Post Category → Equity

How LLC Startups Raise Money

TL;DR: Very similarly to how “classic” C-Corp startups do, with a few important caveats.

Background Reading:

As I’ve written a few times before, the trend of entrepreneurs (somewhat) mindlessly accepting the advice – that forming their companies and raising investment should always be as standardized as clicking a few buttons – appears to be reversing, at least outside of Silicon Valley. This trend is very much related to all the public stories from experienced founders emphasizing the downsides of following a “standard” path, taking on “standard” VC investment with very high-growth expectations, and how it can cut off a lot of more nuanced/appropriate growth and fundraising strategies. For more on that, see: Not Building a Unicorn. 

As entrepreneurs are spending more time exploring all their options, LLCs are increasingly popping up. I’ve written before about when an LLC may make sense for a startup (C-Corps are still by far the dominant structure). It generally boils down to whether the founder team thinks there’s a possibility that, instead of constantly reinvesting earnings for growth and looking for an exit, they’ll decide to let the business become profitable and distribute dividends to investors. C-Corps are very tax inefficient for those kinds of companies.

So naturally as LLCs become part of the discussion, the next question is how LLC startups can raise investment. Some founders have been incorrectly advised that LLC startups simply don’t raise investment at all. They think that C-Corp = investment, and LLC = run on revenue. That’s far from the case. While true that institutional tech VCs very often won’t invest in LLCs (although that too is changing), the pool of investors interested in early-stage tech companies is much more diverse now than it was even five years ago. Lots of strategic investors, angels, and investors from other industries looking at tech are quite comfortable investing in LLCs, and do so all the time.

LLC startup fundraising looks, at a high level, a lot like C-Corp fundraising.

Capital Interests – Units, Membership Interests, Capital Interests. These are all synonyms for the LLC equivalent of stock. The documentation for these types of investments looks very different from a C-Corp preferred stock financing only because the underlying organizational docs of LLCs are different: you don’t have a “Certificate of Incorporation,” as an example, you have an LLC Operating Agreement.  But the core rights/provisions often end up very similar. A liquidation preference giving the investors a right to get their money back before the common – often see “Common Units” for founders/inside people and “Preferred Units” for investors. Voting provisions re: who gets to elect the Board of Managers (LLC equivalent of a Board of Directors), and other similar rights.

Convertible Notes – These look 95% like C-Corp convertible notes, including with discounts/valuation caps to reward early-stage risk, just drafted a bit more flexibly to account for whether the notes convert into LLC equity or C-Corp equity (if the company decides to become a C-Corp).

SAFEs – Yes, there are LLCs now doing SAFEs, although the SAFE instrument requires tweaking (like convertible notes) to make sense for an LLC. Even for C-Corps, we still see SAFEs being used only in a limited number of cases (again, because we serve companies outside of California, where SAFEs dominate). That’s because they are about as company favorable (and investor unfavorable) as you can get, and many investors balk at what they see as an imbalance. LLC SAFEs are even rarer than C-Corp SAFEs, but they do come up.

LLCs are known for their flexibility, and given that LLC companies tend to be more “cash cow” oriented than C-Corps, even more alternative financing structures are popping up: royalty-based investment is one example, where investors take a % of revenue as a way to earn their return, instead of expecting it in the form of a large exit or dividend. But those are still so uncommon (for now at least) that they’re not worth digging further into.

As I’ve repeated several times before, the big issue with LLCs and fundraising is you absolutely need a tax partner involved. By that, I mean a senior lawyer with deep experience in the tax implications of LLC structures and investment. This is not a “startup lawyer,” but a very different specialty. The flexibility of LLCs brings with it significant tax complexity at the entity and individual holder level, and even the brightest corporate lawyers are not qualified to handle that on their own. 

The majority of emerging tech companies still end up as C-Corps, simply because it still makes sense for the type of business they plan to build. But even with C-Corp land, founders are digging much deeper into how to structure and fundraise for their companies, and pushing back on the suggestion that they should just sign some templates and move on; as if what the templates say (and don’t say) doesn’t really matter.  That may still work for the “billion or bust” high growth mentality of unicorns, but entrepreneurs who feel they’re building something different want flexibility, and to understand the full scope of options.

