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 [...]

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