Corporate Structures and Their Effects on Equity Offerings

Advantages and Disadvantages of Startup Equity Offerings

Startup equity offerings predominantly come in the form of C-corporation stock, limited liability company (LLC) membership units, convertible debt, and a relatively new structure called a simple agreement for future equity (SAFE). This article covers the fundamentals of each of these securities and their advantages and drawbacks for investors.

Straight Equity: Stock and LLC Units

If you are new to private securities, your investment portfolio probably consists mainly of public company stocks, corporate and municipal bonds, and various mutual funds. If your portfolio is growth-oriented, the public stocks in your portfolio are likely shares of common stock, rather than preferred stock, because common shares offer the potential to earn greater returns when the companies behind them are consistently profitable. If your portfolio is income-oriented, you may favor preferred stock for reasons we’ll explain below.

Currently, the only kind of corporation that can raise capital via equity crowdfunding is the traditional C corporation. Subchapter S corporations are effectively barred from participating in Title III equity crowdfunding because:

• The number of S corporation stockholders is limited to 100, while the number of C corporation stockholders is unlimited.
• S corporations can issue only one class of stock, while C corporations can issue any number of classes.

Common and Preferred Stock

Common Stock

When founders incorporate their company, they issue common stock to themselves. Common stock is considered ‘pure equity,’ as it entitles shareholders the right to vote on management issues at annual shareholders’ meetings.

Aside from voting, common stock is the type of equity offering that is most directly tied to the actual profitability and growth of a corporation. Common stockholders may receive dividends when the company is profitable, depending on management’s decision about distributing profits. But most investors — at least those whose portfolios are allocated more for growth than for fixed income — tend to focus on stock price rather than dividends, as capital gains depend on the price per share.

Common stock prices fluctuate freely with the performance of the company. In a period of sustained profitability and growth, the price per share normally climbs. Share prices of stock in public companies are reported daily, while the share price of a private company is not known until shares are transferred.

Preferred Stock

Preferred stock is considered a more conservative investment, as the price per share does not fluctuate as freely as that of common stock in the public stock exchanges. So, preferred generally offers less opportunity for capital gain. However,  if you are investing in an early-stage company where the risk of failure is high, preferred stock offers other advantages such as liquidation preferences. Most deal terms allow angel investors to convert their preferred shares to common shares when the company achieves certain milestones.

In public markets, preferred stockholders usually receive dividends when the company is profitable, and those dividends tend to be higher than for common stockholders. This makes the preferred stock more attractive for retirees whose portfolios are allocated more for income and wealth preservation than for capital growth.

The yearly dividends for preferred shares are usually fixed, while the dividends for common shares, if any, are tied to the company’s performance each year, and then only after the fixed dividends are paid to the preferred stockholders.

If the company goes bankrupt or dissolves, preferred stockholders almost always have a claim to company assets ahead of common stockholders. If enough assets are available, preferred stockholders will recover the amount of their investment and sometimes receive an annualized total return. Preferred stockholders, however, do not have direct voting rights, so it’s not considered ‘pure’ equity.

Preferred stock prices for public companies are reported daily just as for common stock, but preferred prices — because the investment is more conservative — are less responsive to general market volatility.

Preferred Stock in Startups

Founders and managers of startups and early-stage corporations generally offer preferred stock rather than common stock when they raise equity capital. For one thing, it lets them maintain a certain degree of control over the company because preferred shareholders do not have voting rights. Investors also often insist on buying preferred shares because of the preferences in the event of failure, as well as the chance to convert to common shares under certain conditions.

Preferred stock for startup companies can be a win-win for both the founders and the investors. The founders retain control and on the flip side, preferred shareholders have better protections against downside risk, thanks to liquidation preferences, but also tend to enjoy the upside if the company succeeds later on, as the shares can be converted to common stock.

Pay close attention to conversion rights if you invest in preferred stock in an equity crowdfunding deal. The downside of not being able to convert to common stock is that the amount of money you can earn in the event of an acquisition will be limited. If the acquisition price is low, then preferred shareholders get their investment back and common shareholders might not get much. But if the acquisition price is high, then preferred shareholders still get their investment back and common shareholders receive a gigantic windfall.

A private company may issue different classes of preferred stock in successive rounds of equity financing, where each class has a unique set of rights, preferences, and other terms. The classes are typically known as Series Seed Preferred, Series A Preferred, Series B Preferred, and so on.

Drawbacks of Corporations

Corporate structure has evolved into a powerful way to finance an enterprise and govern it. From a shareholder’s point of view, this highly evolved structure makes corporate governance fairly uniform, understandable, and predictable.

The same structure that creates these advantages, however, also gives it disadvantages in the context of equity crowdfunding. It is rigid from the point of view of startup founders, who want to keep governance highly centralized in order to empower leaders to make quick decisions and pivots. This diffused corporate governance structure can also be prohibitively expensive for lean startups in particular. The diffusion can require enlisting board meetings, shareholder votes, and more. That is why many startups operate as sole proprietorships, partnerships, or limited liability companies that allow centralized governance and are less costly to operate. Of those simpler entities, only the LLC provides liability protection for investors and can sell shares via equity crowdfunding.

