You formed your LLC and hired some developers with the money you raised on that first friends and family round. You developed a viable product and an impressive business plan. You turn to VCs and independent investors for money but find yourself being told — for like the fifth time— that you may want to consider converting your LLC to a Corporation.
So… should you?
From a corporate governance and capitalization perspective, this switch generally makes sense when a startup is opening itself up to investor capital. It also usually makes sense from a practical perspective as well.
For starters, equity interests in corporations are reflected as shares of stock, whereas equity interests in an LLC are usually reflected as a percentage interest.
As such, the corporation is generally able to issue additional shares, or keep shares in treasury (for equity compensation vesting, for debt to equity conversions, for new offerings, etc).
This also allows for share certificates that survive events of dilution. Here’s what I mean:
Compare the implications of “Brian has 100,000 shares of Company X”, to “Lisa has 10% of the membership interests of the LLC”.
In the first example, if Company X for some reason related to its capitalization needs goes from having 1,000,000 issues shares to 2,000,000 issued shares, Brian still has 100,000 shares.
On the other hand, if the LLC in the second example undertakes a similar dilutive event—for example, because it brought in more capital, — Lisa now has 5%. This means that if the LLC issued a certificate reflecting her 10% ownership at some point, the LLC now needs to track Lisa down and convince her to swap it for one reflecting 5%!
Sure, an LLC can have “units” as opposed to membership interests reflected in percentages, and Lisa’s certificate can reflect 100,000 units, instead of 10%. In this sense, the LLC can act as a corporation, with units. Maybe we can even call them “shares”, why not.
The LLC can choose to include board of director type governance within its operating agreement, so that members vote for directors who, in turn, vote on most key issues.
The LLC can also designate executive positions like a corporation. This would be in contrast with working with the traditional LLC roles of direct voting by members on most issues (rather than by a board), and designating a manager or managers that may or may not be members.
And an equity compensation plan can be made for this LLC. Incentive stock options can be redrafted as incentive unit options, and non-qualified stock options can be redrafted as non-qualified unit options—checking, of course, for any tax implications first. Or maybe we are still calling these units “shares”…
And the corresponding changes can be made to the additional equity grant notices and agreements, indicating that we are working with units of an LLC as opposed to shares of a corporation.
Convertible notes can then be prepared reflecting that we are dealing with LLC units rather than shares, and note purchase agreements would also be drafted to that effect.
And then, when it’s time for the Series A round, a Series A charter can be prepared amending the LLC’s formation document to reflect the new makeup of units and preferred units. We could also address the various rights of these preferred units in a new operating agreement or within the amended formation document.
As you may have caught on, the point is that you can usually work within your LLC structure and still experience capitalization events by calling your interests units rather than reflecting them as pure percentage interests.
You can also paint your brand new car an entirely different color from the original, and change some engine components while you’re at it just to throw off the maintenance team. (This isn’t legal advice!)
But take note that, as an attorney that often represents investors when undertaking investments into LLCs that refuse to join the rest of the world of startups that are seeking VC money, I will generally be pretty annoyed with your lawyers if they are insisting on having my investor client invest in your LLC structure and reinventing every legal document to adapt for this approach.
Save your lawyer time (and yourself some legal fees). If you’re opening your LLC up for VC or other private money, consider listening to the investors’ suggestion to convert from LLC to Corp. Discuss it with your attorney and your accountant, maybe it is the right move. It’s probably the most considerate move, too, if that counts for anything.