Many new solo founders and small teams of co-founders often choose to start their businesses as LLCs. An LLC, short for limited liability company, allows founders to limit their personal liability in running a business, while also allowing founders to be taxed only once on any income (at the individual level). LLCs have the benefit of being relatively easy to form and maintain, and are relatively informal and flexible in terms of governance compared to a corporation, so long as the business remains small.
As a business grows, the flexibility of an LLC can result in a lot of unexpected complexity. Governance structures in corporations are generally standardized and well-understood no matter the size of the corporation, but LLC governance structures are almost endlessly customizable. Many of the routine tasks that are accomplished in corporations are less straightforward in an LLC and require significant legal and tax structuring. Among other examples, issuing stock or options to employees in a corporation is a relatively simple and well-understood process. In an LLC, however, this process requires creating and issuing “profits interests” to employees with additional administrative costs due to employment and tax issues.
For decades, law firms and, more recently, the National Venture Capital Association have worked to standardize documents for corporations in the venture-backed startup space. There have been no similar efforts for LLCs, however, largely because LLCs are not a preferred structure for venture-backed businesses and their investors. Venture financing documents and convertible instruments like the SAFE can be used almost off-the-rack for corporations, but require significant modifications for use by LLCs, if the LLC can attract venture investment at all. The pass-through nature of LLC taxation means that many venture capital funds, which are typically structured as limited partnerships, are unable to invest directly in LLCs because doing so would wreak havoc on their partnership tax returns.
For the above reasons, most companies seeking to raise venture capital will choose to form as a corporation from the outset or convert their LLC into a corporation if they initially incorporated as an LLC.