Insights

Preparing Your Company for What’s Next: The Value of a Business Entity and Structure Check-Up

By Steven Keeler

Before starting, financing, growing and eventually selling a business (or a separate business line or division), business owners should consider and revisit whether to structure a business or new division as (or to change it to) an LLC, an S corporation or a C corporation. Depending on the company’s life-cycle stage, capitalization, ownership and strategic plan, each of these alternatives may be the “best” choice at any particular time. As things change, a current business entity type or at least a company’s ownership and governance structure may become less optimal in achieving the owners’ business goals. Business owners frequently consider changes in the current owners, raising venture capital, giving equity incentives to key people, or even a holding company or subsidiaries to accommodate different owners, investors or a new business line or division.

It may not always be possible or even advisable to change a business’ entity type or structure, depending on tax and other considerations. That said, there is often room for improving a company’s entity structure, not just to give the company’s accountant and attorney more work, but to add real current and future value to the business. These improvements may involve changing to a different entity type, or they may only involve changing the company’s ownership, or updating and improving the company’s governing legal documents. See https://keelercounsel.com/insights-is-your-company-a-c-corporation-s-corporation-or-llc-and-when-might-you-have-to-change.html; https://keelercounsel.com/insights-after-tax-season-private-business-owners-should-work-with-their-advisors-to-minimize-taxes-on-shareholder-value.html; https://keelercounsel.com/insights-your-business-lawyers-best-friend-your-cpa.html
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Rather than repeat the advantages and disadvantages of different business entity types or legal structures, below we share some real-life stories about how a company’s next moves or significant events can be expedited and enhanced by relatively common, but too-often overlooked, legal, tax and accounting blocking and tackling. This blocking and tackling is a team sport, so business owners should own the process and work with professional advisors who are not only experienced and focused, but who play well with others in the advisory team sandbox.

1. Entity Choice and Structures. The choice of, and any future changes in the choice of, business entity are most often driven by tax planning. And because income taxes are money, the choice should always be made with both annual taxes on operations and the potentially significant taxes on a company sale in mind.

(a) VC Raise Without Future Tax Pain.

‍A start-up or emerging growth company had been operating as an LLC for years and needed to raise venture capital (“VC”). Although VC investors often push an LLC to convert to a C corporation, in this case, a significant VC investor did not insist on such a conversion as a condition to their investing. The decision is usually whether to remain an LLC or convert to a C corporation, because an S corporation does not usually provide sufficient flexibility for VC investments. Contrary to the published statistics and advice suggesting that C corporations are the best entity choice for raising venture capital, many LLCs successfully raise venture capital from established institutional VC funds without having to convert to a C corporation. That said, many companies raising VC convert to a C corporation, or make a special election to at least be taxed as a C corporation. Every company and VC fund is different, so it’s ultimately a choice with various pros and cons that can be reviewed and should be negotiated after considering the tax advantages and disadvantages of C corporations as compared with LLCs taxed as partnerships. All said, when a VC investor can invest in an LLC taxed as a partnership, and planning around “section 1202 small business stock” is either not critical or even practicable, business owners should seriously consider preserving their S corporation or LLC “flow-through” tax treatment rather than converting to a C corporation without careful review.

(b) Multiple Entities Attract Investor and Increase Owner Sale Proceeds.

‍Another emerging growth company had been operating as an S corporation and several planned strategic moves required more creativity. First, a separate business division was dropped into an LLC subsidiary of the S corporation not only for business reasons but to allow the business to provide equity incentives to key people who were working exclusively in the LLC subsidiary. Then, the company attracted a family office (“FO”) investor to take a significant stake in the S corporation parent or holding company. Because the FO investor could not invest in an S corporation and the company did not want to convert to a C corporation for various tax reasons, a new LLC was structured between the S corporation parent and the separate division LLC subsidiary to accommodate this new investor and capital. Eventually, the company was able to sell the LLC subsidiary to a private equity buyer and later sold the original core business to a different private equity buyer. The company and its owners benefited greatly from this entity planning as capital was successfully raised and both sales were closed in a tax-efficient manner, significantly increased the net sale proceeds to the owners, and were more attractive to the private equity buyers.

(c) S Corporation/Private Equity Buyer Win-Win Structure.

