When startups are choosing a form of entity – usually either an LLC or a C-corporation in my experience – the common advice is to be an LLC (which by default is taxed as a partnership), unless the company expects to receive venture capital funding, in which case it should be a C-corporation. The conversion to C-corporation status can happen later – even concurrently with the venture capital funding – without tax impact. However, this short article in Inc. magazine by Ryan Feit argues that even startups expecting venture capital funding should resist this advice and remain an LLC. Feit notes that the double taxation of C-corporations (corporate-level tax plus income tax at the shareholder level) has a huge impact, which is why single-taxed LLC are the go-to default, and that the rationale for nevertheless using C-corporations – that the VC funds need it for their internal purposes – is misguided.
When companies are in need of financing, the threshold question is whether the financing will take the form of equity or debt. Of course, there are hybrid forms such as convertible debt, and some financings will involve equity investment completed simultaneously with a bank loan. And sometimes debt will not be an available option, particularly for start-ups with no steady revenue that a lender could rely on for assurance of payment. But in many cases, a company will have a choice of which way to proceed. [Read more…]
The short answer to the above question is “no,” but there are some caveats that we need to discuss (otherwise, this would be my shortest blog post ever).
Limited liability companies do not require ownership to be evidenced by physical certificates, though a company’s operating agreement can provide, voluntarily, that certificates will be issued. More often than not, in my experience, ownership in LLCs is set forth in a table attached to the operating agreement that is updated as ownership changes. This table can reflect either share-like units of ownership called, appropriately, “units” or percentage ownership. The latter is more unwieldy, I think, particularly with LLCs with many members, but you see it a lot particularly in more old fashioned forms.
For privately-held corporations, most states now permit the issuance of “uncertificated” shares, meaning as with LLCs that there is no physical certificate issued and the corporate records must reflect current ownership. Both New York and Delaware permit the issuance of uncertificated shares by resolution of the Board of Directors (Section 508 of the NYBCL and Section 158 of the DGCL, respectively). In some cases, the corporation will send a notice of issuance of stock to the holder. This open source form from Orrick resembles an actual stock certificate in some ways – it’s not really necessary to do it this way, but it may be more reassuring to old school investors who aren’t aware of the trend toward (and legality of) uncertificated shares.
Finally, there are public companies (usually corporations), where uncertificated shares have been more prevalent for a longer period. This SEC summary outlines the possibilities – if you don’t hold a physical certificate, you either have “street name” registration or “direct” registration (DRS). Since 2008, all public companies with stock listed on a major exchange have been required to have DRS-eligible shares.
In preparing a stockholder agreement or operating agreement for a startup (for a corporation or LLC, respectively) with multiple owners, the section of the agreement that generally requires the most thought and discussion with the client relates to share transfers. While it’s possible to punt on all of these questions by having the agreement simply say that no transfers are permitted except as may be agreed by the owners, it’s advisable to at least consider the various scenarios and include appropriate provisions in the agreement. The following are some common ones:
- Permitted Transferees – Share transfers may be made to related persons (like a trust for the benefit of a family member) without consent of the company or other owners.
- Right of First Refusal/Offer – With a right of first refusal (ROFR), if an owner receives an offer from a third party to purchase the owner’s shares, the owner must first offer to sell the shares to the company or existing owners on the same terms. A right of first offer (ROFO) requires the owner to first solicit offers from the company or existing owners, and then the owner can sell to a third party if a deal is not reached. [Read more…]