Choice of Entity for a Start-up Company

The choice of legal entity for your business is a critical decision for any startup company.  If you want to attract venture capital investment, you need to form a corporation, most likely under Delaware law, for a number of reasons.  Venture capital funds are generally unable to invest in an LLC, LP or other so-called “pass-through” entity because of tax issues (an LLC can generate taxable gain or loss to its members from day one, and venture funds are usually prohibited from receiving such gain or loss until their investment is liquidated upon sale).  Many venture capital investors (through their lawyers) encourage startup formation under Delaware law because Delaware has a very well-developed body of corporate law and has a specialized court to hear business cases.  Investment funds also like to use their existing investment documents which may be tailored to Delaware law.  Some venture capital investors, however, are perfectly comfortable investing in a California corporation.

Angel investors (typically wealthy individuals) are sometimes willing to invest in an LLC, especially if the investor will become an active partner in the business and if pass-through tax treatment is advantageous for the investor.  In my experience, though, you lose many of your potential investors if you are organized as an LLC.  LLCs are well-suited for many consulting and other service businesses, and for holding real estate or patents, but corporations dominate the world of startups.

In addition, startup companies generally use stock options as a major form of compensation for employees and consultants.  Only a corporation can issue true stock options.  LLCs can issue other forms of equity incentives to employees, such as “profits” interests, but there are substantial tax and accounting complications due to the fact that most LLCs are taxed as partnerships.  For example, if an employee of an LLC receives an equity interest in the company, the recipient may have to be treated for tax purposes as a “partner” (subject to self-employment tax) rather than an “employee” (whose wages are reported on Form W‑2).  An employee of a corporation who receives stock or stock options will generally continue to be treated as an “employee” for tax purposes. Finally, because of partnership tax treatment, an LLC will often need to adjust the capital accounts of existing LLC members in order to reflect the current fair market value of the company’s assets each time a new LLC interest is issued (potentially incurring additional accounting and valuation expenses).