Converting an LLC to a C Corporation Before You Raise

Many companies start as LLCs because an LLC is quick to form and flexible to run. Then a lead investor sends a term sheet that assumes preferred stock, a board and a stock option plan, and the founders learn that the investor wants a corporation before the money moves.

This post is for founders and operators of LLCs in Arizona, California and Texas who expect to raise from investors who want to buy stock. It explains why investors often ask for a corporation, the main ways to get there, what generally carries over, and what to check before you sign anything. It is general information, not advice about any company, and it does not analyze tax. For the threshold comparison of the two entity types, see our post on choosing between an LLC and a corporation.

“C corporation” describes federal income-tax status, not a separate state-law entity form.¹³ This post addresses changing an LLC’s legal form into a corporation; an LLC’s election to be taxed as a corporation does not itself turn its membership interests into corporate stock.¹⁴

The short answer

Delaware, Arizona, Texas and California each have a statutory conversion procedure that can let an LLC continue as a corporation rather than create a separate corporation and transfer the LLC’s assets to it. The required approvals and filings depend on the LLC’s state of organization and the corporation’s destination state; a conversion across state lines must satisfy the applicable requirements of both states. Under each of those statutes the converted entity is treated as the same entity, and its property and obligations generally stay with it, subject to qualifications in each statute. A conversion still needs the approvals your operating agreement and the statute require, a plan for turning membership interests into shares, new governing documents, and a review of contracts and permits for clauses that react to a change in entity form. Conversion can also have tax consequences; those questions go to the firm's of-counsel tax attorney before anything is filed.

Why investors often ask for a corporation

Equity investors in startups commonly buy preferred stock in a corporation and expect familiar corporate features: a board of directors, authorized shares, a stock option plan for employees, and standard financing documents. An LLC can be drafted to approximate some of those features, but the documents are less standardized, and some investors are not set up to hold LLC interests. That is a market preference, not a legal rule, and it varies by investor.

If the round is likely to be a SAFE or convertible note, ask early whether the investor expects the company to be a corporation at signing or only at conversion. Our post on SAFEs and convertible notes covers those instruments.

The routes to a corporation

Statutory conversion. Each state discussed here lets an LLC convert into a corporation by following a statutory procedure:

• Delaware. Any "other entity," a term that includes a limited liability company, "may convert to a corporation of this State" by filing a certificate of conversion and a certificate of incorporation with the Delaware Secretary of State.¹ A Delaware LLC must also authorize the conversion under its LLC agreement and the applicable LLC Act rules; if the agreement is silent on conversion and does not prohibit it, the statute looks first to the agreement’s merger or consolidation approval provisions and then to statutory default rules.² (Section 266 of the Delaware General Corporation Law governs the reverse: converting a Delaware corporation into another entity.)
• Arizona. "By complying with this article, a domestic entity may become" a domestic entity of a different type, or a foreign entity of a different type if the foreign jurisdiction's law authorizes the conversion.³ The entity approves a plan of conversion, which must state, among other things, "the manner of converting the interests in the converting entity" into interests or securities of the converted entity.⁴
• Texas. "A domestic entity may convert into a different type of domestic entity or a non-code organization by adopting a plan of conversion," and the plan must be in writing and must generally include the manner and basis of converting ownership interests.⁵
• California. A California LLC may convert into another business entity, including a foreign entity, if conditions in the statute are met, such as equal treatment of interests of the same class unless all members of the class consent. The conversion may be effected only if "the law under which the converted entity will exist expressly permits the formation of that entity pursuant to a conversion" and the LLC "complies with all other requirements of any other law that applies to conversion to the converted entity."⁶

Other routes. Instead of converting, some companies form a new corporation and merge the LLC into it, or have the members contribute their LLC interests or the LLC contribute its assets to a new corporation. These routes involve different documents, approvals and transfer mechanics, and they can have different tax consequences. Which route fits depends on the company's facts, and the choice belongs in the same conversation as the review by the firm's of-counsel tax attorney.

What carries over, and what to check anyway

The conversion statutes say the entity continues rather than starts over:

• In Delaware, "for all purposes of the laws of the State of Delaware," the converted corporation is "deemed to be the same entity as the converting other entity," its property and rights "remain vested" in the corporation, and its debts and liabilities "remain attached" to it. Unless otherwise agreed or required by applicable non-Delaware law, the conversion is not a dissolution of the LLC.⁷
• In Arizona, the converted entity is "the same entity without interruption," and its property "remains vested in the converted entity without assignment, reversion or impairment."⁸
• In Texas, the converting entity "continues to exist without interruption" in the new form, and its property stays with it "without ... any transfer or assignment having occurred."⁹
• In California, an entity that converts under the LLC conversion article is, for all purposes other than certain listed parts of the Revenue and Taxation Code, "the same entity that existed before the conversion," the conversion "shall not be deemed a transfer of property," and the converting entity's rights and property vest in, and its debts and obligations continue as those of, the converted entity.¹²

That statutory continuity is helpful, but it does not end the review. Contracts are read on their own terms, and some customer agreements, leases, loan documents and licenses define a change in entity form, a change of control or a merger as an event that requires notice or consent. Arizona also has a transitional rule for certain agreements and organizational documents in effect on December 31, 2014, which the statute calls “protected agreements.” If a protected agreement contains a provision that applies to a merger of a domestic entity but does not refer to conversion, that provision applies to conversion as if it were a merger until the agreement is amended after that date.³ Read the assignment, change-of-control and notice clauses in your significant contracts before you choose a closing date. Our post on the contracts every startup needs lists the agreements that usually matter.

