Should Investors Buck the Status Quo with LLCs?
Sometimes change is good.
Too often investors and entrepreneurs just stick with the status quo, in terms of structuring a venture capital or private equity investment. One notable example is requiring that target portfolio companies formed as limited liability companies reincorporate into a “C” corporation because…well…that is just how it is always done.
Actually, the decision is a bit more thoughtful than that. One concern that investors have with LLCs is the typical pass-through tax election these entities make to provide economic benefits to the founders during the lean, loss years. That is a valid concern because funds investing in a pass-through vehicle will experience phantom losses and gains that flow to them as a result of the investment, which creates accounting nightmares. Many limited partnership or operating agreements for funds prohibit investments in pass-through vehicles for that reason.
Another reason that investors often prefer corporations, particularly in Delaware, is the generally corporation-friendly laws and the deep body of judicial opinions interpreting those laws create some level of predictability on how bad situations will play out. The laws governing LLCs and the related judicial opinions interpreting those laws are not nearly as robust in Delaware or any other state when compared to dealing with corporations.
Avoiding unnecessary tax issues and enjoying the protection of a wealth of well interpreted corporate laws are both relevant analytical points to consider, but they are not necessarily determinative of the choice of entity question.
Funds can eliminate the issue of phantom losses and gains in two ways. The most obvious is to have the LLC make an election to be taxed as a corporation. That sort of flexibility is one of many attractive features of an LLC. The other method to avoid phantom losses and gains is to set up a corporation, often referred to as a “blocker corp,” to serve as an intermediary between the fund and the LLC. This is something that private equity firms do more than traditional venture funds.
Delaware LLCs are not going to win the battle of legal precedent any time soon. But that doesn’t necessarily matter, because there is one step that the LLC can take that arguably trumps all the general predictability—at least, as far as the investors are concerned. That step, of course, is limiting, or even eliminating, fiduciary duties.
Venture capital or private equity investors often want to insert one (or more) of their own onto the boards of directors for their portfolio companies. That makes perfect sense because the investors have a vested interest in keeping abreast of the progress of their investment. The investors also typically have a wealth of experience that adds tremendous value to the development of the company, when they serve on the board. The rub is that serving on the board opens a Pandora’s Box for liability in the form of fiduciary duties.
In an earlier blog post, Mike DiSanto discussed the impact of fiduciary duties have on investor designees serving the board of directors of a portfolio when that portfolio company completes an inside round of bridge financing. But that isn’t the end of the analysis. Inside-led rounds of equity investment present the same issues, and investors wanting to truly double down on an investment shouldn’t be prevented from doing so from the fear that the valuation and other terms used to consummate the equity round will later be deemed to fall outside the inherent fairness test imposed by Delaware corporate law – remember, that standard is applied using 20/20 hindsight, making it ultra risky.
Of course, there is more. In the unfortunate event of a fire sale of a portfolio company, a board dominated by investor designees faces liability when the preferred holders consume all of the acquisition proceeds due to previously negotiated liquidation preference (full case here). Those same directors face potential liability when the board approves a reverse stock split that has ultimately forces a cash-out of minority stockholders (full case here).
There are lots of other examples, but you get the point. Fiduciary duties generally force investor designees serving on the board of a portfolio company to think about what is in the best interest of the stockholder base as a whole (or sometimes just the common holders), not what is best for the investment fund.
Delaware LLCs have a distinct advantage vis-à-vis corporations when it comes to mitigating potential damages for breaches of fiduciary duties. The Delaware Limited Liability Company Act allows for LLCs to expressly limit, or even eliminate, the fiduciary duties of managers or members by expressly stating that in the operating agreement.
Delaware takes this position because LLCs, unlike corporations, are a creature of contract. Not an organic form of entity that is regulated by well established corporate laws. Delaware has long encouraged the policy of freedom of contract, and that policy extends to the operating agreement of a LLC, even if that includes eliminating fiduciary duties.
It is also important to note that, as a creature of contract, Delaware LLCs have the freedom to establish all the various enhanced rights, preferences and privileges that typically go along with an investor acquiring preferred stock in a corporation. In fact, LLCs are often more flexible when it comes to the ability to tailor those rights into exactly what the parties want, rather than having to conform to existing corporate laws on liquidation or voting rights, for example.
All the pros combine to make Delaware LLCs a pretty attractive choice of entity from the perspective of a venture capital or private equity investor. I think it may be time for private equity funds and venture capital firms to reconsider investing directly into LLCs.