Are you planning on getting venture funding or do you want to sell your tech startup for a big chunk of change one day? Then it’s extremely likely your startup should be a Delaware C-Corp.
A disturbing trend has emerged in the last couple of years with “startup lawyers” recommending new startups incorporate as an LLC instead of a corporation and it is time to stop the madness.
Their reasoning is the administrative requirements of being a corporation are too complex and burdensome to be dealt with and it is easier to just be an LLC initially. Or maybe you save a few hundred on filing fees.
This is, in short, not correct nor compelling. And as I wrote almost 10! years ago: if you can get on the Internet, you can handle the complexity of a corporation.
Let’s lay out the “administrative requirements” of being a corporation:
(1) Hold an annual shareholder meeting and take corporate minutes.
(2) File annual report with the Secretary of State
(3) Respect the differences between the board, stockholders, and officers.
For the annual meeting, it can be held anywhere and in any format. Meaning you can have a conference call and call it a day. You don’t have to rent out the huge meeting room at the local Hilton. Corporate minutes are just notes of what happened. This really isn’t a big deal.
You have to file an annual report regardless of your choice of entity so I don’t know why this is constantly brought up either.
What’s funny about LLCs when a ‘startup’ chooses that entity is that the founders typically want to set it up like a corporation…”board of managers”, “officers”, and of course the “members” (shareholders). So right off the bat the LLC has the similar complexity administratively.
And sure, there might be some additional costs with being a Delaware corporation but a few hundred or even $1,000 shouldn’t be the compelling reason for a different type — or state — of entity. And remember – I don’t think you should incorporate until you are ‘all in’ on the startup.
But – Double Taxation!?!?!
Another argument that is brought up frequently is the double taxation issue with C-Corps. So basically, the corporation is taxed at the corporate level and then the shareholders are taxed on any dividends they get and reported on their income tax returns. Hence the double taxation.
Except what dividends???? How many early stage tech startups are issuing dividends? Maybe 1? Any salary founders receive from the company is a business expenses (not double taxed) and anything extra is used to grow the company and its valuation.
Not to be overlooked, a C corporation can provide another tangible tax benefit to founders and their investors. C corporation stock (NOT LLCs and NOT S Corporations) can qualify as “Qualified Small Business Stock” (QSBS). As long as you hold C corp stock for 5 years or more and a few other boxes are checked as set forth in Section 1202 of the Internal Revenue Code, you can get a significant reduction of your long term capital gains tax bill…anywhere from 50% to 100% and subject to certain caps.
Why do I care so much?
First, I feel like some “startup lawyers” are recommending LLCs to startups when they are really including any ‘small business’ as a startup. So OK sure — a ‘startup’ that does not intend high growth or funding can be an LLC. I’ll give you that.
And these lawyers usually write articles or or give presentations titled something like “The Delaware C Corp Myth” to explain why an LLC makes sense for your startup…but the real myth might be that these lawyers recommending LLCs actually work with early-stage tech startups
seeking actually closing venture capital.
Second, I feel like other lawyers like having you convert later so that they can charge you for it. Conversion is typically much more than an initial LLC formation or incorporation.
Oh – but why Delaware?
(1) The Delaware case law is unmatched if an issue comes up. You want to lessen the uncertainty on which way a judge will rule if you are suing someone or being sued. If the issue in your case doesn’t have the case law behind it then that essentially gives the judge a lot of judgment on how they will rule on your case.
(2) VC lawyers and VC firms are already familiar with Delaware requirements and laws. All of the documents are drafted with Delaware being the choice of law. It would be prohibitively expensive for VC firms if they invest in 50 different state entities because now instead of 1 ‘template’ of VC docs it would mean having to customize sets to cater to each state law.
(3) Still not convinced? Here’s an article I wrote 12 years ago on the top 5 reasons to incorporate in Delaware.
So just do your tech startup a favor and incorporate as a Delaware C-Corporation in the beginning if you are an early-stage technology company that plans to raise capital.