Post Category → Equity

When LLCs Make Sense for Startups

TL;DR Nutshell: In the vast majority of instances, tech startups are best served by starting out as Corporations (C or S-corps, but usually C-Corps) on Day 1, and lawyers suggesting otherwise are usually generalists who lack tech/vc-specific domain expertise to understand why. However, there is a narrow set of circumstances in which LLCs make sense for a startup.

Background Reading:

This post is about the “almost” part of that tweet. But to get there, it’s important to address the “simpler” and “tax efficient” aspects, because those are the two core reasons that I often hear pushed onto founders for why they should be LLCs.

LLCs may be simpler generally, but Tech Startup LLCs with investor capital and equity compensation never are.

Here’s a hypothetical: Imagine you’re an athlete who’s signed up for a football camp held in Boston in the middle of February. Your general knowledge of Boston weather tells you that it is going to be a** cold. You ask a few other people with knowledge of Boston, including me (I went to law school there), and receive confirmation that Boston is a** cold in February. So you show up to the camp with only your winter gear… but it turns out the camp is entirely indoors in a heated facility. Whoops. Should’ve asked someone with true domain-specific knowledge of that camp, not just people with general knowledge. 

That, in a nutshell, is what happens when lawyers and other business people tell tech founders to use LLCs. LLCs are extremely common in the general legal world. For simple operations with one or a small number of owners, they are by far the dominant legal structure, because they usually are simpler. However, for tech startups, who very often (i) use equity as a significant part of their compensation for employees/service providers, and (ii) often raise capital with multiple equity classes, complex preferences/rights, etc., things get extremely complex under an LLC structure, much more so than with corporations. The amount of tax and legal analysis that has to be done to issue equity compensation and/or raise capital in an LLC is (without exaggerating) 10x that of a corporation.

So, if your plan is to raise capital and use equity as a form of compensation for employees and contractors (which is usually a hallmark of a tech startup), do not delude yourself for a second that an LLC will be simpler than a corporation. 

The “Double Tax” issue usually only matters if your startup is a “cash cow.”

Yes, in a general sense LLCs have one layer of tax and C-corps have two. That is another reason why (as stated above), LLCs have become a very dominant legal structure, not just for simple companies but also for many large businesses as well. Again, though, context is key. The “additional layer” of tax that corporations face is on net profits; after accounting for expenses, including salaries. No net profits, no corporate tax. So if a startup is going to be generating substantial profits (taxed once) with the end-goal of distributing those profits to shareholders (taxed again at individual level) as a dividend, the two layers are a problem.

But how many high-growth tech startups do you know that, instead of reinvesting profits for growth, pay profits out as dividends? Not many; certainly not in the first 5-10 years of the company’s life. Most high-growth tech startups deliberately operate at a net loss for a very long period of time, and therefore (i) aren’t worrying about taxes on net profits, and also (ii) are taking advantage of those losses at the corporate level in a way that may not be even use-able on the individual level. This, btw, is also why S-corps are usually not very helpful for tech startups either.

And to add an additional wrinkle: in an acquisition, corporations often have the ability to do tax-deferred stock swaps, whereas LLCs don’t. So, in short, the “LLCs save a lot of taxes” perspective, while generally correct, is usually misapplied to tech startups by people who simply don’t do enough startup/vc work to give sound advice. Yes, VCs often push companies to be C-Corps (read the background articles), but VCs are hardly the only reason why the C-Corp structure is used in tech. 

LLCs therefore make sense for tech startups that:
(i) expect substantial net profits very early on;
(ii) aren’t planning on raising institutional venture capital, and/or
(iii) aren’t planning on using equity to compensate a lot of people.

Lots of net profits early on (rare)? The single layer of tax may be worth it, and even institutional VCs sometimes are willing to accept the complexity of an LLC to take advantage of the tax savings.  Not planning on raising VC money any time soon? Other types of non-tech investors are usually more comfortable with LLCs than VCs are. Not planning on paying your employees with equity? Then you’ll avoid the tax nightmare of issuing LLC equity to dozens/hundreds of people.

