Founders typically establish their high-growth startups as C-corporations under the assumption that venture capitalists will eventually require them to convert into a corporation in order to receive VC funding. Other entrepreneurs found their companies as LLCs and then convert into corporations ahead of raising institutional capital. Very few startups remain LLCs all the way through to an exit. This is an all-too-common mistake that can cost owners up to 30% of the ultimate after-tax proceeds from an exit.

The largest drawback of corporations versus LLCs is double taxation. In an asset sale of a corporation (acquirers often favor asset sales), the proceeds will be taxed once at the corporate level and then again at the individual level. On the other hand, LLCs offer pass-through taxation which means that the LLC passes gains through to its owners on a tax-free basis and the owners are solely taxed at a personal level. Assuming a $100 million exit in an asset sale and a 28% personal tax rate, the owners of an LLC would walk away with $72 million whereas the owners of a corporation would receive a mere $50 million. Said another way, the owners of a corporation would need to exit at $144 million, 44% higher, in order to receive the same after-tax proceeds as the owners of an LLC.

For decades venture capitalists have instructed entrepreneurs to use a corporate structure for two reasons. First, in order for a company to IPO, it must be a C-corporation. This might have been valid rationale for founders to establish a corporation 15 years ago but not anymore. According to statistics recently released by the University of Florida, there were just 97 IPOs per year between 2008 and 2014 compared to 469 IPOs between 1993 and 1999. Given that very few startups nowadays will exit through the public markets, it is generally not a good argument that startups should form corporations in order to prepare for an IPO down the line. Furthermore, a startup can always convert from an LLC to a corporation later on ahead of an IPO if they happen to be one of the rare few who do go public.

Second, venture funds typically avoid investing LLCs because LLCs generate gains which can be passed-through to a fund's investors, creating unrelated business taxable income, or UBTI. A venture fund's limited partners are typically pension funds and endowments which are tax-exempt entities. In order to retain their tax-exempt status, pension funds and endowments are prohibited from receiving a given amount of UBTI. As a result, venture funds have traditionally refused to invest in LLCs to avoid dealing with potential UBTI issues and most entrepreneurs haven't realized there is any other choice.

However, there is a way to remain an LLC while also ensuring that venture funds don't need to worry about UBTI. Setting up an intermediate blocker entity allows a venture fund to invest in the blocker corporation, which then invests in the LLC. The blocker will capture and pay corporate taxes on any operating business income from the LLC, ensuring that no UBTI ever reaches the limited partners. This solution requires some additional time and expense, but it's well worth it when you consider the potential tax savings.

When SeedInvest raised our Series A from venture capitalists, we felt considerable pressure to convert into a C-corporation. But we understood the tax implications from our prior experience as private equity investors and we held our ground. In the end, we were able to successfully raise an institutional round while remaining an LLC and maintaining the potentially substantial tax benefits. If you do seek venture capital you will most likely receive similar encouragement to convert to a corporation, but if you are able to hold out, the rewards might very well be outsized.

Published on: Jan 14, 2015