want the complexities or default rules of a limited partnership, and the LLC let you tailor your own rules of governance.

Even back in the day, an entrepreneur would occasionally suggest that we consider organizing a new tech venture as an LLC.  As recently at 18 to 24 months ago, though, I would typically talk him or her out of it.  You’ll close yourself off to venture capital firms, I’d say; people won’t understand your units of equity; fiduciary duties will be less clear, or will have to be drafted; legal costs will be higher.  (One entrepreneur once told me he understood a certain acquisitive software giant preferred to acquire LLCs.  That prompted a call to a former colleague, who then oversaw the giant’s M&A; of over [number between 50 and 100] deals, he told me, two targets had been LLCs, and both were royal pains to do due diligence on.)

I still think the corporate form is right for most startups.  You have to have a unique set of circumstances to opt out of the paradigm that is understood and accepted by most serial entrepreneurs, most investors, most executive talent, and the rest of the players in the eco-system of a developing company.

But an LLC can be a good structure for some entrepreneurs and their backers to consider.  If the venture is to be self-funded, or the need for outside capital is modest and the deal does not need to be syndicated widely, an LLC could present advantages that might be entertained before filing articles of incorporation.  I’m finding LLCs to be particularly flexible in dealing with complex or unusual affiliate relationships, where default corporate opportunity demarcations may not be appropriate.  Tax-wise, the LLC may also make more efficient use of short term losses, while not having some of the disadvantages of a corporation making an S-election.

I may report back with some brief observations on the organizational characteristics of some of these “New Internet” LLCs.  Meantime, please let me know if you have any thoughts about LLCs.

Comments

[Bob Muraski]

Bill,

It often makes sense for a self- or family-funded venture to be organized as an LLC. The company can have multiple classes of equity interest and can allow entities to invest, and investors still can have flow-through taxation – you can't have these benefits at the same time in a corporate structure. However, if a company will depend on the standard "eco-system of a developing company," you're correct that the corporate structure probably is the way to go.

I question whether an LLC really increases transaction due diligence costs. Having been involved with many M&A deals in many industries, I haven't had an experience where the LLC form itself increased the cost of the transaction. M&A deals often are structured as asset purchases, and in that context, the type of entity should have little bearing on the seller's ability to convey title to assets. Due diligence expenses often increase when a company maintains poor records, has an unclear chain of title for key assets, or has an unnecessarily complex ownership structure. In an LLC, just as in a corporation, these issues can be addressed with thoughtful organization and operation of the company.

In the context of a merger between an LLC and a corporation, the transaction costs may increase, but not materially. I suspect some the of increased cost surrounding an LLC is a purchaser's lack of knowledge/experience in dealing with that form of entity.

Bob

[chris evans]

Bill - this is a timely topic. I've been thinking quite a bit about LLCs in light of the WA Supreme Court's decision today in Chadwick Farms. In over a hundred VC financings I've worked on over the last 9 years, only one transaction involved an LLC. The reality is that VC investors don't want units, K-1s or complicated operating agreements - and founders who insist on using LLCs will find that investment committees just don't won't return their calls. There is a perception that LLCs are just "lifestyle companies" for the founders - if they were serious about building a business and getting an exit for investors, they'll use the tried-and-true C-Corp.

[William Carleton]

Bob, I agree, M&A transaction costs should not, as a matter of course, be increased simply by the fact that the target is organized as an LLC. The anecdote reflected, I imagine, just what you allude to: lack of experience and familiarity with LLCs. Chris Evans' comment is pertinent on this, too: "units" can seem mysterious and people can be uncomfortable trying to figure out the ways in which an LLC unit might or might not act like a preferred stock instrument.

--Bill

[William Carleton]

Chris, thank you for the comment. I like how succinctly you've summarized the venture capital antipathy toward LLCs. If one eliminates the "exit" imperative, of course, one can think much more broadly about the pros and cons of different choices of entity; that's a big "if," but a working hypothesis of this blog so far is that new investment paradigms are emerging, whereunder tech ventures might be seeded, grow, generate profits and throw off cash to generate a several X return on investment (not in "an exit" per se, but in distributions aggregated over time). (I'll eventually need to fold into this hypothesis a principle known as "Chuck's Law," formulated by my friend Chuck DelGrande.)

Chris, can you tell us more about the Chadwick Farms case? Would also be good to have a url to link back to any of your virtual spaces.

--Bill

[neilc]

Bill,
It is fascinating to see how these early choices can play out for an entrepreneur growing his/her business. It seems that if you properly stage the development of your new business, that your entity type may change with those stages being achieved.

For a new software company, low cost of entry on the development side provides a tremendous opportunity for entrepreneurs to engage with customers early in the formative stages of the product. The outcome of this early feedback may ultimately impact whether a business is pursued at all. For that reason, it would make sense to keep costs low - A C-corp or S-corp at that stage would be difficult and costly to unravel if the business opportunity faded.

Great post.

[Dave Rice]

Bill,
I'm late coming to this topic as I've been building a company (currently formed as an LLC). That choice was easy for us as we built prototype product and tested the market as a self-funded entity. However, we've made strong progress and are beginning to engage with prospective investors. If we do proceed with outside funding, we'll convert to a C-Corp for two reasons that you mentioned above: 1) investor familiarity, and preference for C-Corps; and 2) our ability to rely on the body of settled law supporting C-Corps. Most experienced angle investors and VCs with whom we've spoken won't consider investing in a technology venture formed as an LLC.

Thanks for raising the topic!

[William Carleton]

Dave, I'm excited to hear you have launched a newco! Looking forwar to hearing more when the time is right.

Thanks for your comment. What you say about investor expectations is right in line with my experience.

Bill

[men's bike jerseys]

Some of the special service people or possibly even the vendors I referred to have been loyal employees for 30 to 40 years.