When investing in a company structured as a Limited Liability Company (LLC), we may be allocated ECI / UBTI (bad income for foreign or tax exempt investors). For this reason, the investment may need to be accompanied by an LLC conversion side letter or facilitated via a blocker entity.
Most venture capital firms prefer to invest in C-Corporations because LLCs pass through taxable income to their investors, which can create complications for certain Limited Partners (LPs).
LLC Conversion Side Letter
If the company is operating as an LLC, we typically require them to sign our standard LLC Conversion Side Letter. This letter ensures that the company will take the necessary steps to convert into a C-Corporation before the investment is converted into equity shares.
By signing this agreement, the company acknowledges that it will eventually transition to a structure that aligns with venture capital investment standards. This approach prevents the fund’s LPs from receiving unwanted pass-through taxable income.
Blocker Entity
A blocker is a legal entity, typically structured as a C-Corporation, that is 100% owned by the fund. The blocker makes the investment in the LLC on behalf of the fund, preventing taxable income from flowing directly to LPs.
However, there are some considerations when using a blocker:
- The blocker is taxed as a C-Corporation, which means that in the event of an exit, there is potential for double taxation (i.e., the proceeds are taxed at the blocker level and again when distributed to LPs).
- This method is often used to protect LPs from pass-through taxable income, which can be problematic for certain investors, such as pension funds and foreign entities.
- Blocker entities are not always required for LLC investments.
Why Do Most VCs Prefer C-Corporations?
Most venture capital firms do not invest in LLCs due to the tax implications associated with pass-through income. If a company is structured as an LLC and plans to raise capital from VCs, converting to a C-Corporation is usually the best course of action.
For specific requirements and questions about facilitating an LLC investment, please contact your Account Manager.