Venture Funds: Don’t Fear the LLC

By on April 15, 2013

It has long been the case that venture funds (classified as partnerships for tax purposes) have insisted that limited liability companies (LLCs) taxed as partnerships convert to C corporations prior to the consummation of a venture financing.   Most commonly, there are three rationales given for this requirement: (1) certain venture fund limited partners are tax exempt institutions or foreign investors and prohibit the venture fund from allocating Unrelated Business Taxable Income or Effectively Connected Income to such types of limited partners that likely would result from an investment directly into an LLC, (2) venture funds are focused on the potential of a future initial public offering (IPO) and the most common vehicle to an IPO is a C corporation and (3) executive talent expects to be issued stock options and are not familiar with the more complex equity issued by an LLC.

Perhaps though it is time to revisit this long held investment philosophy.  Showing flexibility in investment structure may make a venture fund more attractive to the founders of an LLC then other funds less willing to be creative.  Often times founders of LLCs wish to retain the flow through tax treatment benefits they receive, especially in an early financing round after which the founders will retain a significant ownership percentage.  The tax benefits received by the founders as a result of maintaining the LLC structure include: (1) the founders pay a single level of tax on the profits of the business (in a C corporation there are two levels of tax on the distributed profits of the business, which would result in less after tax distributions to the founders) and (2) the active founders can often utilize the losses of the business on their individual returns thereby offsetting other gains they may have.  There are other tax benefits of the LLC structure as well.  If there is a sale of a company structured as an LLC, then the company may be able to deliver a partial step up in the basis of the LLC’s assets to an acquirer, which has real economic value.  And contrary to the commonly held belief that the new management team that the venture fund plans to attract expects to be issued stock options, the LLC has a more tax efficient way of issuing management equity in the business, through profits interests, and this gives management the potential of capital gains rates on gains rather than ordinary income, which arises with respect to stock options.

And LLCs aren’t so bad for venture funds.  First, these days there are a lot fewer IPO exits for venture funds than there used to be and a sale of the business has become a more common path to liquidity.  Second, as mentioned above, an LLC will provide a better structure for delivering at least a partial step in the basis of the LLC’s assets to an acquirer thereby potentially delivering more exit value.  Third, LLCs are creatures of contract unlike corporations and this allows the venture fund and its lawyers to be much more creative with the deal terms, in particular the equity structure.  Fourth, unlike corporations, in Delaware LLCs, the equity holders can limit the fiduciary duties of the board of managers of the LLC, providing potentially important protection for venture fund director representatives.

But you need a creative lawyer because venture funds do have issues with investing in LLCs.  Not to give away all of our secrets but here is the general approach to make investing in an LLC work for a venture fund.  The venture fund would invest into the LLC through what is referred to as a “blocker” corporation (an entity taxed as a C corporation).   The venture fund would fund the “blocker” corporation with its investment and the blocker corporation would make the investment in the LLC.  Therefore, any gain or loss is allocated to the blocker corporation and not to the limited partners of the venture fund.  The blocker corporation would also be responsible for any state tax filings arising from an investment in the LLC (which can be numerous depending on the LLC’s taxable presence in different states).

The limited liability company agreement of the LLC will also need to be amended to accommodate the venture fund’s investment structure.  The agreement will need to include, among other things, the following three items:  (1) in any future round, if insisted by the next institutional investor, the company would agree to convert to a C corporation so as not to limit the company’s future cash needs, (2) in connection with any IPO, the company would agree to convert to a C corporation and (3) in connection with any future sale of the company, the company would structure the sale as a sale of the LLC interests from all the equity holders of the company other than the blocker corporation and include in such sale the shares of the blocker corporation held by the venture fund, so as to avoid the fund from having two levels of tax on the gain from its investment at the time of sale.

Now, that said, one word of caution, as the LLC becomes increasingly profitable, one should consider the recent changes in federal income tax rates and whether in the long run the founder is going to receive enough tax benefits to justify the accommodation.  As the business grows, if there are losses, losses will turn into profits and profits will grow, or at least that is what the business plan says.  As profits grow, those profits will be taxable at increased federal rates for the upper bracket of 39.6 percent plus the additional 3.8 percent for passive investors (plus applicable state taxes).  With federal corporate rates at 35 percent (plus applicable state taxes), if the company is not planning on paying dividends, then long run tax efficiency may be best achieved in a C corporation.  That said, given the ability to provide a basis step up in the assets of the LLC to the buyer in connection with a future sale of the company and if the company is likely to pay dividends, tax efficiency may still be maximized in the LLC structure.

The moral is, don’t pass up a business opportunity just because it comes in the form of an LLC, but heed caution.  A good lawyer can help you get there.

Thomas P. WardThomas P. Ward
Thomas (Tom) P. Ward focuses his practice on the structuring and implementation of transactions involving partnerships and limited liability companies, including private equity fund formation, portfolio company investments and representation of pension fund investors in private equity funds. He also advises clients with respect to the use of profits interests as compensation and legislative efforts to change the tax treatment of carried interests. Read Tom Ward's full bio.