Few tech startups fit the above scenario, and that’s why few are LLCs. The classic tech startups that operate (rationally) as LLCs are bootstrapped/self-funded software and app companies with no plans to scale very quickly with outside capital, and large “marketplace” startups for which the actual investment in the technology is minimal relative to the large amount of revenue/profit pushed through the marketplace. For almost everyone else, C-corps are king, and for good reason.

p.s. I am not your tax lawyer, and am not pretending to know the right answer for your specific company. The above is just general knowledge; not legal advice. If you rely exclusively on a blog post to determine your legal structure, without talking to a professional to understand your context, you’ve taken on the risk of screwing it up.

The Fiduciary Duties of Founders

TL;DR Nutshell: The moment someone is added to a startup’s cap table, founders (as majority stockholders, directors, and officers) becomes fiduciaries of that stockholder. This means that, regardless of how much control founders may have over a company, corporate governance law draws a hard line on how that control can be used. Crossing that line can result in a lawsuit.

This is one of those “core concepts” posts that, to lawyers and professional investors, will seem laughably basic; and yet the topic is something that I regularly see first-time founders get very wrong. And like most SHL posts, I’m going to explain things without referencing statutes or complicated terms. Founders need to understand the concept of Fiduciary Duties. The details they can learn from their lawyers or on-the-job.

State Corporate Law

Most Angel/VC-backed startups are Delaware corps. If they are not Delaware corps, they are usually incorporated in their home state and will be required by institutional investors to become Delaware corps if/when they ever are offered a check.  Whether you are a Delaware corp or not, your state certainly has corporate governance rules giving founders (as directors and majority stockholders) varying degrees of fiduciary responsibility to minority holders in their company. The concept is the same.

At the most fundamental level, to say that founders have fiduciary duties to their stockholders means that they cannot, without seriously risking a lawsuit, unfairly enrich themselves at the expense of other people on their cap table. They can certainly get rich by making everyone on the cap table rich; by growing the pie. But they can’t, without some kind of very credible case that it is necessary for the well-being of the entire business, improve their part of the pie at the expense of the rest of it. 

Hypothetical: Founders X and Y hired Employee A and gave her 5% of the Company that, because of some big contributions she made, was 40% fully vested on the date of issuance (meaning 2% of the Company’s equity, of her holdings, is fully vested). After a few months after the issuance, they have a big dispute and the founders fire Employee A, which they are certainly entitled to do. Under the Stock Issuance Agreement terms, 3% worth of the Company gets returned (because it wasn’t vested yet), and Employee A walks away with the 2% she had vested.

But Founders X and Y are pissed off that Employee A has that 2%. “She doesn’t deserve it. She totally ruined the product” they say. Then the light bulb switches on. “We control the Board and the stockholder vote! We’ll just dilute the hell out of her by issuing ourselves more shares!” they say.

Sorry, dudes. If it was that easy to screw minority stockholders, no one would ever invest in a company.

Delaware and other states have rules around “Interested Party Transactions.”  Without getting in the weeds, Interested Party rules boil down to:

  • A Board of Directors has a duty (a fiduciary duty) to do what’s best for the company and all of its stockholders taken as a whole, without unfairly enriching its own members.
  • Any transaction in which the Board members themselves are specific beneficiaries – meaning they are getting something that others are not – is inherently suspect. It is an “Interested Party Transaction” and is open to claims by minority stockholders (the people who didn’t benefit from the transaction) that it was a fiduciary duty violation.
  • In order to “cleanse” (so-to-speak) the transaction and, in some cases, give it a safe harbor protection from lawsuits, extra steps must be followed to ensure the transaction really was fair. Those steps usually are (i) obtaining approval by the disinterested members of the Board (if any) and/or (ii) obtaining approval by the disinterested stockholders of the company. The disinterested people are the ones who aren’t getting the special benefits.

Put the above 3 bullets together, and it’s clear that Founders X and Y (i) are planning an Interested Party Transaction and (ii) without getting a “cleansing” vote of that transaction, are assuming a very serious risk of a lawsuit. If there were 5 people on the Board, and the planned dilutive issuance to X/Y was approved by the rest of the Board, then the risk profile of the transaction would be very different. Similarly, if there are other people on the cap table besides Founders X/Y and Employee A, then if their votes make up a majority of the stock not held by X/Y (the disinterested stockholders) and they approve the dilutive new stock, we’re again in much safer territory.

