The business is currently a simple WA LLC with 3 Co-Founders each owning 33% of the company.
We have a termsheet for a VC investment that will require us to convert the LLC into a C Corp (the termsheet says Delaware, but the other investment party is also in WA state) so that the C Corp can issue Preferred Stock. Another stipulation is the ability to have a "buy-back" vesting, so if any co-founder leaves before 3 years the C Corp can buy-their shares back - giving everyone an incentive to stick around.
Q 1: What's the general process, and how long does it take to convert from an LLC to a C Corp?
Q 2: How can we minimize any tax implications? Ultimately, we want to own company in the new corporation and not have options or stock grants since these would be taxed based upon the valuation of the company after the money gets put in. We also don't want to be in a situation we have to "buy our shares" to receive any dividends or prior to a liquidation of the company.
Q 3: How much legal time does this usually take. We need to figure in the cost-of-raising capital into our decision whether we move forward with the raise. Since we're raising a smaller amount of money these costs could have a material impact on whether we move forward with the investment opportunity.
Your questions go far beyond what anyone can answer here. First, though, let me note that VCs in general prefer C Corps, so the conversion itself is fairly standard. That said, I hope you have jumped through all the securities hoops. If not, the conversion you ask about in Q1 gets a lot more complex, and there frankly is no way to calculate the budget you ask about in Q3. Finally, as far as Q2, you should already have two accountants involved: one to do your books and the other to provide an independent audit of your books to include with your offering to VCs (I know you haven't raised any funds yet; you still need an audit.). Your first accountant should have already reviewed the tax ramifications of the conversion prior to your signing off on it. Since that apparently did not happen, it needs to happen now.
Mergers / Acquisitions Attorney
First, congrats on getting a term sheet from a VC. Times are tight out there, so just getting one in the door is a good accomplishment. Second, these basic terms you've mentioned are very common in a VC investment -- converting into a C-corp and putting 3-4 year vesting on the four founders. Nothing unusual from my experience. I've published a couple legal guides on Avvo that have some common term sheet terms we've seen on recent deals -- that could be a helpful guide as you negotiate the term sheet.
To your questions -- again, there are lots of things in this question, but here are a couple basic thoughts:
(1) The conversion process can be done in a couple of ways, the most common are either (a) a merger of your WA LLC into a DE or WA c-corporation, (b) a type of share exchange where you would give your member interests in the LLC in exchange for your common stock of the new C-corporation. The most common approach would probably be a merger in this case. Unfortunately, Washington doesn't have a conversion mechanism (like Delaware does), so the merger approach is the most common process (which is too bad, since the process is simpler/cheaper). The process of doing the merger into a C-corporation is fairly straightforward -- probably no more than a couple weeks all in. But the issue will come down to timing the tax issues. So be sure to talk with your tax advisors who should be able to help ensure your tax liability is minimized or zero.
(2) With respect to the tax consequences, I'll defer to a tax expert on that topic, but generally, a merger/conversion from an LLC to a c-corp is a taxable transaction. That said, depending on your balance sheet (the amount of liabilities compared to assets), there are oftentimes ways to structure it as a tax-free transaction. For this, talk to a tax attorney (I can recommend a good one if you need) and the money spent talking to a tax person is well worth it and your VC may actually require it. The key is the amount of debt on your books, so if you have a great deal of outstanding debt you may have some taxes to pay. Even so, depending on the balance sheet of corporation and the tax basis of each of you have, the taxes you each owe could be minimal. But in order to make any determination, see your balance sheet would be key -- particularly understanding your assets and liabilities.
(3) As far as the time/cost required to do the conversion, I'll start with the answer every lawyer loves to use: it depends. It can be a complicated transaction, but if you've done them before, you know what problems to avoid. Ultimately, it will largely depend on how much of the tax work is done by your attorneys and how much you can have your accountants and tax advisors handle. In deals I've worked on that are lower costs, the accountants will handle the tax piece of the transaction (providing comfort and assurances on the tax compliance of the conversion). So I would talk to an attorney that has done a conversion, pre-VC funding. Then, connect your attorney and your tax/accounting people together. Usually, your accountant will be cheaper, so as much of the tax side of things you can put in the hands of your tax advisor, the better. Pitch the work to a couple attorneys and ask for an estimate. They should be able to help once they see the balance sheet.
And finally, I have had at least one client do a Series A investment (from angels rather than a VC) where the investors receive Series A Preferred Units and didn't do a conversion first. So consider that as an option if the VC will consider it. Probably fairly unlikely, but at least a point of discussion if you uncover big tax issues.
If I can give you any further insights into the other conversions I've worked on or a referral of a good tax attorney that has worked on some WA LLC merger/conversions, happy to do so. Good luck.
My partners and I do a great deal of work with startups in similar circumstances. You have two issues with regard to your C corp. First, you need to make certain that the transaction is tax free under the Internal Revenue Code. Second, you need to comply with WA and/or DE law. You should be able to easily sell all assets of the LLC to the C corporation in exchange for stock. If structured properly, that transaction should have no tax consequences for you now (though some day there will be capital gains consequences). It is not uncommon, by the way, for a corporation to be organized in DE even when the business is elsewhere. For example, a CA client of mine just dissolved its CA LLC and now operates with a DE corporation, which is registered to do business in CA.
A shareholders' agreement, perhaps in conjunction with an employment agreement, will resolve the buyback issues.
As to your questions:
1. The whole process of moving from an LLC to a C corporation can be done in a day or two, depending on the complexity of the relevant agreements. The transaction is simple, but the agreements must be precise to protect all of the players.
2. Although I need more information, I believe that if the three members of the LLC assign their membership in the LLC to the corporation in exchange for stock, your basis in the stock will be the same as your basis in the LLC. There will be no tax consequences now. You should be able to avoid tax consequences with regard to equity until you sell the company or take it public. I recently completed a similar transaction under similar circumstances for a tech company (interactive adveertising).
3. It is difficult to estimate legal time and costs. I would be happy to discuss these with you. I have done similar transactions and can review those to estimate. I do recognize that startups are conscious of cash flow issues, and often it is possible to take some fees in equity, use reduced fees until funding and profits are in place, etc.
I would be happy to discuss further.
Global Capital Law Group
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