I have often heard that having an LLC discourages investors and that when getting an investment in your company investors really prefer Incorporations over LLC's.
Is that true?
In this audio snippet, you'll hear about:
- It's not a taxation issue as much as a control issue
- Investor may put money in, and not have any control, depending upon the structure of the Operating Agreement
- That's not the case in an Incorporation
- Depending upon how LLC is structured, the investor may not have control
Audio Transcript
Travis:
I have often heard that having an LLC
discourages investors, and that when getting an investment in your
company, investors really prefer corporations over LLCs, is that true?
Yosef:
A great question again, Travis. That's a great question.
Travis:
Thanks.
Yosef:
I'll tell you why I really think it's a great question. This is not an
issue about taxation, as much as it's an issue about control. In a
traditional corporation, the amount of shares that you have dictates
how much control you have over the corporation.
In
an LLC, depending on how the operating grommet is drafted, that may or
may not be the case. The managing member, or depending on which state
it's in, whether they are even allowed to have a managing member, or
it's got to be a totally–membered managed LLC, you may not have a
situation where you are in control over the money that you've invested.
You
may, in fact, find yourself in a situation where you've invested 100%
of the capital, and you basically allow somebody else to take over and
make all the investment decisions. There's a fundamentally economic
problem with that called "moral hazard." It actually exists in
traditional corporations as well, but it's only exacerbated in LLCs.
The
investor may have invested, say, a million dollars into a project. The
investor's concerned about preserving his wealth, and earning a decent
return.
Travis:
Mm–hmm.
Yosef:
An LLC manager's compensation is only tied to how successful he can
perform, so he will take risks that the investor would never take.
Travis:
Right.
Yosef:
In order to possibly earn a significant return, so that the manager can make some money.
Travis:
OK.
Yosef:
But of course, the investor himself would never want to take those
risks and never make those investment choices, because those are
principles...
Travis:
So that will definitely discourage an investor from investing into an
LLC, because they don't have as much say over how that money is
ultimately used.
Yosef:
Depending on how the LLC is structured, the investor may not have
sufficient control, and control is a really important issue in a
successful investment.
Travis:
I have to ask this question: I imagine that that control is outlined in
the operating agreement that is filed when the LLC is formed. Is that
correct?
Yosef:
Travis, as you know, it should be, but it may not be.
Travis:
OK.
Yosef:
The state does not necessarily require a specific format for the
operating agreements, so the investors are pretty much left to their
own devices.
Travis:
Ah, I see.
Yosef:
And depending on the quality and caliber of your professional representation, it may or may not be there.
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