The key is that, in an interested party transaction, you need to get a majority of the people who aren’t getting the ‘special benefits’ to approve the deal. If you can’t, then you’re asking for pain. 

If the entire cap table is X, Y, and A, then X & Y are just asking for trouble and (frankly) deluding themselves by thinking that they can dilute A (without her consent) in a legally air-tight manner. I’ve seen founders throw out a phrase like “let’s just do a recap” (short for recapitalization) as if recaps are a magical get-out-of-fiduciary-duties card. I think that idea was spread by ‘The Social Network,’ but I’m not entirely sure. Recaps are complicated, and you still have to worry about fiduciary duties to get them done properly.

Corporate Governance is Real

The overarching umbrella of the rules, processes, etc. that govern how corporate directors and officers interact with stockholders is called ‘corporate governance.’ Founders sometimes think it’s all silliness reserved for when they go IPO, but it’s not. From Day 1, corporate governance matters. Yes, it becomes more formalized as you grow as a company and the stakes get higher, but it’s the same rules at Seed v. at Series D, just being applied differently. You better believe it matters the moment a VC is on your cap table.

Fiduciary duties do not mean that you always have to do what your minority stockholders want. That would be impossible. It just means that, as a director/officer, you have to do what’s best for the Company (the whole pie), and not just for yourself. If there’s a financing coming up that some of your stockholders don’t like, you should be safe if disinterested parties approve it as something that is the best move for the entire company. I say should, because the rules, the process, and even the language in your board resolutions matter. They can be (and often are) the difference between moving forward knowing that your decisions can’t be challenged v. handing disgruntled stockholders a loaded gun to use against you when you least want them to.

Startup Accelerator Anti-Dilution Provisions; The Fine Print

TL;DR Nutshell: All major startup accelerators have uniquely strong anti-dilution protection in their stock purchase agreements.  These provisions are serious, can have a material impact on cap tables, and founders should be aware of what they mean. Many of them are also structured in ways that really don’t make sense economically, and are unfair to founders. Some better approaches are out there and worth considering.

It used to be common knowledge in startup circles: no one, not the CEO, not your first big investor, not even your grandma got full anti-dilution protection.  Maybe they got that watered-down weighted average stuff that is common in VC rounds, but the idea of guaranteeing someone X% of the cap table was a non-starter… until accelerators showed up. On top of receiving their % of the cap table (anywhere from 2-8%, depending on the accelerator), the vast majority have provisions requiring you to “top up” their shares if they experience any kind of dilution pushing their ownership below the % they originally purchased.

Granted, the protection typically expires at a seed equity or Series A round (called a ‘qualified financing’ in the docs).  Full anti-dilution forever would be non-sense.  But these provisions are still a big deal and can materially impact the capitalization distribution of the Company, and even impact how a company might go about structuring seed rounds.  While we definitely haven’t seen every accelerator’s anti-dilution provisions, we’ve seen enough, certainly most of the top accelerators’, to say that most fall into the following categories:

A. Protection from only additional Founder issuances – The most company/founder favorable anti-dilution protection, but unfortunately not the most common; though at least one very elite accelerator uses it.  In short, the accelerator is protected only if the founders issue themselves new equity, or otherwise somehow increase their ownership %s, after issuing the accelerator shares.  If stock, warrants, notes, etc. are issued to outsiders, like for services or for investment, no “top up” is required.

B. Full protection until a qualified equity round – This is the least company/founder favorable, and is unfortunately the most common; including among some top brand accelerators.  Basically, no matter the reason for issuing additional securities – services, investment, etc. – you must top-up the accelerator completely until the company raises $X in an equity round.  That last point is extremely important, and I will discuss it further below, given the fact that convertible notes/SAFEs (and not stock) have become by far the predominant form of raising seed rounds.

C. Full protection until a qualified equity or debt/SAFE round – This is a middle-ground provision that is less common than “B” above, yet at least is more agnostic as to its impact on seed round structures. If, after issuing the accelerator shares, you raise a round of $X of equity or convertible notes/SAFEs, the anti-dilution protection stops.

