Fundraising · Entrepreneur

Is C-Corp registered in Delaware the only option, if you are seeking to be funded?

Nickolay Kolev Freelancer at Private

September 20th, 2016

Of all available options to incorporate, I hear it again and again that if you are to seek funding - angels of VC - you have to be incorporated in Delaware and be a C-Corp entity.

The argument is that 1) C-Corp set up is the most favorable for investors and 2) this is the way it has been done for a very long time and investors are simply the most comfortable with this approach.

This means that if you register in any other way, you will have to restructure. If you have registered outside Delaware, you will most likely have to move your company registration, or no funding.

Ideally, I would like to incorporate as LLC, because the paperwork is not that strict and demanding, also tax benefits. Once an investor is interested, move to C-Corp. But do I need to register the LLC in Delaware to ensure easy conversion?

On top of this states started to look into 'where you perform business activities'. I am in California, which means no matter where I register, I will be under California's law and taxation rules; no real benefit to be registered in Delaware with the only exception to satisfy potential investors rules.

What is your experience and how did you approach this? 

Irwin Stein Very experienced (40 years) corporate,securities and real estate attorney.

September 20th, 2016

Not every question posed on FD has a correct answer, but this one does.  Where you incorporate and what form you chose has both tax and legal implications.  The correct answer for you may not be the same for everyone else.   No angel or VC worth its salt  cares about where you are incorporated and if they did it can fixed at the time they fund you. 

Don Ross Managing Partner Digital Health at Life Science Angels

September 20th, 2016

Also, for entrepreneurs and Angel investors, the company must be a C-corporation to take advantage of the 1202 tax exclusion (potentially exclude up to $10 million in gain upon an exit). See article: 

Don Ross Managing Partner Digital Health at Life Science Angels

September 20th, 2016

Why Delaware? Delaware has well understood laws and a separate court system for commercial disputes. Even in California (Silicon Valley), Delaware is preferred. 

That said, companies incorporate in other states do get funded. 

Martin Omansky Independent Venture Capital & Private Equity Professional

September 20th, 2016

Delaware is chosen because its laws and courts are friendly to management, but California is not too shabby. Going to "C" from LLC is often a nightmare. More investors are choosing LLC's model anyway, especially angels that want "current income". Consult your securities and tax law specialists for guidance. Sent from my iPhone

Sam Thacker 512-990-8756 Growth capital for SMB & mid-market companies

September 20th, 2016

I have been guiding entrepreneurs through VC, private equity and subordinated debt since 1994. 

It is absolutely not necessary to incorporate in Delaware if you are going to chase VC or PE. I can't speak for angel investors because I don't deal with them. 

It is probably true that 20 years ago it made a difference to be a DE corp. Today, you still have to register as a foreign corporation in any state you want to do business (have an office). You can't escape paying a state's income taxes or franchise taxes, and not registering in other states carries fines and penalties. 

Regarding the "C" corp question, if you are chasing VC or PE, they do want you to be a C corp most of the time. There are exceptions when LLCs will work fine and LLPs work too. 

The biggest reason for the C-corp requirement is to make it easier for the VC or PE to have a preferred class of stock. Most VCs and PE firms don't want the pass through liabilities associated with the LLCs and S-corps. There is also a limit to the number of shareholders in LLCs and S-corps. 

There are a number of good VCs and PE firms that want you to be a C corp for exactly the reason you don't want to be one. They want you to spend the time and effort for strong corporate governance. They require you have quarterly board meetings, and they want to make sure you operate your company so it doesn't have any potential contingent liabilities that can arise from the looser legal requirements of a LLC or S-corp.

Hope that helps. Feel free to call me with specifics because there are numerous cases when an LLC will work just fine.

Sam Thacker
Business Finance Solutions

Joseph Wang Chief Science Officer at Bitquant Research Laboratories

September 21st, 2016

If you are bootstrapping a startup in the US, it is a very bad idea to start with anything other than a corporation in your principal place of business, and most likely an s-corporation or LLC. At that stage you want to minimize the paperwork, and a non-local incorporation or a c-corporation will mean that you are spending more time filing papers and less time growing the business. If it's a multi-state company then Nevada is better for small companies than Delaware

Once you catch the eye of an angel investor or VC, then they may have you change the corporate structure at that point, but the cost of that part of the other legal work they are likely to do, and it's likely to be the most expensive thing.

