Tech Transfer Central
University-Industry Engagement Advisor
ARTICLE REPRINT

LLCs offer advantages for university start-ups, but beware of tax implications

This article appeared in the July 2015 issue of Technology Transfer Tactics. Click here for a free sample issue or click here to subscribe.

Don't forget to sign up for Tech Transfer eNews, our free email newsletter filled with helpful tips, industry news, special reports, and key legal and regulatory updates, sent to your inbox every Wednesday!

You'll also receive info on upcoming webinars and other related products.

The acronym “LLC” has become an easily recognizable term in the business community, but while these entities certainly have come into favor among entrepreneurs, limited liability companies have not yet become a staple in tech transfer.

LLCs certainly offer significant advantages in some respects for university TTOs, and many are being formed in the world of faculty start-ups. For example, Jeffrey Dunbar, director of the University at Buffalo’s Office of Science, Technology Transfer and Economic Outreach, tells TTT that “three out of five” of its current start-ups are LLCs. And Robert B. McGrath, PhD, senior associate vice provost in Drexel University’s Office of Technology Commercialization, reported that 50% of his school’s start-ups are now LLCs.

The two shared their experience and guidance on LLCs as part of a panel discussion at the 2015 AUTM annual convention in New Orleans. In addition to McGrath and Dunbar, the panel, entitled “Understanding the Implications of LLCs,” included Christine A. Reuther, Esq., and Christopher F. Wright, Esq., both with McCausland Keen & Buckman in Radnor, PA.

It is only natural for TTOs to become more and more exposed to LLCs because, as Wright offered in his presentation, “the lion’s share of start-ups are now being formed [in] LLCs.” That’s because, he continued, the entrepreneur is attracted to its unique advantages. “When I start a company, if it’s inside the university or as an independent entrepreneur, most of the time I set it up as an LLC,” said Wright. LLCs, in short, combine the pass-through taxation of a partnership, but because of its structure the members cannot be held personally liable for its debts or liabilities.

“LLCs tend to be formed by very early investors,” Dunbar noted during his presentation. “In other words, angels, not VCs, who prefer to become a C-corp. If you’re an angel in my start-up LLC, it distributes its losses to you, and you can write them off against investment gains.”

The downside to LLCs

But the tax implications of LLCs, which make them so attractive to entrepreneurs and investors, require additional caution – and knowledge – on the part of universities. “What some may not realize is that the LLC is not a separate taxable entity,” noted Reuther. “All income and loss flows through to the members, and that would include an exempt member like the university. The concern is because it’s not a separate taxpayer, every member is treated as being engaged in whatever business that LLC is doing. It requires a whole different weight of oversight. IP guys need to recognize that if you are going to get in an LLC, you have to engage your finance people and tax people and find out what their feelings are about getting taxable income that may or may not be good income for an exempt organization.”

For example, she added, while under the guidelines of Unrelated Business Income Tax (UBIT) royalty income and equity proceeds received by the university are “good income,” allocation of most LLC operating net income is “bad income” – that is, classified as unrelated business income.

In addition, she added, “Because an exempt organization is treated as doing whatever the LLC is doing for tax purposes, it needs to make sure the LLC is not doing something an exempt person could not do. You have to limit the ability of the LLC to engage in lobbying. The other thing you have to have control over is a change in the purpose of the organization. If you’re an exempt member you want to make sure it has a very narrow purpose — and that you have the right to approve any changes.

Learning and evolving

In light of these specific challenges, both McGrath and Dunbar have not only dedicated themselves to learning a good deal about LLCs, but they have also added more sophisticated approaches as they gained experience.

According to McGrath, Drexel began its involvement with LLCs in 2005, when a faculty member decided he wanted to start a company as an LLC. Fortunately, the university’s general counsel had had some experience with them. “I had no background to evaluate them, so we worked with counsel both internal and external,” he tells TTT. “I had seen the word, but I did not really know what an LLC was. We then asked, ‘What is different about LLCs from what we normally do?’”

Among the things he learned was that while you still do a license agreement with an LLC, and you still negotiate equity terms in a separate agreement, every LLC is different, and “things like investor rights, management, income distribution, etc. are all creatures of the state laws that govern LLCs,” he explained.

“Once we understood that, we got some advice from both the internals and externals about the risk for the university (the controller, senior VPs, VP of finance, head of the tax office, and so on) — taxes, liability, everything,” he adds.

Over the years, McGrath continued such consultations, and changed tactics accordingly when needed. For example, in negotiations the other party may suggest using the laws of New Jersey or Pennsylvania, while Drexel had been using Delaware. “When someone suggested Pennsylvania, we try to say ‘Let’s do Delaware,’ because it’s easier if we know what to do,” says McGrath. “Complexity adds time and money, so we try to avoid that.”

McGrath and his team addressed cost control aggressively — and they had good cause. While an average C-corp. negotiation may cost $2,500-$3,000, “complicated, heavily negotiated LLCs can run up to $20,000,” he told the AUTM attendees.

Accordingly, a goal was set to streamline the process. McGrath presented the following outline, which could also apply to non-LLC deals:

  • Negotiate the key financial terms of the deal (including equity) in a term sheet. Include reimbursement of the university’s costs to negotiate the agreements in the term sheet and final agreement.
  • Sign the term sheet!
  • Build on the preliminary agreement
  • Transfer these key terms to the License and Operating Agreements
  • Stick to the term sheet.

McGrath asserted that this approach reduces costs to $10,000 or less. He then recommended that the TTO and its advisors develop a boilerplate LLC Operating Agreement for the university. (A model of Drexel’s agreement can be found on its TTO’s website, http://www.drexel.edu/commercialization/. Just type “LLC Operating Agreement” in the search box.)

