Limited Liability Companies (LLCs) are a very popular form of organizing small businesses. In essence, they are a hybrid entity that provides the limited liability protection of a C corporation with the tax benefits of a partnership. LLCs are also incredibly easy to set up. While a C corporation requires the entrepreneur to think ahead about stock authorizations and board composition when filing the articles of incorporation, nothing of the sort is requires for an LLC articles of organization. Step one, check the company name is available. Step two, file the articles of organization. And now the LLC exists.
Some of the entrepreneurs we’ve come across have not taken any further corporate governance steps after filing the LLC articles of organization. This is unfortunate because the most important document for an LLC after it comes into existence is its operating agreement. Many well-intentioned entrepreneurs merely adopt some boilerplate terms for the LLC operating agreement, exposing themselves to major issues when seeking outside investment.
In a basic LLC, all the owners are "members" of the company. The company can be member-managed, or manager-managed. For a member-managed LLC, all of the current owners have a day-to-day role running the company. Alternatively, for a manager-managed LLC, the current members vote to make a few members the managers with day-to-day authority over the company. This arrangement is very different from that of a C corporation with shareholders. Members voting for managers is not like shareholders voting for a board of directors. Instead, this is more like general partners assigning a few general partners to act as company officers. The non-managing members still have a say in everything that happens to the company, from entering into contracts to hiring and firing employees. Also, like a general partnership, the default rules require unanimous consent to admit new members.
Notice, in a basic LLC all of the managers of the company must be members. There is no opportunity to bring in leadership who are not already owners of the company. This is not desirable for a company intending to grow because it reduces the entrepreneur's flexibility in how the company is managed.
Entrepreneurs can remedy this situation by essentially replicating the form of a C corporation within their LLC operating agreement. For instance, there could be classes of memberships with limited rights, a board of managers replicating the board of directors, and authorized officers with day-to-day control of the company who do not have to be members. This is possible because LLCs are creatures of contract. LLCs are flexible, but only insofar as the entrepreneur clearly spells out this structure in the operating agreement, establishes lines of authority, and remedies for aggrieved members.
But an entrepreneur must also think about company structure from the perspective of an outside investor. There is a reason that comparatively few LLC memberships are traded or sold in private transactions. Why would I invest in an LLC trying to be a C corporation, when I can just invest in a C corporation, in which I will know what my rights are as a shareholder under state laws and have a clear idea of how I can exit my investment?
Additionally, outside investors are often wary of LLCs because of the limited corporate governance requirements. When an investor is putting money into a new venture, the investor is not just investing in the idea of the company, but also the people running it. If the investor sees that the original leadership didn’t set up a clear corporate governance structure but just set up an LLC without a detailed operating agreement, that does not bode well for the company.
In sum, for an entrepreneur seeking outside investment, using a C corporation rather than an LLC has real advantages. Doing so will give the company leadership the flexibility to operate the company as needed to be successful. It may also be more appealing for outside investors to get a better picture of how the company is run and what their potential exit might be.