There are legal reasons why VC and PE will prefer a Delaware C-corporation for US companies, but that's something you can and should worry about once you have a VC/PE company look seriously at you. Dealing with that issue is minor enough so that it's not going to be part of the investment decision.

This assumes US. If you have non-US investors things can get messy for tax reasons, and it's likely want to do something like BVI or HK if it's a non-US company.

Scott McGregor Advisor, co-founder, consultant and part time executive to Tech Start-ups. Based in Silicon Valley.

September 21st, 2016

If your business is in California, then as Nickolay's is noted, you will still have to pay California taxes on your business, regardless of where it is registered (as Nickolay noted!).    That isn't necessarily the case in other states, so for people not doing business in California, the tax and fees question might be material. Nevada was a favored state for many years because it was LLC friendly and had no income tax.  So

But if your business is in California,  why else might it matter where you are registered? Three reasons: 
  1. The corporate laws on the books in different states vary.  Some states  have laws on the books that are founder friendly or management friendly. Other have laws that are more investor friendly.   Some are more employer friendly and others more employee friendly,  or more seller friendly vs. more consumer friendly.  Some will provide shareholders more privacy, others less.     If any of those concerns matter, it might be a reason to prefer registration in one jurisdiction over another.
  2. The established case law (precedents).  In a court case, it isn't just what is in the written law that matters, because court cases are generally in court because it is a matter of interpretation, and a judge needs to make that interpretation.  But in common law states (every state except Louisiana), case law precedent limits or guides all subsequent decisions.  Therefore, there is far less uncertainty in states with lots of established case law.  And uncertainty in legal proceedings generally means extra costly legal proceedings!  That's why a small state like Delaware is so popular.  So many companies have been registered there, for so long that by now so there is a huge amount of case law and that makes it easier  for your attorneys -- unless all that case law is unfavorable to a company like yours, in which case you might want to be in a state where there is no case law against you yet.  California, is a very populous state (and reasonably litigious) so CA has lots of case law on the books.   So that might be as material a difference between DE and CA as it might be between either of those and say Wyoming or Hawaii.  Furthermore, CA has more than its fair share of TECH related cases, often decided favorably to the tech companies, so if you are in a tech related business, that settled case law might be a big reason to prefer CA (or if you don't want tech friendly judges deciding you cases a great reason to register elsewhere).
  3. Filings and Processing.  Some states are really fast at processing your documents (e.g. DE).  Others are much slower (like CA) and may have long backlogs .  Some are friendly to online filings and interactions others required everything in hard copy delivered to the Secretary of State's physical address.   Some have very low cost filing fees, others are higher.  
Similarly, there are reasons you might want to prefer to be an LLC or S Corp early on because you can be a pass through entity tax wise.   So if you have a lot of personal income, but also early tax losses in your business, you might want to distribute those early losses back to the shareholders.   Also, if there aren't a lot of investors and you don't anticipate adding others or a lot of employees with vesting options, etc. an LLC can be less legal stuff to manage.  But if you are going to be raising private equity from VCs soon, becoming a C-corp from the start just saves you one more legal delay for conversion when you want to close that money. 

I find that most of my startups, go through the following stages:  
  1. It's slightly less work to be an LLC, registered in my own state (CA) but not that big of deal if I deal with DE or another state (NV, WY, AZ, HI...),  because there just isn't that much interaction with the Secy of State for these early stage companies.   Also the tax issues are small because the income is small or actually a loss.  
  2. The company is getting bigger, we are doing more things like issuing more shares, changing bylaws, modifying option plans, etc.   Now form of governance and state of registration starts to matter more -- but I also now know WHAT about it matters, and which form and which jurisdiction would be better for my immediate needs is becoming very clear.   Conversion is more of a hassle than it would be at stage 1, but not terribly onerous, and the value I am saving or the benefits I am getting by conversion or registration are worth the cost.
  3. The company is big.  Lawsuit risks are higher. We have more obligations to more people.  Taxes matter more, etc.  (Should I keep an offshore company in Ireland that keeps foreign profits and minimize taxes?) Now we are big enough, some of these choices matter substantially.   But the net earnings of the company can more than handle spending a lot of money on the right lawyers and tax experts to figure it out, and battle it out or not.  

