C Corp vs LLC: Post-Funding Business Structure Guide

Many startup founders consider forming a limited liability company (LLC) to maintain flexibility at the stage when they are bootstrapping their company or while raising initial funding from angel investors. An LLC offers simplicity, pass-through tax benefits, and fewer formalities at the early stages of a startup. However, as the company grows and seeks larger investments or implements stock options for employees, converting to a C-Corporation often becomes essential. This article explores how an early-stage startup can leverage an LLC structure to attract angel investors, while strategically planning a future conversion to a C-Corp. Key considerations include the use of a Simple Agreement for Future Equity (SAFE) or convertible notes in an LLC, properly timing and executing the conversion, structuring the capitalization table for a smooth transition, and ensuring proper legal frameworks are in place right from the jump.

Using an LLC as an initial business entity can provide valuable flexibility for startups in their infancy. LLCs combine elements of corporations and partnerships, offering limited liability protection with simpler governance requirements. Early-stage companies often choose LLC status for LLC tax benefits like pass through taxation that avoids corporate “double tax” on profits, as well as operational flexibility when it comes to profit distribution. This means initial losses or profits flow directly to the founders’ personal tax returns, which can be advantageous when the startup is pre-revenue or incurring losses. The LLC structure also involves fewer corporate formalities. For example, this structure generally doesn’t mandate a board of directors or annual shareholder meetings, allowing founders to focus on product development and market fit rather than complex compliance in the very early days.

Another benefit of LLCs is ownership flexibility. Depending on your business structure, you may have a single member LLC corporation or a multi member LLC meaning your LLC has two or more owners (also known as members), including individuals or even other business entities. They can allocate profits and decision-making rights in creative ways through various mechanisms set forth in the LLC operating agreement. This can be useful for a small founding team or family-and-friends investors who want customizable arrangements. In short, an LLC can serve as a flexible launchpad for a startup, keeping things simple until the company validates its business model. However, this initial simplicity comes with trade-offs as the startup begins to scale and seek outside capital.

One critical consideration for founders is understanding business structure and how the LLC business structure impacts fundraising from angel investors. While many angels are high-net-worth individuals who invest early, they often share similar preferences with institutional venture capital when it comes to entity type. Both venture capitalists and angel investors tend to prefer C-corporations for startup investments. Their reasons often include the ease of issuing stock—especially preferred stock classes—and their having more familiarity with corporate governance structures that protect investor rights.

Under an LLC, bringing in outside investors means adding them as new members of the LLC and issuing them some form of membership interest in the LLC. This addition can trigger tax complications: because an LLC is a pass through entity, new investor-members could receive IRS Schedule K-1 forms and be allocated a share of the startup’s taxable income or losses. Investors may face tax on the company’s profits even if no cash is distributed to them, which is often an unwelcome surprise. Many institutional investors, such as VC funds with pension funds or foreign limited partnerships, are actually unable to invest in pass-through entities like LLCs for this very reason. Even individual angel investors might be discouraged by the idea of handling K-1s or paying tax on so-called phantom income.

To mitigate these issues, some angel investors will request that the startup convert to a C-corporation as a condition of their investment. It is common that the decision to convert an LLC into a corporation is driven by investor requirements before closing a significant financing. Angels who foresee the startup needing venture capital later may also insist on a C-corporation from the beginning. Nevertheless, some angels are willing to invest in an LLC if there’s a clear plan and timeline to convert to a corporate structure. Founders should communicate their conversion strategy upfront. For example, the strategy may be to plan to incorporate as a Delaware C-corporation once the startup is preparing for a larger Series A round or institutional investment. This assurance can make angels more comfortable to invest during the LLC phase, knowing that their membership interests will eventually translate into stock holdings.

Standard startup financing instruments like SAFEs and convertible promissory notes were originally designed for C-corporation startups, but they can be adapted for an LLC in early fundraising. However, one must proceed with any such adaptation cautiously. 

SAFE Agreement

A SAFE is an agreement that an investor’s money will convert into equity in a future priced round. As such, it was designed for C-corporations and assumes that the company will issue stock upon a conversion event. The problem with such an adaptation is that LLCs don’t issue stock: they issue membership units or interests. Meanwhile, a traditional SAFE has no clear stock to convert into. While some founders attempt to tweak SAFE language to work with membership interest units, this approach can introduce significant legal uncertainty. For example, one would have to define equivalent rights in LLC terms for what would have been preferred shares, a process which can defeat the simplicity that made SAFEs attractive to begin with. In short, using a vanilla SAFE for an LLC could defeat the purpose of the SAFE’s intended simplicity.