Two other items need a separate check:

• IP. Confirm that the LLC actually owns the code, brand and other IP it uses. If a founder or contractor never signed an assignment, the conversion carries over only what the LLC owned. Our post on IP assignment covers the gap.
• Permits, registrations and accounts. Licenses, foreign registrations, bank accounts and payroll and tax accounts may each need an update. See our post on registering an out-of-state business.

Consents under your operating agreement

Approval comes from two places: the operating agreement and the statute. In Delaware, start with the LLC agreement’s conversion provisions, including any prohibition on conversion. If the agreement does not address conversion and does not prohibit it, the statute looks first to the agreement’s merger or consolidation approval provisions and then to statutory default voting rules, including a special rule for LLCs whose original certificates of formation were filed and effective on or before July 31, 2015.² In Arizona, the plan is approved under the governing statute and organizational documents, and, if neither addresses conversion or merger, "by all of the interest holders of the entity entitled to vote on or consent to any matter."¹⁰ In California, the plan must be approved "by all managers and a majority of the members of each class of membership interest," or by a majority of each class if there are no managers, unless the operating agreement requires more.¹¹ Both states impose stricter approval if members would become personally liable for the converted entity's obligations: Arizona requires approval in a record by each interest holder who will have that liability, subject to exceptions in the statute,¹⁰ and California requires approval by all members unless the plan gives all members dissenters' rights.¹¹

In Texas, review the company agreement together with the Business Organizations Code’s conversion and LLC voting rules to determine the required approvals.¹⁵¹⁶ A conversion cannot impose owner liability on a member without that member’s consent.¹⁵

Read your operating agreement for conversion, merger and amendment provisions, any member veto rights, and any right that is triggered by a change in form. A member who did not expect the conversion is better approached before the vote than after it.

Translating the cap table and founder vesting

The plan of conversion says how each membership interest becomes shares. California's plan must state "the manner of converting the membership interests of each of the members into shares of, securities of, or interests in, the converted entity."¹¹ That is where the business deal is set: how many shares each member receives, whether any class of interest becomes a different class of stock, and what happens to profits interests or options issued under the LLC.

An investor may ask for founder shares to be subject to vesting as part of the financing. If the LLC did not already have vesting, address whether to introduce it, how to credit prior service, and what approvals and documents are needed rather than assuming that conversion itself creates a vesting schedule. Our post on founder vesting explains how vesting works, and our post on the founders' agreement covers the related founder terms. Equity changes at this stage can have tax consequences for the members; those questions go to the firm's of-counsel tax attorney before the plan is final.

Questions to settle before you convert

1. Has your likely lead investor said it requires a corporation, and by when: at signing, at closing, or at conversion of a SAFE or note?
2. Will the corporation be formed in Delaware or in your home state, and does your home state's law allow the conversion you want? Our post on operating across Arizona, California and Texas covers related multi-state issues.
3. What approvals do your operating agreement and the conversion statute require, and do any members hold a veto?
4. How will each membership interest, profits interest or LLC option translate into shares or options?
5. Which significant contracts, leases, licenses and loans have change-of-form, change-of-control or assignment clauses?
6. Does the LLC own all of its IP, and are founder and contractor assignments signed?
7. Has the firm's of-counsel tax attorney reviewed the route and timing before anything is filed?

What this post does not cover

This post does not analyze the tax consequences of any route, recommend a state of incorporation, or address securities law questions raised by issuing shares or options. It does not cover converting a corporation into an LLC, or partnerships. For the structural basics, see our posts on LLCs versus partnerships and how an LLC protects personal assets.

How we can help

Accord & Shield Legal handles entity conversions, formation documents, operating agreement amendments and founder equity documents for companies in Arizona, California and Texas, with conversion-related tax questions reviewed by the firm’s of-counsel tax attorney. To better understand the scope of your matter, you can schedule an initial consultation. The consultation is evaluation-only; no legal advice is provided. Representation begins only after an engagement agreement is signed and any required retainer is received. Please do not send confidential or sensitive documents before we confirm that we can assist.

This article is general information, not legal advice. Reading it does not create an attorney-client relationship. Whether and how to convert, and the tax consequences of doing so, depend on your facts and documents; consult an attorney about your situation.