Kishore Swaminathan Serial entrepreneur looking for a cofounder

September 29th, 2016

Don't sweat this.This is not an important or complicated decision. [I am not alawyer but I've been involved in and advised startups].

1. Incorporate as an LLC in Delaware.

2. Apply for a EIN (Employee Identification Number) with IRS as an LLC. It will ask how many members there are in the LLC. Make sure you don't put 1 [if you don't have a cofounder yet, you can include a close family member and give them a small stake].

3. If you have other income and you expect to put considerable amount of your own money (say > 20K) into the new business, then file form 2553 with IRS asking to be taxed as an S-corp so you can write off your new business losses against your other income.

4. If you don't have much income and do not expect to spend much from your pocket, then file form 8832 with IRS to be taxed as a C-corp.

5. If you and your cofounders have any vesting schedules, file 83(b) elections with IRS.

6. For seed rounds, issue convertible equity or convertible debt. This way, the entity classification is irrelevant to your seed investors.

7. When a real professional investor is ready to invest in your company, convert your Delaware LLC to the right entity in the right state. There are different types of conversions such as "asset transfer", "interest transfer" etc, with significantly different tax consequences, so hire a good attorney to advise you.

Here is the rationale. The entity type and state of incorporation are not irreversible. When you start, you don't have a great deal of time or money and your chances of getting VC funding is frankly not very high. So go for the simplest: You can create a Delaware LLC in 10 minutes for under $200 (including agent fees) with essentially one piece of paper.

Of the steps above, step 2 (making sure that you are not a 1-member LLC) and step 5 are the two important steps to take initially. 

Step 2 is important because a 1-member LLC is treated as "disregarded" entity by IRS; having more than 1 member makes you a corporation (in IRS view) so you can choose S- or C- status which will make conversion easier later. 

83(b) is important because it establishes the cost basis of your stake in the company so that every vesting event does not become a taxable event. 

Everything else can be fixed later as your business model evolves and your business has more resources.

Nickolay Kolev Freelancer at Private

September 28th, 2016

I had the chance to talk to a lawyer last night and wanted to share what he suggested.

In general, if you are going to take all money earned by your venture, then it doesn't matter, because you will be avoiding the double taxation associated with a C-Corp entity and there is no real advantage of establishing an LLC.

C-Corp is very easy to establish, it is a cookie-cutter process, should be quick too. C-Copr has the flexibility of different types of shares as an LLC does.

LLC is a very flexible structure and setting up an LLC is not a simple process, if you want it done right.

A S-Corp can be easily transformed to a C-Corp and has the same pass-through benefits from taxation point of view as the LLC.

The big issue for me is that S-Corp has only one type of shares. This means if you invite investors, you cannot offer other types of shares and this is a huge limit.

LLC to C-Corp is not an easy transformation, but is done often enough. Many companies that get funded do move to a C-Copr, so it shouldn't be that difficult to be done by a good lawyer (sure, no cheap).

All structures provide the same corp-wall to isolate your personal assets from the company's assets and debts. BUT! If you are not strictly doing your minutes and meetings and you are a C-Corp, that can be potentially used as a way to get to your personal assets. On the other hand, LLC has lighter requirements for documentation and in general is a better option for a single-person or a partnership type of entity.

So, I am leaning towards LLC or S-Corp, registered in Cali, and then, if I get funded, I will transform to anything the investors prefer. It turns out when you get investments, you will be asked to change your company structure/registration anyway. I will go with the easy-to-manage entity for now. I guess this is the way, if you call yourself LEAN or following AGILE ideas. :)

Kishore Swaminathan Serial entrepreneur looking for a cofounder

September 29th, 2016

CA should be fine too. As I said, this is not a terribly important issue to sweat over.

I prefer DE for the following reasons.

- There is lot more info related to DE companies and laws that you can research yourself.

- DE annual tax is $300, CA is $800. You still have to pay $800 to CA for "doing business" there, though there are ways of getting around that. So DE registration will cost you ~$300 more at most.

- When you get to the point of conversion, you are likely to find lot more lawyers experienced in a DE entity conversion than a CA entity conversion.

While there may not be any significant advantages being a DE LLC, for a cost of $300 extra a year, you won't have any significant disadvantages either.