‍Another company had long been an S corporation and decided to sell to a private equity (“PE”) fund. In what has become a very common scenario in sales of S corporations to PE funds, certain of the owners wanted to receive some cash from the sale and to get a “second bite at the apple” by retaining some go-forward equity in the buyer so that they could later benefit from a second sale by the buyer at a higher valuation. To avoid any tax on their equity “rollover”, the S corporation formed new S corporation holding company and then converted the old operating S corporation to an LLC taxed as a partnership. The result was a win-win for the company’s owners and the buyer. The sale was treated as an equity (or “stock” or “membership interest”) sale for legal (non-tax) purposes (thereby avoiding assignments of customer and vendor contracts and other transaction issues) and as an asset sale for tax purposes. Certain legal work on the transaction was reduced, the owners’ after-tax cash proceeds were increased, and their retained equity was not currently taxable.

(d) Friends and Family-Backed Business Restructurings for Future Growth and Sale.

‍Like many early-stage companies, another business had raised VC from friends and family, anticipating they would do additional financing rounds as they grew. They soon realized that they could complete their growth without additional outside capital and would likely sell or exit to a strategic or financial buyer. The founders owned their equity in the LLC operating business through an older S corporation that they shared. The company decided to incentivize certain key people with “profits interests” and “options” in the LLC operating business to align their interests with the owners’ goal to grow and sell the business. Later, the company started a new line of business within a new LLC subsidiary of the LLC operating business, and granted separate equity incentives in that new LLC subsidiary to key people working exclusively in that division of the business. All of these moves and attendant entity structure changes were designed to permit an eventual sale of the entire business or the separate division entities in a tax efficient manner, thereby increasing the potential sale proceeds to the founders and other equity owners.

2. Entity Ownership and Governance Improvements.

Often, a business’ existing entity type cannot be changed in a tax-efficient manner. However, in addition to occasionally using multiple-entity structures to achieve various business and tax goals, business owners should always consider reviewing and changing their organizational legal documents in connection with certain company events, changes or transactions.

(a) Avoiding Owner (or Their Estate) and Employee Disputes and Deadlocks.

‍Business owners are, of course, human. Many of them work in a culture of mutual trust and respect. Some of them discover that, while they may all be good people, people can change. Such changes run the gamut from a simple difference in business vision or goals to personal life events like illness, death or divorce. A surprising number of businesses are owned 50-50 by two owners or family groups. Even the closest of equal business partners often come to realize that, in order to protect the business and avoid.

future deadlocks, their shareholders agreement (if a corporation) or operating agreement (if an LLC) should provide for their continued ownership and voting or management rights in the events of death, disability or a disagreement or decision-making deadlock. The failure to provide for any of these events may stall the company’s growth and even scare away potential investors or buyers. Many companies are wise to amend or replace their company legal documents to provide fair and workable outcomes in these unexpected but possible future events. Even if there is only one majority owner of the company, the company legal documents should provide for clear ownership transfer or “buy-sell” provisions and voting and management rights to protect both the controlling owners and the business from future minority owner legal claims or even litigation. These protections can be further provided in any equity incentive agreements with key employees that carefully and appropriately limit the employees’ transfer, voting and management rights. Many things can happen on the way to a company’s achieving its ultimate strategic goals and plans, and the company’s value is usually increased by protecting against future misunderstandings or disputes. That said, the “best” business owners and advisors also understand the value and benefit in treating minority owners fairly while, at the same time, clearly reflecting everyone’s expectations in the company’s legal documents. See https://keelercounsel.com/insights-50-50-private-company-ownership-challenges-and-proper-planning.html; https://keelercounsel.com/insights-giving-employees-a-piece-of-the-company-equity-pie.html; https://keelercounsel.com/insights-when-company-founders-or-their-co-owners-have-a-falling-out-plan-while-the-marriage-is-still-good.html

(b) Owner Versus Investor Rights.In any VC or minority growth equity or PE investment transaction, the shareholders agreement, operating agreement and other agreements will typically require separate economic, voting and management rights for the owners or founders, on the one hand, and the investors, on the other hand. Investors will usually insist on a range of approval or “veto” rights with respect to major company actions like the issuance of new equity or a company sale. The first priority should be to select an experienced and trustworthy investor. After that, the owners and investors can negotiate their respective rights relating to everything from new equity issuances and transfers, an eventual sale of the business, to specified major decisions or transactions. These terms are usually more uniform for institutional VC investors in early-stage companies, but can vary widely for companies raising minority growth equity capital from PE funds and even more from FO and other non-traditional investors. See www.keelercounsel.com/insights-venture-capital-term-sheets-from-the-founders-and-companys-perspective; www.keelercounsel.com/insights-so-your-business-is-not-early-stage-or-ready-to-exit-meet-growth-private-equity-and-prepare-to-get-your-terms.

(c) Multiple Owner Ownership and Governance Rights.

