10 Key Issues in Setting Up an LLC
A limited liability company (LLC) is a popular business structure for startup businesses. LLCs are formed in accordance with state law and have the benefit of providing limited liability protection for the owners. LLCs can also provide for “flow through” tax treatment so that there is not the double level of tax found with C corporations. Only the owners of the LLC are taxed (unless a voluntary contrary election is made), and there is no tax at the LLC level.
The exact rules for setting up an LLC vary by state, although the general requirements are quite similar. You don’t have to hire legal counsel to form an LLC, but it is sometimes advisable if the LLC will have multiple owners or outside investors.
There are a variety of online services that will prepare the paperwork for you and make the required filings for a modest fee. Companies such as LegalZoom and RocketLawyer have set up thousands of LLCs.
In this article, I review a number of the key steps and issues in organizing an LLC.
1. Pick the State Where You Want to Organize the LLC.
Because an LLC is formed in accordance with the rules and requirements of a particular state law, the first decision to be made is where you should organize the LLC. Delaware is often chosen because of its well-developed law. But in the vast majority of instances, you should form the LLC in the state where the business will be operated, as this will save you some fees and complexities.
If your LLC will operate or do business in several states, you may be required to register in all of the states where you will be doing business. This will typically involve filing a notice with each Secretary of State and paying the related filing fees.
2. Naming the LLC.
The next step to organizing an LLC is to pick an available business name for the LLC. There are multiple issues in picking an LLC name:
- The name typically needs to end with “LLC,” “Limited Liability Company,” or some permitted abbreviation thereof.
- The name must be distinguishable from all active foreign and domestic LLCs filed with the Secretary of State (in California, you can do a preliminary search of LLC names on record at https://businesssearch.sos.ca.gov/ ).
- The name can’t contain some terms that may be prohibited by state law (such as “bank,” “trustee” or “insurance company”).
- The name can’t contain the words corporation, inc., incorporated, or corp. (to ensure that the LLC is not misconstrued as a corporation).
- You need to do a trademark search to ensure you aren’t violating another party’s trademark (check uspto.gov ).
- Conduct a thorough Internet search on the proposed name to see if other companies use of the name could cause you problems.
- Don’t pick a name that could be limiting as you grow the business (such as “San Francisco Tires, LLC”).
- Check on the availability of getting the “.com” domain name associated with the business (as opposed to “.org,” “.net,” or some other variant).
- If you want to use a name other than your formal LLC name publicly, then you may be required to file a “fictitious business name” statement or “doing business statement” (DBA).
Picking a good name is not easy, and obtaining the desired domain name you want will likely involve some meaningful cost if it is already owned by a third party. For more advice on this, see 12 Tips for Naming Your Startup Business.
3. File the LLC Articles of Organization.
An LLC is officially formed when you prepare and file an “Articles of Organization” (a few states call this something else) with the Secretary of State. Here are some tips on preparing the LLC Articles of Organization:
- The Articles of Organization tend to be short and easy to complete.
- You need to designate a “registered agent” for the LLC—someone who is designated as authorized to receive any legal documents (such as complaints, service of process, subpoenas, etc.). This can be a service company (such as CT Corporation or LegalZoom) or an LLC member.
- You will have to pay a filing fee (typically around $100), and in some states a minimum annual tax (such as $800 in California).
- You need to include a statement as to the LLC’s purpose (in California the wording is automatically set forth in the form—“The purpose of the limited liability company is to engage in any lawful act or activity for which a limited liability company may be organized under the California Revised Limited Liability Company Act”).
- Some states such as California require you to check a box to indicate if the LLC will be managed by “one manager,” “more than one manager,” or “all limited liability company member(s).”
The website of the Secretary of State will provide sample Articles of Organization in either Word or PDF format. For example, see the sample Articles of Organization in California , Delaware , and New York.
