Budding Companies Part 3: Governance, Exits and Investors
By Charles S. Alovisetti, Partner
Sep 9, 2019
This is the third post in Vicente Sederberg’s “Budding Companies: Forming Cannabis Startups” series, which explores different issues involved in the formation of new marijuana and hemp companies. Read Part 1 and Part 2 first!
In addition to different administrative costs and taxation, LLCs and corporations are also subject to different rules regarding governances. Unlike an LLC, which has broad authority to set up its governance and economic terms as the owners may see fit, a corporation must follow certain clear governance structures. Corporations, by law, are managed by a board of directors, who in turn appoint officers to run the day-to-day operations. Shareholders cannot manage day-to-day operations. Only by making shareholder proposals or by electing directors do the shareholders influence the operations of the company. Unlike LLCs, a corporation, by law, must put certain major decisions to a shareholder vote. For example, under Delaware law, a corporation selling all or substantially all of its assets must approve such decision by votes of both the board of directors and at least a majority of its shareholders. In addition, there are corporate formalities that should be followed by a corporation. Board meetings need to be properly noticed and held, and formal written records kept for these events.
Unlike corporations, LLCs are typically permitted by state law to set forth the terms of their governance and economic distributions as they see fit in an operating agreement. An LLC can be run directly by its owners or by a manager, or in some other unique fashion determined by its owners. This may prove useful in the case of a company where flexibility regarding governance is desirable.
Exits and Tax Consequences
The tax consequences of selling an LLC and corporation differ and can have a major impact on potential exits. One option that a corporation provides is the ability to take advantage of a tax-free reorganization under IRC Section 368, something that is not available to LLCs. With a 368 reorganization, if structured correctly, a buyer can acquire a corporation in exchange for stock in the buyer without creating a taxable transaction, where the same transaction with an LLC may result in a taxable event. Many public companies in the cannabis space like using this structure since it allows them to use their stock as consideration for acquisitions, and many of the largest cannabis transactions are stock-only deals.
On the other hand, selling assets is more tax-efficient for an LLC than for a corporation. If an LLC sells its assets, the owners will only pay one level of tax on the gain recognized on the assets sold. A corporation, however, has two levels of tax on an asset sale: the corporation must pay for any gain recognized on the assets and the shareholders pay taxes on any gain paid out as a dividend. Since many buyers in the cannabis industry are nervous about hidden liabilities, they may want to opt for an asset acquisition over a stock deal or merger. An asset sale also allows the buyers to get a basis step-up in the acquired assets, which is a significant tax advantage.
A corporation can also be better suited for an IPO transaction as publicly traded companies are almost uniformly corporations. However, it is possible to structure an IPO with an LLC or convert an LLC to a corporation prior to an IPO, it can just increase complexity and cost down the line.
The structure of a corporation’s incentive equity options can also be an advantage. It is possible to grant employees profits interests in an LLC as a form of incentive equity (which while different, can approximate options in a corporation). However, many employees do not appreciate the value of profits interests in the same way they understand options. This perception has value to a company when attracting employees.
Legal Costs and Investor Views
Finally, investors have traditionally preferred corporations, rather than LLCs, as investment targets. And while sophisticated investors are far more comfortable with LLCs now than in the past, corporations are still preferred.
The fact that corporations have traditionally been the choice for startup companies means that many of the legal forms used to raise capital are standardized. The National Venture Capital Association (NVCA) has developed a collection of form Series A investment documents posted on its website for use with corporations, but not for LLCs. These forms were developed to help reduce costs and friction associated with financings. Having widely accepted forms can also mean lower legal bills and shorter negotiations. Form documents are now available for earlier stage equity financings (often called “seed-stage financing”). While the time may seem ripe for someone to create equivalent LLC forms, they do not currently exist. In addition, partnership tax is far more complicated than C corporation tax and this complexity can add to the time and expense of preparing documentation for an LLC transaction.
As mentioned in Part I, it can be tricky to use convertible notes, a very popular early-stage investment structure, with LLCs. It is possible, but convertible notes need to be structured carefully to avoid adverse tax consequences (e.g., members having to recognize gain due to forgiveness of indebtedness income). This complexity requires the participation of an experienced tax attorney and adds time and expense to an early-stage investment.
There are a number of other entity types, including limited partnerships, limited liability partnerships, limited liability limited partnerships, cooperatives, sole proprietorships, and nonprofit corporations. These have their uses, but they are rarely appropriate for a startup business for a number of reasons. Some require governance structures that are too complex for startups and others make it too difficult to finance the company.
Choosing the right entity type is not a decision with a clear-cut right and wrong answer that applies to all scenarios. Much depends on individual facts and circumstances. And while entity selection is rarely an irreversible decision (it is usually possible to convert one entity form into another), conversion down the line can have adverse tax consequences and can result in costly legal bills. Please think carefully before making an entity choice selection.