The “C” anti-dilution category is a little tricky, because even if the “tolling” of the anti-dilution stops at raising, for example, $250K in convertible notes (assuming that’s the qualified financing threshold), you still have to provide a top-up when those $250K in notes eventually convert.  While that’s still free shares to the accelerator, it ends up being far fewer top-up shares than there would be under the “B” (more common) type of anti-dilution protection.

Example: 

  • StartCo issues Accelerator 6% of stock as part of the program.
  • After the program, the Company (in sequence) (i) issues stock to several employees, (ii) raises $2MM in convertible notes @ various caps, (iii) issues some more options, and then (iv) eventually closes a $4MM Series A round.
  • The “qualified financing” threshold in the accelerator’s stock agreement (for purposes of ending anti-dilution protection) is $250K.

If StartCo had attended an accelerator with “A” type anti-dilution, they wouldn’t have had to top-up the accelerator at all – no free shares. As long as no equity was issued to the original founders, the accelerator continued to be diluted by future issuances just like the founders themselves were.

If StartCo had attended an accelerator with “C” type anti-dilution, they would’ve had to “top up” (or “true up,” however you want to call it) the accelerator for (i) the stock issued before the note round(s), and (ii) only for the first $250K in notes of the seed round. Once the $250K in notes was issued, anti-dilution stopped, though some top-up shares would need to be issued in the Series A round once it’s known exactly how many shares those $250K in notes convert into. While this scenario is worse for the company/founders than scenario “A,” it’s not nearly as bad as “B.”

If StartCo had attended a “B” category accelerator, which remember is the most common, including among some top accelerators, every single issuance before the Series A, including often (i) option pool shares reserved in connection with the Series A and placed in the “pre-money” and (ii) (in the worst variants of this category) all $2MM in notes, would require anti-dilution top-ups. That’s A LOT of free shares to the accelerator.

Accelerator A asked for 6% only on Day 1. Accelerator C asked for 6% on Day 1 and for maybe 3-6 months. Accelerator B asked for 6% for possibly 1-2 years. 6% is not just 6%. The details matter. A lot.

And perhaps more interestingly, “B” type anti-dilution is relevant to how founders structure their seed (pre-A) rounds.  If StartCo had raised $250K in seed equity, it could’ve cut off the accelerator’s anti-dilution immediately. But by raising seed money as notes and putting off equity for a Series A round (which is extremely common), it let the accelerator’s anti-dilution drag-on. Does it really make sense for accelerator anti-dilution to favor one type of seed round structure over another?

Which accelerator’s anti-dilution makes more sense?

As someone on the company side and at a firm that (deliberately) doesn’t represent accelerators, I’m obviously partial to the “A” approach of accelerator anti-dilution.  But stepping back and trying to assess things objectively, it also just makes more sense.  What exactly should an accelerator’s anti-dilution protection be “protecting” for? If the concern is that a set of founders with low ethics will immediately dilute the accelerator post-program by issuing themselves more equity, then “A” anti-dilution protects for that.

Perhaps, for economic reasons and much like the qualified financing threshold in a convertible note/SAFE, the accelerator doesn’t want its ownership % to be cemented until a serious financing round has occurred that prices the company’s equity. If (and I do mean if) that is the intent, it’s not clear why it should matter whether the seed round is debt/SAFEs or equity, as long as it’s large enough to be considered a real seed round. Plenty of VCs/seed funds who are more than capable of pricing companies (via caps) are signing notes/SAFEs.  The logic for “B” and “C” type anti-dilution must be, fundamentally, about grabbing a larger share of the cap table; not “protection.” 

If accelerators insist on “protection” for more than just self-interested equity issuances, then they should at least modify their anti-dilution provisions to stop favoring equity seed rounds over debt/SAFE rounds, given how much more prevalent the latter have become. And founders should be aware that if a particular accelerator is asking for 6% w/ “B” anti-dilution, that could be equivalent to 10%+ on Day 1 (much more than simply 6%), after accounting for all the free shares that must be given to fulfill long-term anti-dilution obligations. 

Kudos to the few accelerators who’ve moved toward the most company/founder favorable (and justifiable) type of anti-dilution; the “A” category above.  As for those preferring the “B” and “C” categories, which includes some very well-known brands, it would be great to hear some thoughts on why you think they are a more reasonable structure.  If I were a founder in one of those accelerators, I’d be interested in hearing those thoughts as well.