Convertible Notes

Convertible notes tend to be a more workable option for LLCs. A convertible note is debt that converts into equity upon certain triggers (like a qualified financing or conversion to a corporation). Unlike a SAFE, a note can accrue interest and has a maturity date, but importantly, the note can be drafted to specify what happens if the LLC converts to a corporation. For instance, the note could state that it will convert into shares of the new C-corporation at a defined price or discount once the conversion event happens. This gives angels some assurance of equity upside later, without immediately making them LLC members. In practice, convertible notes are more flexible for LLC fundraising and can delay the actual issuance of equity until after a corporate conversion.

Profit Interest Units

Another approach is to offer early investors profits interest units in the LLC instead of using a SAFE. A profits interest gives the holder a right to a share of future profits or sale proceeds above a certain valuation threshold, rather than current ownership. This can mimic the equity upside of stock for an angel investor without immediately complicating the ownership structure. Profit interests, discussed more below, come with their own tax considerations, but can be one way to reward an early investor in an LLC.

Founders should weigh these three options and consider consulting with a qualified startup attorney/transactional attorney to choose the right instrument. While SAFEs are popular in the startup world, in an LLC context, a SAFE may need to be completely restructured into something closer to a convertible note or profits interest agreement to function properly. In many cases, a straightforward convertible note, or simply converting to a C-corporation at the time of the raise, might be the cleaner solution when the overarching goal is to raise capital in a manner that keeps confusion and risk to a minimum for both the startup and the angel investors providing early funds.

Converting from an LLC to a C-corporation is a pivotal step that should be timed strategically if and when the members have agreed to take this step according to the level of consent required under their operating agreement. Often, the catalyst for this conversion is a substantial investment round or the need to implement a formal stock option plan for employees. In fact, many startups plan to convert just before a Series A financing or another major funding event because most venture investors require a C-corporation structure as a condition of closing. From a timing perspective, founders should be aware of both practical and tax implications:

• Start of a Tax Year.  Converting effectively at the beginning of a calendar or fiscal year (e.g., January 1st) can simplify taxes and accounting and reduce administrative burden. This avoids having to file two sets of tax returns in one year: one for the LLC portion of the year, and one for the C-corporation for the remainder. It also spares the team from allocating income and expenses between pre and post-conversion periods and employees from receiving two separate W-2 forms in the same year.
• Before Major Investment or Exit. If a major investor has conditioned their funding on the company being a corporation, the conversion should be completed before that investment closes. This might mean scrambling to file conversion documents in the midst of deal negotiations. Similarly, well before a potential IPO or acquisition, the company should already be a corporation; no investor or acquirer wants the uncertainty of dealing with conversion steps during a transaction.
• Simplicity of Capitalization Table.  It would be ideal to convert at a point when the LLC’s cap table is still relatively simple with a limited number of members, classes, and special allocations. Complicated cap tables, such as multiple classes of membership units or numerous profits interest grants, can in turn complicate converting to a C-corporation. If a startup anticipates rapid growth in its number of equity holders, converting sooner rather than later can prevent administrative headaches.
• Accounting and Tax Triggers. Generally, converting an LLC taxed as a partnership into a corporation can be done without immediate tax implications to the members if the conversion is structured properly, such that the conversion is treated as a tax-free contribution of assets to a new corporation. However, there are scenarios where a conversion can trigger taxable gain, such as if the LLC has significant liabilities or has deducted losses using borrowed funds. As such, it is critical to consult CPAs and perhaps other tax advisors prior to conversion to calculate any potential tax consequences. Proper planning can usually avoid a taxable event, but any accumulated earnings, appreciated assets, or debt ought to be reviewed.
• Governance Readiness. A converting startup should prepare to put formal corporate governance in place at the time of conversion. This means creating a board of directors—which often consists of the founders and key investors, at least initially—-and adopting bylaws and other corporate policies. The timing of conversion might also coincide with expanding the management team or bringing in independent board members as the company matures.
• Method of Conversion. Legally, the process of conversion can be executed in a few ways. Many states, including Delaware, allow for a statutory conversion in which the LLC can directly file documents with each such state’s Secretary of State, or equivalent agency, to become a corporation. This is often the simplest means of conversion. Other methods include forming a new corporation and merging the LLC into it, or having the LLC contribute its assets to a newly formed corporation in exchange for stock, then liquidating the LLC. In some cases, the LLC’s members might even transfer their membership interests to a new holding corporation, turning the LLC into a subsidiary. Each approach has its nuances in terms of legal filings and tax outcome. Founders should work with qualified corporate and transactional attorneys to choose the conversion method that best fits their situation and applicable state law.

