If you are the founder of a startup business, you will inevitably come across the question of whether to structure the business as an LLC or a Corporation.
As a tech industry attorney, I get asked this question a lot, regardless of whether the business is at an initial or more advanced funding and monetization stage.
As with most legal questions, there is no “one size fits all” answer because many factors must be considered. Below are 8 important considerations to keep in mind when determining whether to work under an LLC or a Corporate structure.
Part of the attractiveness of an LLC is that these entities are generally not taxed at a corporate level. Instead, the LLC’s income is typically filtered through to the LLC’s members. For this reason, LLCs are commonly referred to as “pass-through” entities. Contrast this with a C-Corporation, which is generally taxed at the corporate level as well as at the shareholder level. However, a Corporation can elect S-Corp status to be taxed as a “pass-through” entity. As most tech startups are not profitable during initial stages, these “pass-through” benefits are generally of little significance at pre-profit stages.
LLCs are usually simple to manage from a corporate formalities perspective. LLCs are often operated by a Manager, who need not be a Member. (A Member is, basically, the equivalent of a corporate shareholder). Additionally, LLCs usually do not have a board of directors. As such, LLCs are often operated with minimal formalities such as board meetings and minutes. Depending on the Operating Agreement executed by the LLC’s Members, the Manager may be given broad powers to act independently of the Members, or the powers given may be limited so that membership resolutions and approvals are required for certain actions, such as significant expenditures.
Generally speaking, an LLC’s Member has more control over the LLC’s affairs than a corporate shareholder would have over a corporation, assuming similar equity interests and standard structures. Typically, a corporate shareholder only has the right to vote for a board member, and the board of directors then votes on substantive matters, such as approving budgets and expenditures. In contrast, an LLC member generally votes on substantive matters (like budgets), and therefore, has powers that are more similar to those of a corporation’s board member than to those of a shareholder. Of course, these traditional roles can be altered in corporate governance documents such as operating agreements, bylaws and shareholder agreements.
LLC equity ownership is generally referred to as a Membership Interest, which is assigned a percentage value as it relates to the entire LLC ownership. This is ideal for most small businesses that are owned by a small number of Members. For example, an LLC may have 4 Members, each owning a 25% Membership Interest in the LLC. However, complications may arise when it comes to seeking investors or admitting new Members because the membership interest percentages of the original owners would have to be diluted to make room for new members.
Alternatively, corporate equity ownership is generally in the form of a fixed number of shares. The Corporate structure is designed to more easily facilitate the admittance of new shareholders and issuance of new shares. Although the same dilution in percentage value of the shares would occur under a corporate structure upon the issuance of new shares, the fact that Corporations deal in a fixed number of shares rather than a percentage interest creates an important distinction, as you will see in the next section.
As previously discussed, LLC ownership is viewed as a percentage of a whole. Using our previous example, a simple 4 member LLC may have a structure in which each of the 4 members has a 25% membership interest, for a total of 100%. So, what happens when the LLC wishes to give 2%, vesting over a 2-year time period, to one of its employees? And what happens if the LLC expects to grant a total of 10% in equity to employees over time? Should the LLC make a reserve of 10% now, thereby diluting all of the members accordingly? That would mean that the members would report their ownership interest in a way that does not add up to 100%, until the 10% is fully vested. Alternatively, should the 10% be awarded over time, reducing each existing member’s 25% proportionately as the 10% kicks in? What about voting rights? Will the 2% employee, or the 10% total employees, have full membership rights once their membership interests vest? As indicated above, LLC members usually have powers that are more similar to those of a corporate board member than to those of a shareholder. I think you get the picture by now: structuring equity compensation under an LLC is impractical.
With a corporation, on the other hand, shareholders have a set number of shares, and this number does not change if additional shares are set aside for an equity compensation plan. Thus, 4 shareholders can each hold 1,000,000 shares. An equity compensation plan could subsequently be created by issuing 400,000 unvested shares under an equity compensation program (resulting in 4,400,000 total issued shares). The 4 shareholders would each still hold 1,000,000 shares, and the shareholder’s ownership as a percentage would remain unaffected until such time as the shares kick in. In addition, the shares reserved for equity compensation can be of an entirely different class so that the employee that obtains equity may have rights that differ from the remaining shareholders, such as the ability to vote.
Finally, because the shares are already set aside, the corporation’s board usually has the power to grant the equity compensation awards without requiring all shareholders to participate in the decision each time an award is granted under the equity compensation program.