‍Many companies have a handful of owners, none of whom own a majority of the company’s equity. And many of these may have historically operated as informal partnerships (versus separating governance among owners and a board of directors) with few rules embedded in the company’s shareholders agreement or operating agreement. Some of these companies may have different classes of corporation stock or LLC interests with different rights to dividends, company sale proceeds and voting and management. The owners may have different management roles and be of different ages, making it important to consider eventual management succession upon retirements, deaths and other events. Some or all of the owners may have the right to serve on a board of directors or board of managers. Major company transactions may require a majority or some greater owner vote. The owners may want the ability to gift portions of their ownership to their families for estate planning purposes, the right to have their ownership purchased when they retire or die, or the right for themselves or their families to retain their ownership until an ultimate sale of the business. Obviously, negotiating a “one size fits all” approach to continued ownership and management of the company and any company buybacks will be more challenging when there are more than 2 or 3 owners. With the help of experienced advisors, the business owners can hopefully compromise and arrive at an appropriate structure that will enhance the company’s value by mitigating the risk of future disputes and thereby increase the value of each owner’s equity in the business. In our experience, potential investors in or buyers of the business will always assign a higher value to a business whose owners have addressed these issues in reasonably good legal documents. See https://keelercounsel.com/insights-the-underrated-value-of-a-company-board.html

3. Entity Events That May Need Fixing.

‍(a) Past Mistakes That May Come Back To Roost.

‍As advisors, we honestly don’t like discovering that a company has done something that may create legal or tax risks for the business, its owners or employees. But mistakes can happen. Unfortunately, many of them occur either because the business owners handled their own legal or tax work or continued to work with accountants or lawyers that their business may have outgrown. For example, we often find S corporations that may have violated S corporation tax rules, presenting some risk that the IRS could determine that they are no longer an S corporation. We also routinely find that companies have transferred ownership or equity incentives to owners or employees in a manner that was taxable to the owners or employees, but without reporting these taxable events. While these technical foot faults may never be discovered, potential investors and buyers almost always do enough of their own due diligence on a business to find these types of problems. Having an investor’s or buyer’s counsel dig up these problems is not only embarrassing, resolving them while trying to raise capital or sell a business will usually increase costs and may even jeopardize a transaction. So, fixing any problems which can be fixed as soon as possible should most often be worth the cost and professional fees.

(c) Messy Cap Tables and Long Forgotten Agreements.

‍We frequently meet good companies with sloppy or incomplete paperwork that may lead to future disputes regarding equity ownership. The legal documents may reflect one set of share or LLC interest numbers or percentages while the Excel spreadsheet, stock ledger or capitalization table used for accounting and tax purposes may reflect different numbers. See. https://keelercounsel.com/insights-planning-a-companys-ownership-why-your-capitalization-table-matters.html An old employee offer letter or other agreement may contain an ambiguous right to receive a percentage of company revenue, profits or even sale proceeds. Equity ownership may have been granted to someone while the legal documents gave the existing owners a “preemptive” or first right to purchase their pro rata portion of the equity being issues or sold. These types of agreements or arrangements, which may have been discussed years ago, but may now be forgotten or subject to materially different interpretations, often become a source of disagreement and hard feelings. If and when they come up in investor or buyer due diligence (and, in our experience, they almost always do during a seller’s due diligence responses or negotiation of seller representations and warranties), they may create problems that will be more expensive to resolve than would have been the case if earlier detected and handled

Understandably, many business owners view accounting, tax and legal check-ups as “insurance” and the associated professional fees as “insurance premiums” that won’t provide any real value. In fact, having a business’ entity structure and underlying legal documents reviewed as a company changes and evolves will almost always add value to the business. This includes more near-term value in avoiding unnecessary owner or employee misunderstandings, disputes or tax surprises that may be more expensive to fix (or may not be fixable) later, and longer-term value in enhancing owner trust and respect and avoiding investor or buyer due diligence surprises. A business is likely the business owner’s most valuable asset. Like a home, periodic inspections and maintenance will ultimately not only save the owner money, they’ll likely enhance the company’s curb appeal to lenders, investors, buyers, and in some cases, even customers and suppliers. A company founder or principal owner is the caretaker of the company. They should treat it like the potentially great source of wealth they’ve built it to become. Legal, accounting and tax checkups will not always result in changes or lawyer or accountant work, but revisiting and updating a business’ entity and governance structure as the business grows and changes should ultimately enhance the valuation multiple achieved in a financing or on a sale and avoid future costs and the risk of failed transactions resulting from investor or buyer concerns or owner or employee disputes.