When operating as an LLC, startups cannot issue stock options in the traditional sense, because there are only membership units, rather than stock. This presents a challenge in incentivizing employees or advisors with equity before conversion. The common workaround is issuing profits interest units in the LLC. A profits interest grants the recipient a right to a percentage of future profits or appreciation of the company, without giving them a share of existing value at the time of the grant. Essentially, this is like granting equity that starts with a hurdle equal to the company’s current value; any increase beyond that accrues to the holder of the profits interest. For example, if a founder grants 1% profits interest when the LLC is worth $1M, and later the company sells for $5M, that holder would get 1% of the $4M gain above the initial value, or $40K. The initial $1M value is not shared with profits interest holders. As such, they are only rewarded for growth, akin to how stock options only have value if the stock price rises above the grant price.

The benefit of profits interests is twofold. 

1. First, they typically do not incur tax at grant because they represent zero immediate value if structured with the hurdle equal to current value. 
2. Second, they allow LLCs to mimic equity incentives to attract talent. 

However, profits interests can complicate the cap table. If the LLC later converts to a corporation, the conversion plan must account for these profits interests. This is usually accounted for by converting them into an appropriate number of common shares or options in the new C-corporation. The conversion needs to preserve the economic rights of the profits interest holders. This might mean that upon conversion, a profits interest with its threshold could translate into a smaller number of shares, or perhaps vest into options with an exercise price reflecting the old threshold. Every situation can be unique, which is why careful documentation is needed. In fact, companies sometimes hold off on granting wide equity incentives until after converting to a C-corporation to avoid this complexity. If a company expects to become a C-corporation soon, it may decide to wait and then set up a stock option plan post-conversion rather than issue many profits interests shortly before. 

By contrast, once the company is a C-corporation, it can issue traditional stock options to employees, such as incentive stock options (ISOs). These options are more straightforward than profits interests. Further advantages of the corporation is they can create stock option pools and grants with standard vesting and employees can benefit from potential ISO tax advantages. None of this is available in an LLC form, as it is very complex for LLCs to issue the equivalent of stock options and tax-favored ISOs are simply not possible for an LLC. Moreover, a C-corporation can offer qualified small business stock (QSBS) to early  shareholders, potentially allowing a significant tax exclusion on gains if the stock is held for five or more years. Meanwhile, LLC ownership does not qualify for QSBS benefits. As such, founders and angel investors looking toward a future exit have a strong incentive to convert and start that QSBS holding period clock on their shares.

From a structuring standpoint, when operating as an LLC with an eye toward future conversion, it is prudent to keep the equity structure as simple and aligned as possible with a future corporate structure. That structure might involve creating a single class of membership units that resembles common stock, using vesting schedules for membership interests similar to stock vesting, and documenting any special rights of members in a way that can translate into preferred stock terms later. Further, the LLC’s operating agreement can be drafted to anticipate conversion. For example, the agreement can include provisions that allow for a conversion to proceed upon the members reaching a certain voting threshold, as well as provisions that automatically terminate certain LLC-specific rights upon conversion. By structuring the cap table and member agreements from the start with an eventual C-corporation in mind, the startup can minimize friction when the time comes to convert. Complex allocations or numerous classes of units should be avoided unless absolutely necessary, as these will all need to be mapped to new securities in the corporation.