Comparing Startup Accelerators

Related Reading:

Over the past several years, accelerators have emerged as a powerful filtering and signaling mechanism in early-stage startup ecosystems, allowing high-potential young startups to connect with investors, advisors, and other strategic partners far faster and more efficiently than before. While it definitely feels like the accelerator “bubble” has somewhat burst, and their numbers are normalizing, I’m still often asked by CEOs for advice on how to assess various programs. The below outlines how I would approach the decision:

Cash and Equity.

Very simply, what are you giving and what are you getting in return in terms of cash and equity for joining the program?

Re: cash, the more “unbundled” types of accelerators (less formalized) tend to not provide any cash upfront, but also typically “cost” less in equity, often just 1-2% of your fully diluted capitalization. More traditional and comprehensive programs often require 5-8% of common stock, but often provide between $20K and $100K up-front as well.

Anti-Dilution.

See: Startup Accelerator Anti-Dilution Provisions; The Fine Print.   Most accelerators, with a few exceptions, have much more aggressive anti-dilution provisions than a typical seed or VC investor would get, and the “fine print” can dramatically influence the total equity requirement depending on your circumstances and fundraising plans. This is something you should walk through with an experienced advisor, lawyer or otherwise, to prevent surprises.

Pro-Rata / Future Investment Rights.

See: The Many Flavors of Pro-Rata Rights. Some accelerators will require you to “make room” for them in future financings up to a certain amount. This is not necessarily a bad thing, and it’s very reasonable given that the ability to make follow-on investments in “winners” is virtually essential for very early-stage startup investors (angels, accelerators) to make good returns. However, for the most in-demand startups, over-committing on future participation rights can become a problem because it can require you to raise more money than you really need to.

Fundraising / general success of past companies.

See: Ask the users.  If fast-track access to investors is not at the top of your priority list, then this may not be as big of a deal for you. But 95% of founders I’ve worked with have viewed “cutting in line” to speak with investors as the main reason for entering an accelerator. And don’t rely solely on numbers reported by the accelerators themselves. There are lots of ways of fudging the figures, including by “annexing” already successful companies into the accelerator (in exchange for free help) and using their brand/fundraising numbers to puff up the accelerator; neglecting to mention that the accelerator had nothing to do with those numbers.

Entrepreneurs often celebrate faking it until you make it. Know that some accelerators do the same. When an accelerator says “our companies have raised an aggregate of $200 million,” they may be neglecting to mention that a huge chunk of that was raised before some of the companies (the top ones) ever “entered” the accelerator. 

Ask specific founders, off the record. Without a doubt, the overall “prestige” of the accelerator’s past cohorts will have a dramatic impact on the accelerator’s ability to deliver on its “benefits” to you. There’s a heavy snowball / power law type effect with accelerators where the best ones attract the best companies, which then attract lots of capital/great mentors, which then attracts more great companies, further improving the accelerator’s brand, and so on and so on. And the same is true in reverse: accelerators with poor reputations and bad averse selection (they are just getting the companies everyone else rejected) can actually make it harder to raise money, and are best avoided.

Time commitments and Geography.

Many accelerators involve a substantial time commitment (including travel time) in terms of going through the “program” of events, meetings, training, etc. Feedback (given privately) varies on the ROI of those obligations, depending on the accelerator, type of company, etc. Some entrepreneurs find it invaluable. Others find it a necessary cost to getting access to the accelerator’s network, which is what they’re really there for. In any case, travel and time commitments are a real cost, so take that into account.

Market Focus.

One of the most common complaints I’ve heard from entrepreneurs, after having gone through an accelerator, is that it wasn’t helpful for their “type” of business. Some accelerators are very up-front and overt about their market focus: biotech, energy tech, transportation, etc.  Others are more generalist, but if you dig deep you’ll realize that all or most of their cohort is slanted in one direction, which will mean the accelerator’s network of investors and mentors will be as well.

An example: a heavily hardware-focused startup may not find as much success in an accelerator where the vast majority of companies are SaaS based. The same goes for a health tech startup entering an accelerator full of consumer or B2B startups.

Culture.

In much the same way that entrepreneurs’ own personalities set the culture for their companies, the creators and managers of accelerators heavily influence both their “online” and “offline” culture. Personalities, ages, lifestyles, and values will vary. Some accelerators are well-known for being extremely friendly, generous, and community-oriented. Others are known for being more competitive and “eat what you kill” in their approach. I’ve seen more aggressive entrepreneurs feel that their particular accelerator was a bit too “kumbaya,” while those with opposite personalities felt right at home. 