Limited Liability Companies

The LLC is a relatively new legal entity, first created in Wyoming in 1977. It combines the personal liability protection of corporations with the flow-through tax advantages of partnerships and S corporations. In fact, the flow-through tax treatment is only one of the various taxation options that LLCs may select, but it is the most common.

Owners of LLCs, whether they are founders or investors , are known legally as members of the LLC, and their equity is called membership interest or units. An LLC can have an unlimited number of members and can issue various classes of membership interest.

Most states allow two major types of LLCs: member-managed and manager-managed.

Member- and Manager-Managed LLCs

Member-managed LLCs function much like a general partnership, where all members participate in the management of the company. In manager-managed LLCs, much like limited partnerships, one member, or a small committee of members, makes the most important decisions, while all other members are passive and have limited or no participation in management. In this respect, manager-managed LLCs are an alternative to old-style limited partnerships. General partners run the company and limited partners do not. They have added liability protection in addition to more flexibility in other areas of governance.

The operating agreement establishes whether the LLC is member-managed or manager-managed, which is an important distinction in the context of equity crowdfunding. As we mentioned earlier, generally, in a member-managed LLC, all members — including passive investors — can vote on major decisions that, according to the operating agreement, require such a vote.

In a manager-managed LLC, only the designated managers—which may be members or nonmember employees — can vote. An LLC that intends to raise capital via equity crowdfunding must be manager-managed if it does not want to allow hundreds or thousands of passive members, mostly strangers, to vote. Keeping track of many dispersed members so that they can be contacted each time a vote is required would be an administrative burden.

LLC Liability Protection and Operating Agreement

All LLC members are not personally liable for acts and debts of the LLC. This ‘veil’ of personal liability protection is not absolute: the LLC veil can be pierced when a member commits fraud, fails to deposit taxes withheld from employee wages, and so on. Of course, a member can personally guarantee the debt of an LLC and be on the hook, but the veil is otherwise a strong one and safeguards personal assets from business risk.

An LLC’s operating agreement establishes the governance of the entity. Operating agreements are similar to corporate bylaws, but they are more flexible than bylaws. LLCs do not rest upon centuries of legal precedent and standardization as do corporations. It is the operating agreement alone that creates the ‘constitution’ for how an LLC is governed.

An LLC operating agreement should include how the company is managed and how it allocates profits and losses among its members. Unfortunately, too many startup LLCs don’t include that information. These LLCs present a challenge for investors trying to evaluate deal terms and conduct due diligence.

Management may decide that different classes of membership interest receive different proportions of profits and losses. So if you invest in an LLC membership unit that represents 2% , it is possible that you would receive less than 2% of the profit or loss. But in the long term, you might consider that trivial relative to the increase in value of the unit, in the event of an exit whereby you earn a large gain on your investment.

Tax Advantages of the LLC

The tax advantage of an LLC is that the company typically does not pay income tax due to company profits and losses flowing to the individual members, usually in proportion to their ownership interest. However, that income must be claimed on each member’s tax returns.

By contrast, C corporation income is taxed twice, once on the corporate tax return and when income is distributed as dividends on the stockholders’ tax returns. If an LLC has more than 100 members, it may lose the ability to pass income through to members. LLCs can elect to be treated as C corporations for tax purposes, but that is rare. Thus, LLCs and their owners can avoid double taxation.

A distributive share of LLC losses can be deducted from investors’ taxable income on their individual tax returns, as losses flow through just as income does. Each year the LLC issues a tax form, typically a Schedule K-1, to each member showing that member’s distributive profit or loss. With tax issues, a loss might be a good thing, since it can be deducted from other income.

Tax Advantage Caveats

There are two minor hitches to this tax advantage. First, passive members can deduct losses only from passive income, such as interest, dividends, certain rents, royalties, and pensions.

The second hitch is that an LLC’s operating agreement may provide that yearly profits and or losses will be distributed to members not in proportion to their ownership interest. Such a provision would affect not only your pass-through income and loss for tax purposes but also your ultimate calculation of the return on investment (ROI). Talk to your personal accountant before you invest to fully understand whether a loss can be used on your tax return, what income can be offset, and how profit might affect your tax situation.

LLC Drawbacks

In equity crowdfunding, there are three kinds of drawbacks to LLCs: taxation, employee incentive options, and liquidity and exit.

Taxation

The first problem with LLC income taxation for investors is that members must pay income tax on flow-through profits even if none of the profits are actually distributed. In other words, the company may earn a profit in 2020 but use it to pay expenses in 2021, or it may keep it in the bank to be used for future business development. In that situation, members do not receive any portion of the income but still must pay their distributed share of income tax on the profit. This problem can be overcome by designating, in the deal that investors make when they buy LLC membership, that each year the company shall distribute enough of the profit for members to at least pay income tax (if the company makes a profit).

