Raising Capital for Your Business
One of the primary concerns of starting a new venture is acquiring capital. This need for cash can be a game-changer when it comes to selecting an entity type for your new business.
If you seriously intend to go after private equity (venture capital, institutional investors, and so on) or raise money through an initial public offering (IPO), then there’s a chance that you’ll want to form your business as a corporation rather than a limited liability company.
If you’re raising venture capital, your first round of financing is either your seed round or your Series A round (if you don’t raise a seed round first). When you get your first term sheet, one of the things you’ll notice is that the venture capital firm or institutional investor isn’t issued plain ol’ common stock. Instead, the investor gets preferred shares, usually titled Series A, that offers special privileges, such as
Liquidity (the shares can be converted to common stock).
First dibs at dividends and the proceeds of any liquidation that occurs.
Anti-dilution protection, which allows the investor to maintain fractional (for example, 15 percent) ownership of the company even when more stock is issued in the future.
Mandatory or optional redemption schedules (indicating when the investor can sell out). This keeps the investor in the game until the company has had a chance to prove itself.
Special voting rights and preferences giving the investor special abilities to exercise control over the management.
A fixed return on investment.
Any future financing rounds are titled Series B, Series C, and so on, with the most recent taking priority and first position.
Venture capitalists have investors, too! Because some of the larger venture capital firms have investors of a certain type (such as pension funds or other pseudo nonprofit or public interest companies) for tax purposes, they cannot invest in a pass-through entity like an LLC with partnership taxation.
This is one of the reasons why, if you are operating as an LLC, you’ll likely be required to convert to a regular (C) corporation before a venture capital firm will invest capital.
Corporation shares were made to be liquid and freely transferable. Although a limited liability company can be structured to have similar flexibility, LLCs aren’t designed for it.
Also, although the formalities required for corporations may be a drag for a small business owner, sophisticated investors have grown to appreciate them. With the law on their side, they can be sure to get their regular financial statements and know that all corporate decisions are properly documented, which helps prevent intercompany disputes later on.
The fixed structure of shareholders, board of directors, and officers of a corporation also offers an established set of roles that have been tried and tested over the years. Usually, larger investors request to sit on the board of directors, while you and your founders — the entrepreneurs — take the officer roles.
Because corporations have been around for so long, a lot of case law has developed around them, which significantly limits the chance of courtroom surprises down the road.
This is especially true in Delaware, where a special chancery court handles all business issues and is backed by hundreds of years of case law. LLCs, on the other hand, don’t have the benefit of a long history. They are the new kid on the block, and when an investment firm is handing over millions of dollars, the last thing it wants is another unknown.
Small-time angel investors, friends, family members, and other investors who don’t require a complex capital structure in order to invest money in your business or idea may actually prefer a limited liability company over a corporation.
Most companies don’t operate at a profit in their first year, and due to the pass-through taxation of LLCs, the company’s losses flow to its owners. These losses can be used as a fat write-off to offset an investor’s other income. With all other things being equal, the investor gets to write off the value of her investment immediately.
When you are raising money for your LLC, you must make sure that you have an ironclad operating agreement and buy-sell agreements in place.