Jennifer -- I appreciate your questions. You are exactly right that there is no federal or SRO prohibition on doing an initial public offering as an LLC. You are also correct in noting that some LLCs are publicly traded, OchZiff is another. However, LLCs are creatures of state laws and there are multiple states that do not allow free exchange of LLC interests which would make an IPO impossible without first converting to a different entity/state.

Even if you formed your LLC in a state that has an IPO friendly set of statutes, in my experience you would still have a practical near impossibility because of the underwriters. It is hard enough to get underwriters interested in a start-up IPO, it would take an extraordinarily exceptional circumstance to convince them to underwrite anything non-standard, e.g. an LLC.

I guess my final thought is, why ratchet up your level of difficulty as a start-up? If you know you are creating a company that will need VC and that hopes someday to IPO, why not take the structural path of least resistance? (Again, this is not to say that LLCs are not VERY useful in many other circumstances.)

As for restricted stock v. options, the usual drawback to doing restricted stock in a start-up is that the recipient may have to pay taxes on grant (if an 83b election is made) or on vesting. Either way, the stock is not typically liquid in a start-up (so you can't sell it to pay the taxes) and most founders/start-up employees are in cash conservation mode. -- Hank

In my experience -- the key to this question is whether the start-up expects/wants to raise VC.

To make a VC investment in an LLC requires an entirely new set of forms developed from scratch. The classic rights, preferences and privileges of a VC preferred stock investment do not translate easily or comfortably into the LLC format (although, admittedly it can be done). Developing these scratch documents is a costly endeavor (and obtaining venture capital is not cheap anyway) -- it is unlikely at best that a VC will want to bear these additional costs.

Also, an LLC is not able to issue stock options to its employees with the same tax advantages as a corporation. And the manners of obtaining liquidity in an LLC (through distributions or liquidation) do not translate easily into the VC world and have potentially different tax treatment. For example, the flow-through tax treatment of an LLC could potentially cause problems for the limited partners of the VC. Finally, and perhaps most importantly, it is not possible to do an IPO with an LLC. Any LLC that wanted to go public would be required to first convert to a corporation anyway with potentially very adverse tax consequences.

This is not to say that an LLC is not an excellent choice for joint ventures or small businesses which will never need to raise money from a VC. LLCs are very flexible entities that can provide favorable tax treatment for individual investors. It is just exceptionally rare to find a VC that is willing to invest in an LLC.

One last thing, S Corps are prohibited from having shareholders that are not natural persons (or certain trusts) so an S Corp could never take institutional money. Also, I have seen people experience real pain (as in tax pain) when converting from an S to a C -- all in all it is a tricky question that bears some real thought before answering -- need to tailor the answer to the recipient.

I did a blog post on this in more detail a little bit ago here - http://dividendsandpreferences.blogspot.com/2009/...

Mark M. -- I don't disagree with your analysis of the economics. Also, I certainly agree that one of the attractive features of using convertible debt in the angel round is the ability to delay valuation and pricing of the company -- must angels are ill-equiped to do these sorts of analyses anyway. However, I think the actual terms of angel debt are quite variable, depending on local market terms, the sophistication of the angel and the relative sophistication of the company. I have certainly seen angel debt done without a prepayment penalty which puts the equity upside entirely in the warrants.

One final note -- although it is a relatively common practice to give the angels a discounted conversion price to reward them for their time value, if the company is contemplating venture funding, this is a bad idea. Mainly because the discounted conversion price screws up the liquidation preferences (and potentially the conversion preferences). In my experience, VCs will not respect this discount and will force a re-negotiation, which may result in the angels losing their kicker. In most cases, the same economic result can be attained with a 100% conversion value at the next round but with an appropriately priced warrant. The 100% conversion protects the liquidation waterfall for the VCs and the warrant provides the angels with their equity upside.

hank

Marc D. is exactly right -- venture debt in its classic form is typically only available to growth stage companies that either already have venture capital or could easily obtain venture capital. Depending on the venture debt firm, some will only co-invest with other equity VCs while others are willing to go it alone.

One additional thing to consider is that debt is not completely foreclosed to a very early stage start-up. In fact, it is quite typical for angel investors to take convertible debt in the seed round. This is a similar economic play to venture debt as this angel convertible debt will usually have warrant coverage for an equity kicker. If the start-up ends up not needing additional equity, then it pays off the convertible debt plus interest and the angel still has a warrant for his equity upside. If the start-up ends up needing VC early stage or growth money, then the debt converts at par for the follow on round.

While convertible notes are very useful in the angel/seed round context -- they do not solve the issue of the Form D and whether it will inadvertently expose a company in stealth mode. This is because convertible notes are usually considered "securities" within the meaning of the securities laws and any offering of them would require a Form D filing in its own right.

However, as Josh hints at above, the new Form D rules actually may make it easier to stay in stealth mode than previously was the case. I am going to blog on this later tonight at http://dividendsandpreferences.blogspot.com/