Employee Incentives

Another drawback of LLCs is the difficulty of giving employees equity incentives such as options on membership interests, similar to corporate stock options. Corporations can grant options to employees fairly easily and with favorable tax consequences. For LLCs, however, granting options is complex and the tax consequences are not necessarily as favorable.

Liquidity and Exit

A final drawback is that LLCs present certain problems in the areas of liquidity and exiting the company for investors. This is because venture capitalists typically do not want flow-through income, in addition to the fact that LLCs cannot go public. An LLC can still be acquired by another company, but that possibility may be limited by the difficulty of swapping LLC units for stock shares in a merger-oriented acquisition.

It is possible for an LLC to convert to a C corporation when the need to raise venture capital or issue incentive options to employees becomes more urgent than preserving the flow-through tax advantages and flexible management structure. In fact, converting the form of equity is quite common. If planned well, such a conversion is possible to accomplish without much expense, disruption of the business operation, or adverse tax consequences as in some states like California and Delaware. But businesses that expect to grow quickly, especially in the technology and healthcare industries, know that they will eventually need to raise venture capital, as well as go public at some point. This is why they typically incorporate rather than convert from an LLC.

Stock or LLC Units: Which Is Better for Investors?

Many investors ask which of the two straight-equity securities — stock or LLC units — is a more attractive investment whereas the more appropriate question is whether the company is operating under the structure that will best help it achieve its goals. Another important consideration is whether the company has outlined how investors will share in the profits and gains.

Convertible Debt: The Hybrid Security

Convertible debt is actually a hybrid of equity and debt. Whether this type of equity offering is issued by a corporation or an LLC, convertible debt starts out as a loan to the company in the form of a note that can be traded for shares of stock or LLC units. It can be a useful tool for issuers that are pre-revenue like start-ups.

Some convertible notes give investors the option to convert to equity, while others require investors to convert, typically because of some specific event that involves a valuation and or transfer (e.g., a round of equity financing or acquisition).

When properly structured, convertible notes give investors the best of both worlds: liquidation preferences if the company becomes insolvent and capital gain if the company grows and gets acquired.

Mechanics of Convertible Debt

The basic mechanics of convertible debt are easy to understand, but the variables can get complex.

Let’s say you invest $1,000 in Startup City, Inc. in an equity crowdfunding deal whereby the issuer promises to pay you ‘x’ percent interest every month and then repay your principal in three years. If at any point before the three years, a group of angel investors or a VC fund invests in Startup City, you have an opportunity to convert your $1,000 note, plus accrued interest, into Startup City stock.

But how many shares will you receive for your $1,000? Or rather, what is the price per share at the time of conversion? The convertible note should show that answer, which — like a term sheet for straight equity — lists all the terms of the investment. This is where it gets complicated.

The reason it’s complicated is that when you invested, the valuation of the company was not discussed. The valuation was probably very difficult to calculate at that time because the company did not have enough revenue to use as a basis for the calculation. And that is the beauty of convertible debt for entrepreneurs: The company can attract investors without having to propose a valuation.

The price per share that you and other convertible-debt investors pay to convert is derived from the price that later, straight-equity investors pay.

Let’s say two years after you invested, Startup City has become profitable, and the new investors agree to pay $1 per share of preferred stock, valuing the company at $4 million. Would you be satisfied paying $1 per share for 1,000 shares? Heck no. Early investors invested when the company was not yet profitable, taking the greater risk.

You should be rewarded for taking that risk and providing seed capital to the company when it wasn’t so attractive to angel investors, not be penalized by having to pay the same price as angels who waited. This fairness issue is typically resolved in one of two ways: discounts on the price that later investors pay or caps on the price that earlier investors pay.

Successfully investing in convertible debt revolves around assessing the possibility that the issuer will attract future rounds of straight-equity financing if the business is successful. Without that possibility, it’s just a loan.

A New Type of Equity Offering: SAFE

SAFE (Simple Agreement for Future Equity) is like convertible debt without the debt. SAFE is essentially a warrant entitling investors to shares in a company when it raises ‘priced’ equity capital, when it is acquired, or when, and if, it files for an IPO.

Investors must understand that a SAFE is not an ownership of a current equity stake in the company and is only converted if — and only if — those events take place. This also means investors likely have no voting rights.

Issuing SAFEs is relatively easy for startups as they are flexible, simpler to implement, and do not accrue interest. According to the SEC, a SAFE is most appropriate for a fast-growing startup that will likely need to raise additional capital from investors.

Investors in particular, see this as an opportunity to invest quickly in a promising startup without the negotiating hassles of other types of equity offerings.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Turning an Idea or Product Into a Business
2. Selecting the Right Valuation Expert
3. Raising Capital: Negotiating with Potential Investors

This is an updated version of an article originally published on March 30, 2016 and updated June 11, 2020. This article was most recently updated by the Financial Poise Editors.]

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