What’s wrong with an LLC?

(Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. He submitted this column to VentureBeat.)

A reader writes:  I set up an LLC on LegalZoom about a year ago and now my new lawyer is telling me I have to change it to a corporation if I want to get VC funding.  My accountant, though, told me an LLC is the best structure.  I don’t know what to do and I don’t have a lot of money.  What do you think?

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Answer:  As I have previously discussed, each venture is unique and the correct choice of entity depends upon a number of different factors, including the type of business, whether it will be seeking outside investors and the amount of initial capital contributions of the founder(s), among other things

There are three major advantages to utilizing an LLC.  First, an LLC is a “pass-through” entity for income tax purposes – which means that profits and losses flow directly through the entity to the members (unless the LLC elects otherwise, which is quite rare).  This can be very appealing to avoid the double taxation of profits of a C corporation and to permit the members to write-off certain losses of the company.

Second, an LLC offers extraordinary flexibility, including the distribution of cash and other assets, the allocation of profits and losses, and management structure (all of which is generally reflected in a written operating agreement).  Indeed, an LLC may be operated like a corporation, (with a Board of Managers and officers), a general partnership (with all members appointed “managers”) or a sole proprietorship (with one member or outside individual/entity appointed the manager). In certain states (like Delaware), an LLC may even limit the fiduciary obligations of its manager(s).

An LLC is also a pretty effective shield against personal liability – although if it’s a single-member LLC, that’s not always true.

There are disadvantages to utilizing an LLC, though. The most significant of these for entrepreneurs is that VC funds and other institutional investors usually do not invest in pass-through entities such LLC’s (or S corporations).  So if you plan to seek VC funding, an LLC is probably not the way to go. Converting an LLC to a C corporation (which is where VC’s like to invest) can be tricky and expensive.

Beyond that, there is a complexity (particularly from a tax and accounting perspective) with LLCs, as well as a limitation on capital structure – for example, it is difficult and expensive to grant options to employees/consultants and to issue other types of securities, such as “preferred” membership interests.

So in this case, it sounds like your lawyer is correct. If you’re seeking VC funding, it makes sense to convert to a C corporation and otherwise get your house in order before you approach investors.  That being said, you will need input from strong tax counsel to make the conversion. And if it turns out that you can’t afford to convert, you should go directly to the investors and propose either making the conversion a condition to closing the investment or setting-up what’s called a blocker corporation, which would permit you to maintain the LLC structure.

Be warned, though, that neither alternative is generally appealing to investors.

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Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.