In addition to financial and tax considerations, startups should prepare for governance and regulatory changes when converting to a corporation. LLCs offer a lot of informal governance flexibility: they can be managed by the members or by appointed managers and the day-to-day decision-making authority is dictated by the operating agreement, which can be tailored extensively. Upon converting to a C-corporation, the company will adopt the more standardized corporate governance model: a board of directors elected by shareholders, officers appointed to manage operations, and by-laws laying out decision processes. Founders who may have been operating very informally will need to get used to board meetings, board approvals for major actions, and increased formality in record-keeping once a corporation is in place.

Other aspects of corporate governance are compliance and filings. A corporation has to observe certain corporate formalities that an LLC in many states may handle more lightly. Those formalities include annual franchise taxes, filings, issuing stock certificates, and tracking shares in a cap table system. Additionally, if the startup will be issuing stock to many investors or option holders, it must ensure securities law compliance, which usually means filing exemptions like Rule 701 for equity compensations or Form D for fundraising. In essence, the conversion marks a graduation to a structure built for larger scale, which comes with the need for more rigorous legal and accounting oversight.

Voting and control can also shift at conversion. In an LLC, voting rights can be unequal or customized. In a corporation, typically each share of a given class has equal voting rights, unless special classes of stock are created. As such, part of the conversion process may involve negotiating a new charter (Certificate of Incorporation) that sets forth classes of stock and their relative rights. Founders should be prepared that their former simple “member-managed” world of the LLC will evolve into a shareholder-director-officer hierarchy. Consequently, they should plan their leadership and control strategy accordingly. For example, they ought to ensure that, post-conversion, they retain a certain percentage of ownership or board seats if that retention is important to them.

Navigating the journey from an LLC to a C-corporation, while managing angel investments, SAFEs/notes, and eventual stock option plans, involves complex legal and strategic decisions. A corporate law firm experienced in startup financing can be an invaluable partner to guide founders through these challenging steps. For example, attorneys can advise at the formation stage whether an LLC is an appropriate business entity, or if a C-corporation is better given the startup’s funding goals. If starting as an LLC, legal counsel will draft an operating agreement that lays the groundwork for future changes, ensuring there are provisions to add new investors smoothly and to approve a conversion when the time comes.

When founders are raising money under the LLC structure, a corporate law firm can help structure investor agreements that protect the startup’s flexibility. This includes crafting convertible notes or customized SAFE-like instruments for an LLC, and making sure the terms will carry over properly once the company converts to a corporation. The firm will also flag tax issues to discuss with their client’s CPA, such as potential phantom income to investors or the importance of timing a conversion at year’s end. As the startup approaches a conversion, the law firm will manage the preparation of a conversion plan, the state filings (e.g., Certificate of Conversion and new Certificate of Incorporation), and conduct due diligence to confirm all the conversion approvals needed from members and third parties like lenders, landlords, and suppliers. Further, they will also update or create cap table records to seamlessly replace membership units with shares of stock, and draft new by-laws, stock option plans, and other corporate agreements to take effect. In short, founders collaborating with seasoned startup attorneys ensures the company’s legal framework is built to scale from initial LLC agility to the robustness of a venture-ready C-corporation.

For startup founders, raising capital as an LLC can offer a useful early runway. Nevertheless, it pays to plan ahead for the inevitable conversion that high-growth companies undertake. By understanding the key considerations of conversion, from investor expectations and SAFE/convertible note adaptations to cap table structure and timing, founders can avoid costly surprises and make the transition on their own terms. Converting to a C-corporation is more than a mere legal formality; it is a strategic move signaling that the startup is ready for scalable growth, sophisticated investors, and broad-based equity incentives like stock options.

While the LLC-to-C-Corp path can be navigated successfully, it involves many technical steps and potential pitfalls. This is where engaging a knowledgeable corporate law firm truly adds value. With the right legal guidance from the jump, a startup can structure its foundation for flexibility and future funding. Amini & Conant encourages startup founders to contact our corporate law team for tailored advice on entity structure, fundraising strategy, and setting up the proper legal framework to support long-term success. With proactive legal planning, founders can focus on building their business and be confident that, when the time comes to convert and scale, they are on solid footing legally and ready to attract that next level of investment.

This publication is provided by Amini & Conant, LLP for educational and informational purposes only and is not intended and should not be construed as legal advice. Should the reader seek further analysis of the subject matter or answers to specific questions about the subject matter, please contact the author at joel@aminiconant.com. This publication is considered advertising under applicable state laws.

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