“Most corporate attorneys that do this kind of work have a standard operating agreement that applies to the state of choice, and we chose Delaware,” McGrath explains. To build a standardized agreement for the school, Drexel’s attorneys “looked at what things needed to be changed to reflect our non-profit status.”

Unit Warrant Certificate recommended

Although Dunbar first became involved with LLCs in 2002 — even earlier than McGrath — he eventually benefitted from Wright’s legal advice as well as McGrath’s counsel to overcome the challenges he encountered. “We really saw this emerging trend that forming start-ups as LLCs was preferred,” he recalled. But with his initial efforts, he says his general counsel became extremely concerned and said he was “putting us all at risk.”

The counsel, Dunbar notes, was concerned about UBIT. “SUNY is a state university, but back in the 70’s the Research Council Foundation was created as a 501c3 not-for-profit to manage sponsored programs in IP. They then have those UBIT concerns. In those early stages it was just a red flag he wanted to avoid entirely.”

That’s when Dunbar proceeded to “get more educated,” and eventually in 2014 “we did our first membership.” However, there was a period of “benchmarking and education” –and progress — between 2004, when the university’s first LLC Unit Warrant Certificate was developed, and 2013. The Unit Warrant Certificate was adopted to address concerns over membership in an LLC that would pass through UBIT.

“Chris (Wright) told me that some universities had adopted the warrant approach,” he recalls. “We engaged him to do one, he helped us develop the unit warranty certificate and we negotiated with the general counsel when the research foundation was comfortable enough with it.”

This was where McGrath entered the picture. Wright introduced him to Dunbar, who was quite impressed. “I scheduled a conference call with Bob and the Research Council Foundation so they could learn, and they became comfortable,” he recalls.

When an LLC Unit Warrant Certificate is employed, the university does not hold shares in the company. Rather, it retains the right to purchase units (securities) in the future at a fixed exercise price. It also involves a repurchase right, which is necessary to ensure an exit opportunity. Triggers include termination of the license by the foundation, or the lack of conversion to C-corp. within a fixed number of years.

Another advantage of this approach is that it allows for anti-dilution protection. “You might say we have anti-dilution protection until the company has raised its first million dollars in funding,” Dunbar explains. “If they issue more shares before that they have to give us more shares so we keep the same percentage of ownership.” He adds that his university typically takes 5% equity, non-dilutable up to $1 million.

Dunbar says his office created the warrant approach “so we could have the right to purchase shares in an LLC when it seemed safe and governable to the research foundation.” However, he adds, “they have a level of complexity, and tax concerns for inventors. LLCs prefer we come in as a member like everyone else.” At this point, he notes, the foundation has now become comfortable with actually taking membership and being able to manage UBIT. “The risk of a big payout is very low; it usually comes at an exit point rather than as cash distribution to the member,” Dunbar explains.

Another reason for the shift to a membership position was that “there was a big change in general counsel,” he adds. “They understood the mission, and they have a better risk tolerance. They have been very helpful.”

While the warrant approach is still in the SUNY toolbox when it is needed, “in the last few [deals] we took the membership process,” notes Dunbar. “Negotiating the operating agreement then becomes very important and involved.”

Here again he benefitted from McGrath’s experience. “They got out in front of the pack dealing with membership interests,” he asserts.

How to get started

If a TTO has not yet been doing licenses with LLCs, how should the manager go about learning the process? “They could do it with an attorney, but I’d also take into account other TTOs — especially in their state,” McGrath advises. “If a smaller university like Drexel has a larger one nearby it like Pitt and they have worked with LLCs one way or another that has the look of what you want to do, then that’s where I’d start. If you’re serious, you need both internal and external advice, but most universities don’t have the expertise.”

In addition, he says, you need to be in lockstep with your faculty inventors, because they need the right people to help them interpret the risks. “When you do an LLC with a faculty inventor, if they are allowed to get personal equity on the outside they are a party to that operating agreement for the LLC,” McGrath explains. “The university can’t counsel them, so they need to have their own counsel to guide them as to what they should do when they sign on as a member of an LLC.”

Once you begin working with LLCs, how do you evaluate your efforts? “What we will be looking for is if it has solved problems we had that existed when we couldn’t take membership interest, and if it did not create new ones,” says Dunbar. “For example, how much time and expense goes into negotiating the operating agreement? The foundation engaged outside counsel who had a lot of experience. They said we want a middle-of-the-road template operating agreement where the founder, research foundation and subsequent interests are all balanced out. They have done this, and we’ve said to the start-ups we have to get an operating agreement done to minimize time, so we can start with a template we agree on.”

Dunbar says he likes to take the template out to attorneys around campus that often represent start-ups and review it with them, essentially gaining their endorsement. “This is a good starting point,” he asserts. “We can keep formation-of-company costs down if everyone agrees and we negotiate for a license. If it is done quickly and at minimal cost, any money the company has is used to advance technology and improve the health and well-being of the public.”

Contact Dunbar at 716-645-8134 or dunbarj@buffalo.edu; McGrath at 215-895-0303 or Robert.mcgrath@drexel.edu; Reuther at 610-341-1071 or creuther@mkbattorneys.com; and Wright at 610-341-1026 or cwright@mkbattorneys.com.


About Technology Transfer Tactics monthly newsletter...

Find more articles like this one when you subscribe to Technology Transfer Tactics monthly newsletter. Sign up today and get immediate access to our Subscriber-Only Online Resource Center, which includes the entire archive of TTT back issues (since 2007), as well as our treasury of industry research reports, legal opinions, sample forms and contracts, government documents and more.