LLCs are the rage these days, but when it comes to crowdfunding, the corporation provides the better structure.
First, the overwhelming advantage to forming a LLC over a corporation is the pass-through taxation. While I’ve seen it done, it doesn’t normally make a lot of sense to form a LLC if it is going to be taxed as a C corporation. In a crowdfunding environment, however, companies might be bringing on hundreds or even thousands of new owners. Do you really want to deliver K-1s annually to hundreds or thousands of investors? What a nightmare.
Second, a critical flaw with LLCs is investor protection. While some states may have non-waivable duties of the managers of a LLC (for example, Section 608.423 of the Florida Limited Liability Company Act), Delaware, for example, allows for the complete denial of fiduciary duties of the managers to the company and the members (owners) of the company. Section 18-1101(c) of the Delaware Limited Liability Act provides:
“To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member’s or manager’s or other person’s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.”
The standard of “good faith and fair dealing” is a far cry from the fiduciary standard that directors of a Delaware corporation are held to. Investors in crowdfunding transactions will likely have little or no negotiating leverage, few investor rights and little voting power. The fiduciary duty of directors of corporations to the stockholders may be the only real protection that crowdfunding investors have. In LLCs, the removal of fiduciary duties goes too far, and the market (or maybe even the SEC) should not allow it.
Third, with corporations there are fairly standard legal documents, and investors know the rules of the game. This is because the corporations code of each state (much more in depth than the LLC act of each state) provides the rules of the game. Stockholders elect directors. Directors elect officers. Certain transactions (like a sale of the company) go to the stockholders for a vote up or down, and stockholders that don’t approve the sale have appraisal rights. Corporations have to have annual meetings of the board and the stockholders. Etc. Etc. These rules are set forth in the applicable state corporations code.
By contrast, LLCs have few rules. The basic principle is freedom of contract—put it all in the company’s operating agreement. The rules, and investor’s rights, can and do differ dramatically from company to company with LLCs. True, LLCs offer greater flexibility, but in the crowdfunding environment greater flexibility is not a good thing. It will likely mean that investors have fewer rights and protections, because they will not be able to band together to negotiate any investor protections. In an environment where concerns for investor protection and transparency are paramount for crowdfunding transactions, the corporate structure is better because it provides the rules and investor protections by law, which cannot be undone by the corporation’s formative documents.
This article originally appeared on Venture Docs, an online platform for automating the creation of important legal documents for startup companies, investors, crowdfunding portals and attorneys.