It’s not a
huge secret that institutional investors are more likely to invest in a corporation over an LLC, but why is that the case? Ultimately, it comes down to what these entities are at the basic level.
Corporations
We all kind of know what corporations are. They’re from centuries ago as a way to separate ownership from liability. Before corporations existed, the owner of the company was responsible for whatever the company did. The way the corporate structure is set up, owners are called shareholders. The shareholders vote for a board of directors who then appoint the managers (or executives) of the company. This separation makes it so that the owners don’t directly manage the company, and that was what you needed to limit your liability.
Corporations, because of their structure, are considered separate legal entities with their own taxes, and the board of directors and management operate basically as trustees making the decisions for the corporation, much like how a guardian can make the legal decisions for a child.
Limited Liability Companies
Limited Liability Companies, LLCs, are the newer vehicle for limiting liability for the owners (members in LLCs). Instead of creating the board structure, LLCs are a conglomerate of their owners, which means that an LLC is not a separate legal entity. The taxes and decisions are all passed through to the owners by default.
Because there is no company level taxation in an LLC (absent electing C Corp taxation with the IRS), all profit of the company is recorded on the members’ individual tax returns.
The decisions of an LLC are made by the members. The biggest decision is the Operating Agreement, which can limit the management authority of the members, but that agreement can still be changed by the members.
Tax Issue
We’ve seen that the taxes of the corporation’s profits are handled at the corporate level and the LLC has the taxes flow through to the members. This is where the first problem arises for why investors do not like LLCs. Typically, investors are looking for a payout at the end of a certain period of time. To get that payout, there are times when the company shows a profit or a loss. In the event the company shows a profit, the members are all taxed on their share of that profit. If the company keeps the money to build going forward, the investor may see a tax bill without actually receiving any money from the company.
Additionally, taxes are harder for the members of an LLC than shareholders of a corporation. In a corporation, owners can receive dividends and salary. In an LLC, owners receive profit in whatever mechanism the money came into the company. It could be royalties, rental income, dividends, ordinary income, capital gains, and more in just one year. This can lead to a higher administrative cost of owning a portion of an LLC.
Adding Owners and Investors
The second issue comes up when you look at the process for how you add additional owners to a company. Presumably, properly run companies would never dilute a current shareholder, only allowing new owners to buy in at an appropriate price, but that’s not always the case. Because of this, investors like to see safeguards to ensure their investment is protected.
In a corporation, there are safeguards already built in through how shares are issued. In order to issue shares, a corporation has to get a certain number approved by the state they’re in. If they’re publicly traded, they also need to get the SEC to approve their shares.
After getting the total number of shares approved, a corporation will also have a Stock plan, Bylaws, and the Stock Transfer Agreement (however they agree to transfer). Each of these creates a contractual duty to the shareholders in certain aspects that protects the shareholders’ interests.
In an LLC, however, there is typically only an Operating Agreement, and maybe an Equity Agreement of some sort. You also do not need approval to issue more ownership interest in an LLC because technically, you’re only ever giving out percentages and bringing in new members lowers everyone else’s percents, unless there’s terms in the Operating Agreement or Equity Agreements stating otherwise.
Because of the way LLC ownership is handled, there is also a lot more flexibility, which tends to be less certain for investors. Stock ownership is fairly clean cut by comparison to LLC ownership interests.
If you have any questions about investors in LLCs or Corporations, or would like to set up a consultation for your business, please contact us at richard@lawplusplus.com or by calling 919-912-9640.