The Limited Liability Company
When working with LLC’s you may encounter the term “angel investor.” An angel is typically a wealthy individual (or, given the 1990s, a group of wealthy individuals) who make investments in start-up companies. Such investments are usually small, relative to the investments of professional investment firms such as venture capital firms, which also operate in financing new companies. Additionally, it is typical that “angels” will invest very early on in the lifecycle of a new firm and that their investment will be highly speculative and risky.
Introduction to the Limited Liability Company
The Limited Liability Company (LLC) is a more recent invention of the business law community. The LLC is a hybrid entity, as it shares some features with the corporation while having some features that are more typical of partnerships. The goal of the LLC's originators was to create a business form that shared some of the best aspects of both of these two divergent business forms, combining them into one, relatively flexible entity.
An LLC is made up of "members" - the LLC equivalent of a shareholder (in a corporation) or a partner (in a partnership). The LLC is itself, a distinct entity (like a corporation) capable of suing and being sued. It is liable for its own torts and contracts, and it has several other features typical of a legal “person.” At the same time, however, the LLC is not liable for its own tax bill, but is a pass-through entity (unlike a corporation, but like a partnership).
LLCs comprise a growing percentage of the business community and are often the form of choice for small companies who view themselves as having substantial growth potential. The ease of creation and the flexibility with which it is able to perform business functions combine to make the LLC a popular choice until the firm requires capital from a professional investor (like a venture capitalist) or from the public markets.
EXAMPLE: A new Internet start-up has decided to get going and form a business company. The company’s founders, being seasoned businesspersons, would like to be able to control any profits from the company in a way that allows them flexibility in reporting those earnings on their own tax returns. At the same time, as each founder also has substantial assets of his own, they would like to use a business form that shields those assets from personal liability. An LLC would probably be a good choice for a company with these characteristics.
Businesses that might be an LLC:
- Start-up Internet companies and other small, technology-oriented ventures
- A variety of companies, including communications and manufacturing firms that do not anticipate the need for large capital contributions
- these days, anyone can put together an LLC for many things, not just service or technology ventures.
As observed above, the LLC borrows all of its features from corporations and partnerships. While there are no new inventions with respect to the structure or function of an LLC, it is the LLC's unique combination of these functions that makes it attractive to new and growing businesses.
LLC's are formed, in the usual case, by filing "Articles of Organization" (or similar documents known by various names in different states) describing the purpose, management, and organization of the firm. See, e.g.,
EXAMPLE: Rowan and Bob decide to form an LLC. They draft Articles of Organization for the firm and submit them to the state. After the state has approved the formation of the firm, they then take out an advertisement in the state newspaper and publish information regarding the company’s formation for 6 weeks. In most states, these actions would complete the requirements for the formation of a LLC.
Ownership and Operation
Operation of an LLC is presumed, by operation of law, to be conducted by all members of the LLC. This default position, however, may be altered by agreement to specify a certain subset of members to have management control. See
Ownership of an LLC, by default, is based on the size of the capital contribution of an individual member relative to the gross amount of capital contributed by all members. Each member's ownership in the LLC is the same as the percentage in the LLC of its capital contributions. Note, however, that such an arrangement may be altered by agreement of the members. Such an alteration generally requires a unanimous vote of the members.
EXAMPLE: Members A, B, C, and D have formed an LLC. However, only A and B have provided substantial capital to the firm whereas C and D are to manage the company once it gets under way. Worried about how they are to protect their investment, A and B condition their contribution upon the stipulation that they are to serve as an oversight board for major decisions made by C and D. Such an agreement, if written and accepted by all members, will thus alter the otherwise equitable governance rules for the LLC form.
The LLC, as a pass-through entity, is not subject to a tax at the organizational level. This means that taxation of the LLC occurs solely on the basis of profits and losses as allocated to each member's capital account. Also related to the nature of a partnership is the fact that taxation of the individual member occurs whether or not there is a distribution by the company. Distributions from an LLC are typically more consistent than those from a partnership, as the LLC is generally designed for more constant, long-term growth as an investment vehicle than is a partnership.
The single most important characteristic and driving force behind the growth of the LLC as a business form is the limited liability that accrues to the LLC's members. Specifically, members of the LLC are not personally liable for the debts and obligations of the firm. See, e.g.,
This liability shield is the principal reason that the number of LLCs has seen phenomenal growth over the past decade. Company founders and early investors, particularly those engaged in high-risk / high-potential enterprises, as was typical during the Internet start-up boom, sought a business form that provided as much flexibility as possible to meet their needs. Enter the LLC.
With its ability to pass through losses, which, with Internet companies, were often frequent and large, the founders of the firm found a means to use those losses to offset their taxable gains from other investments. At the same time, the LLC offered entrepreneurs a flexible management structure, without the limits of the LLP, and an organizational structure that allowed a large number of investors for ease of rapid financing. Finally, given the risks inherent in such businesses, and concurrently, the often untested background of the individuals running the company, the liability shield offered by the LLC provided valuable protection for those both managing the firm and its investors.
EXAMPLE: Dale and Tess have a great new idea for a mobile phone company. They approach Louis, a wealthy individual and self-proclaimed “angel investor,” and pitch him their idea. Louis likes the sound of the idea and the terms that Dale and Tess are proposing. He is worried, however, that since Dale and Tess are inexperienced, they might make some mistakes that could cost him his investment, or worse, expose him to personal liability. Because of this, he conditions his investment on the firm forming as an LLC to provide him with an equal management share and the benefits of limited liability.
Capitalization and Fund Raising
Capitalizing an LLC, like a partnership, requires capital contributions to form and operate the firm. One benefit of the LLC, as opposed to unwieldy partnerships and other tax-advantaged business forms, is the fact that very few states place an upper limit on the number of investors the firm may have.
Like shares of a corporation, interests in an LLC are freely transferrable by members. See
EXAMPLE: Marsha, Greg, and Cindy have formed an LLC and share equal management control. Greg, however, has been given the opportunity to sing lead vocals for a Beatles cover band and needs to leave the firm in order to go on tour. He thus decides to sell his interest in the LLC to Alice. Alice, though entitled to Greg’s equal share in the LLC’s earnings, does not have the right to vote on or otherwise manage the operations of the firm.
A Note on the Growth of LLCs
One factor that is questioned by the well versed entrepreneur is the issue that might best be phrased, "where do I turn when things go wrong?" As a fairly recent invention, the amount and consistency of case law pertaining to LLCs is small. This knowledge base, while growing, provides some degree of disquiet to both the founder and investor. As we mentioned in the discussion of why many companies choose Delaware as their state of incorporation, a broad and identifiable set of laws and precedents is an extremely valuable tool for a company and its managers when times turn tough. Given this situation, it may be some time before there is a true explosion in the number of firms electing the LLC as their forms of choice.