Choosing a Legal Structure in Private Equity Deals
LBO deals are typically done through limited liability companies, while venture capital deals are typically done through corporations. The difference is governed by tax considerations and the expected exit strategy.
In LBO deals, the acquired company is typically generating taxable income—the same taxable income used to repay the debt incurred to buy the company in the first place. In venture capital deals, the company is typically not generating taxable income, as it is spending money on people and technology at least as fast as it is generating revenues. When revenues do catch up, it can shelter the income awhile longer as it burns through the accumulated net operating losses. As a result, LBO deals typically favor a legal structure that minimizes tax liability (such as the limited liability company), while venture capital deals typically don’t care about taxes, and therefore use a taxable corporation.
Venture capital deals, and other companies that expect to be publicly traded, are typically organized as corporations. Corporate shares are designed to be liquid and easily traded on national stock exchanges. For this reason, most venture capital deals are made through corporations with multiple classes of preferred stock, each convertible into common shares, as hope springs eternal that the company will one day go public and mint money for the original investors.
At the present time, corporate law is more thoroughly developed than LLC law and is therefore more predictable from a legal standpoint, although this difference is quickly fading away.
Another reason that corporations are favored in venture capital deals is that they better accommodate stock options. It is difficult to grant traditional stock options to key management of an LLC. The tax code does not permit LLCs to issue incentive stock options, which are treated as capital assets rather than ordinary income, and therefore provide a significant advantage in recruiting management. Also, the exercise of the options in the LLC context can raise tricky tax issues, as capital accounts must be rearranged.