Do your diligence before entering any accelerator, and make sure you assess its offerings in light of your company’s own priorities and needs. I’ve seen companies emerge with polar opposite opinions of the same accelerator, even within the same cohort.  In many cases, it’s less about the program being good or bad in an objective sense, and more about whether it was a good or bad “fit” for that particular startup. 

Startup Equity Compensation for LLCs

Background Reading:

As I’ve written before, with more entrepreneurs realizing that the “standard” (whatever that means) corporate trajectory for startups may not be what’s best for their specific company, we are seeing more tech companies explore the possibility of operating as LLCs (limited liability companies). By all accounts, C-Corps are still the market norm, especially for companies with no near-term plans to achieve profitability (everything is reinvested for growth) and with plans to raise conventional institutional venture capital.

But nevertheless, the “LLC Startup” market is real, and there’s far less info ‘out there’ for entrepreneurs to understand core concepts.  Here we’re going to cover the basics of how LLC startups typically issue equity, and how it differs from what C-Corp startups do.

The primary driver behind why LLC equity comp is very different from C-Corp equity comp is that W-2 employees of an LLC can’t hold equity in that LLC, under IRS rules. For C-Corps, both contractors and employees can hold equity, which simplifies equity compensation. But for LLCs, holding *true* equity requires the LLC to issue you a K-1 on an annual basis (you’re a “partner” for tax purposes), and the Company doesn’t cover employment taxes the way it does for W-2 employees.

Units/Membership Interests and Profits Interests (True Equity)

High-level executives (including founders) in an LLC startup are usually OK with this issue, and will hold direct equity in the LLC. They’ll receive K-1s annually.

That equity usually takes one of two forms: Units (sometimes called membership interests), which are the LLC equivalent of stock. Units can be voted (usually) on Day 1, and they are taxable on receipt if their “fair market value” is not paid for, which is why they’re typically issued only in the very early days of the company, like founder/early employee common stock in C-Corps. They can be expensive to receive if they are very valuable (in the IRS’ judgment) on the issue date.

As the value (for tax purposes) of units increases, companies will switch to Profits Interests, which are kind-of a LLC corollary to options, because (i) they only entitle you to the appreciation in value of your equity after the grant date, and (ii) when issued properly, they are tax-free to receive. When profits interests are granted, the Company has to obtain or decide on a valuation that pegs the “threshold value” of the company on the grant date, and the recipient of the PI is then entitled to the increase in value of the equity above that threshold value.

Returns on both units and profits interests receive capital gains treatment, like stock in a corporation. While units usually have voting rights, profits interests can have voting rights, but companies often times structure them to not vote.

Unit Appreciation Rights (Phantom Equity)

While founders and senior executives of LLCs will often be OK with K-1 status and holding true equity, it can become problematic for a number of reasons (tax oriented, benefits oriented, etc.) to have everyone be a K-1 recipient as the business scales. When LLCs want to issue equity-like compensation to lower-level employees, while continuing to treat them as true W-2s, they will usually switch to Unit Appreciation Rights, which are the LLC equivalent of phantom equity.

UARs don’t vote, and aren’t really equity at all. Instead, they entitle the recipient to a cash payment (like a bonus) upon some future milestone (typically an acquisition/exit) that is pegged to the value of equity. Much like profits interests, on the grant date a valuation is determined, and then as the LLC’s equity appreciates in value after the grant date, the UAR holder’s future bonus increases proportionately. When granted properly, UARs are also (like PIs) tax free on the grant date.

While the upside of UARs is that they significantly simplify tax filings/treatment for recipients (no annual K-1s, can stay W-2), the downside is that returns on the UARs are treated as ordinary income by the IRS; no capital gains treatment.

LLCs require Tax Specialists

The main reason startups choose to be LLCs is taxes: given the nature of their business, they want to avoid the corporate-level tax applied to C-Corps, even if that means deviating from the C-Corp norms of typical venture-backed startups.

But the cost of those tax savings is significant ongoing tax complexity in issuing and managing equity, and making annual tax filings. That requires not just good accountants, but good tax lawyers; who are very different from classic “startup lawyers.” If you’re planning to be an LLC that will use equity as compensation, make sure you’re using lawyers with access to solid tax counsel.

Tax Disclaimer: I’m not your tax lawyer or advisor. I don’t want to be your tax lawyer or advisor. The above is just a summary of what we typically see in the market for LLC startup equity. LLCs are highly flexible, and circumstances vary. Do NOT try to rely on any of the above advice without engaging your own personal tax advisors, including tax lawyers.