Best of Both Worlds: Converting Your Startup From a LLC to a Corporation

Entrepreneurs often ask my opinion on which type of entity is best for a startup or small business and, while I have written about this before, I generally say that one size never fits all.  That choice is made by each company depending on founder structures, short- and long-term planning, and, of course, tax.  I have seen companies start as corporations and as LLCs and both can be successful depending on your circumstance.  But are you stuck with that form once you make that choice?  That requires a bit of explanation. C-Corporations as Default? Many lawyers and entrepreneurs will tell you that all new startups must be Delaware corporations, and more explicitly, C-corporations.  This is the result of a common view that Delaware law is more friendly to your business than your state's, the courts are specialized and prepared to deal with business law issues that your company may face, and that a C-corporation is the structure that you will need in the event you take on investors (which you will certainly need if you are going to be taken seriously).

Without rehashing my previous post, I don't automatically subscribe to that line of thinking.  There are some startups that have very valid reasons for starting as, say, a limited liability company.  Those are mostly attributable to the flow-through tax structure and the flexibility of management and with allocations and distributions to the members. In other words, a company can take advantage of the tax savings of not having to pay corporate tax like a C-corporation during the early years of operation, the flexibility of adjusting the amount of distributions it gives to its members, and the freedom to customize management and ownership structures.

Can you Change your Entity? And if your LLC needs to be corporation later in life - for, say, investment or tax reasons - state laws provide mechanisms that vary by state for conversion from a LLC to a corporation (note: converting from a corporation to a LLC results in a much different, and less favorable tax treatment).  In Delaware, it is as simple as filing a conversion form.  In other states, such as Massachusetts, the same thing is accomplished through a somewhat more complicated conversion process or by enacting a full merger of your company into a newly-created Delaware entity.

What's it Going to Cost? Yes, there are both legal fees and filing fees associated with this type of conversion that will dissuade some companies from going down this route.  Your company needs to weigh the savings of flow-through tax treatment it will enjoy as a LLC with the cost of going through the conversion later.  And in addition to the legal fees, there are certainly some additional tax issues to consider (there we go again with the tax issues) particularly if you have passive members or hold certain types of debt.  But for many small and growing companies, you could accomplish a conversion without breaking the bank.  The key will be to make sure that your lawyer and accountant are involved early in the process.

Have you converted?  What was your experience?

Of Shoestrings and Bootstraps: How to Start a Business Without Investors

As a follow up to my recent post on starting a business without breaking the bank, here is another example of a successful business that is being successfully built without angels, venture capital, or other outside investors.  For this entrepreneur, maintaining control over decision-making and keeping the employees engaged through their own ownership stakes seem to be the key to their success. While the founder has to give up some ownership in either case, for this company, giving up value to the employees made for a stronger organization. As she notes in the interview, there may be a time to take on experienced investors at some point in the company's development - so called "smart capital" because with the money comes the expertise of seasoned investors and often former entrepreneurs who can provide value to building your business.  But many entrepreneurs are more reluctant to take that plunge until they have established the business and need the capital to advance to a new level.

I am curious to hear more stories of this (both successful and otherwise).  Has bootstrapping worked - or not worked - for you?

Can a Court Rewrite Your LLC Agreement? You Might Be Surprised.

What do you do if you never put a limited liability company operating agreement on paper?  In some cases, the answer may be decided against your wishes by a court. I was recently speaking with a small business owner who ran into trouble with the other member of his limited liability company.  The two had formed the LLC six years ago by filing with the Commonwealth but never put an operating agreement on paper.  However, he indicated that they had an oral agreement on a variety of things that would normally be in an operating agreement - how the LLC is managed, how the profits and losses are divided, how to buyout a member who leaves, etc.  Now he wanted to use some of those agreements to resolve the conflict.

In Massachusetts (as well as many other states), a written operating agreement is not required; members can have an oral agreement on how their company is structured and operated.  But that flexibility can bring risk.  Here's why.

States have a common law concept called the "statute of frauds".  (For those of you who eyes are immediately starting to glaze over at the sight of technical legal talk, you can skip to the paragraph that begins "So what does this mean for your company?" to understand the practical implications.) State laws vary, but generally the statute of frauds states that certain contracts must be in writing and signed if you are going to enforce them.  In addition to other things, this common law principal includes any contract that cannot by its terms be performed within a year.  Note that an agreement that happens to take more than a year is not automatically subject unless the agreement specifically states that it will take more than a year.  If so, the contract is not automatically void, but one party can raise the statute of frauds in order to have the contract voided.  Remember that this is a complex topic because there are some exceptions, but as a general principal, long-term unwritten agreements carry some uncertainty.

This issue became much more relevant to LLCs last year when the Delaware Chancery Court ruled that an oral LLC agreement was subject to the statute of frauds.  In Olson v. Halvorsen, C.A. No. 1884-VCL (Del. Ch. Dec. 22, 2008), a hedge fund founder who was removed by the other members demanded that the court enforce a multi-year earnout agreement that was included in their unsigned draft of an LLC agreement - an earnout worth well over $100 million!  The court held that because the earnout was to be paid over the course of six years, it falls within the statute of frauds and was therefore unenforceable.  The former hedge fund manager's claim for the payout was rejected.

The applicability of this case in Delaware adds some uncertainty to the operating agreements of LLCs formed there.  Other states, including Massachusetts, have yet to decide this issue definitively, but the Delaware courts often serve as a model for other courts when they are facing corporate and LLC issues.  So this decision may eventually have implications for your agreement.

So what does this mean for your company? If your LLC is operating under an oral operating agreement, many of the provisions with respect to management and such may be enforceable because they can be performed within a year.  However, as the court decided in Delaware, if you have an oral agreement with the other members that entitles you to some benefit that extends beyond one year, you may lose that right in a dispute.  For example, if the members agree that if you were to be hit by a bus tomorrow, the other members would buy back your membership interest with installment payments over five years, the other members might be able to successfully void that provision upon your untimely demise under the statute of frauds.

So here are some tips with respect to operating agreements in light of this case law:

1. Put your LLC operating agreement in writing.  Operating Agreements do not have to be fancy.  You can write the provisions of your agreement in any way that expresses the true intent of the parties.  Working with a lawyer may help save a tremendous amount of agony since they have experience in drafting agreements that will be enforceable.  But don't get caught up in the formalities - just get it in writing.
2. Make sure everyone signs the agreement.  A critical element of the statute of frauds is that the agreement must be signed by the person against whom it will be enforced.  As in the Olson case described above, the members wrote out the provisions of an agreement, but the courts did not enforce it because the parties never signed it.  I have dealt with other situations where clients "forget" to sign a document.  It may be easily overlooked a the end of a negotiation, a critical issue to protecting your rights.
3. Revisit your agreement periodically.  Companies that have been operating for several years might be surprised by what is in their operating agreements because the needs of the members and the company may change over time.  This is even more important if you are operating with an oral agreement.  After a few years, the members may have very different recollections of your agreement, which may lead to messy disputes down the road.  I would recommend that you take a fresh look at your agreement annually when you have an annual meeting.