4. Prepare the LLC Operating Agreement.
The LLC Operating Agreement sets forth the owners’ (called “members” in an LLC) financial, management, and other rights and responsibilities. Here are some key issues that should be addressed in the LLC Operating Agreement:
- What amount of capital contributions are made to the LLC by the parties, and when those contributions are required to be made
- Any penalties or remedies if the capital contributions are not made
- How profits and losses are to split and distributed among the owners
- Whether any members or class of securities of the LLC have preferences in distributions or on liquidation (akin to “preferred stock” in a corporation)
- Who will manage the LLC (a sole manager, a group of managers, or all of the members)
- How any officers will be appointed
- Voting rights for major events like additional capital contributions or sale of the business
- Indemnification protection for the managers running the business
- Restrictions on transfer of LLC interests (the LLC interests are often referred to as “units”)
- Procedures for meetings of the members
- Procedures for dissolution
Most lawyers or online filing services have a standard form of LLC Operating Agreement that you can tailor to your individual situation
5. Analyze the Issues of Raising Money from Investors.
If your LLC plans to raise money from angel investors, family members, venture capital firms, or other investors, take into account the following:
- Many investors, especially venture capital firms, prefer to invest in corporations and not LLCs.
- Issuing LLC units to investors will likely invoke application of federal and state securities laws, so you need to get good legal advice to properly employ a “private placement exemption” from the burdensome filing requirements.
- The investors should be made aware of the risks of the investment, and make representations and warranties to the effect that they are sophisticated investors, are “accredited,” that they understand the risks involved, and that they are prepared for the loss of their entire investment.
- The rights of the investors (rights to profits, distributions, tax benefits, voting rights, pre-emptive rights for future unit issuances, etc.) need to be clearly set forth in the LLC’s Articles of Organization and/or in an investor rights agreement.
6. Obtain an Employer Identification Number.
An Employer Identification Number (EIN) is obtained from the IRS and is required if you plan to have any employees for the LLC. The EIN is also referred to as a “Federal Tax Identification Number.”
In the past, an IRS Form SS-4 was filed to obtain an EIN, and it sometimes took many weeks to get; however, now you can obtain one online via the IRS website. The online process now allows you to get an EIN immediately, and the service is free.
Most banks require you to have an EIN before you can open a business account.
7. Obtain the Necessary Business Licenses.
Depending on the nature of your business, you will also have to obtain a local, state, or federal business license. For example, if your business sells alcohol or firearms, then you will need a federal, state, and/or business license. Some cities, such as San Francisco, require business licenses for companies engaging in business within the city. Other cities, such as Chicago, require special licenses for business activities such as retail, restaurants, entertainment venues, theaters, day care, manufacturing facilities, and motor vehicle repair shops.
8. Set Up an LLC Bank Account.
You want to properly capitalize your LLC with funds sufficient to operate the business, and you want to ensure that the LLC account is separate from your personal accounts. This will require you to set up a bank/checking account in the LLC’s name. Expect that the bank will want to see your filed Articles of Organization, your EIN, and possibly resolutions of the LLC authorizing the opening of the account. You will need to designate who has signing authority, and whether two signatures will be required for large checks over a specified amount.
9. Maintain an LLC Membership Ledger.
An LLC Membership Ledger is akin to a stock ledger of a corporation. It shows the names and addresses of the LLC owners (members), what class of units they hold, how many units they hold, and when these units were acquired. The Membership Ledger also records the transfer of units by parties and the dates of transfer. It’s important to keep the LLC Membership Ledger up to date.
10. Keep Current with Required Filings.
Most states require some form of annual report filing. Missing the deadline for such filings can lead to penalties and late fees, and even suspension or dissolution of the LLC.
As you start to do business in other states, make sure you make any required state or local filings in those new jurisdictions.
If the information in your LLC filings changes (such as business name or business address), make sure to appropriately amend your filings.
For more on this topic, be sure to read The Pros and Cons of a Limited Liability Company.
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Copyright © by Richard D. Harroch. All Rights Reserved.
Richard D. Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners, a large venture capital fund in the San Francisco area. His focus is on investing in Internet and digital media companies, and he was the founder of several Internet companies. His articles have appeared online in Forbes, Fortune, MSN, Yahoo, Fox Business, and AllBusiness.com . Richard is the author of several books on startups and entrepreneurship as well as the co-author of Poker for Dummies and a Wall Street Journal -bestselling book on small business. He was also a corporate partner at the law firm of Orrick, Herrington & Sutcliffe, with experience in startups, mergers and acquisitions, strategic alliances, and venture capital. Richard can be reached through LinkedIn.
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