People always wonder why entrepreneurs and startup founders always chose Delaware to be their company’s home state. There are many reasons for this, but here are the main ones:
- Delaware’s corporate rules and regulations are known to be business-friendly. They are designed to provide maximum flexibility in structuring business entities and allocating rights and duties among founders and shareholders.
- Whenever an issue arises, and founders or shareholders end up having a corporate dispute, Delaware’s Court of Chancery relies on judges instead of juries. This means that an experienced judge with a significant background in complex legal matters will decide on the matter relatively quickly in case of litigation. Most of the time, the sitting judge provides a written opinion that legal consultants can solve disputes and avoid lawsuits.
- Investors, mainly Venture Capitalists, are more familiar with Delaware’s corporate rules and regulations, which means that all of their corporate documents are already drafted according to the Laws and regulations applicable in Delaware and with Delaware as the choice of governing law. Therefore, it would be burdensome and expensive for investors to invest in companies registered with many different states and customize templates for each jurisdiction.
Why a C-Corporation instead of an LLC?
The main reason to consider here is the ability to raise funds. C-Corp is the preferred structure for startup founders planning to raise money from investors in the future. Investors won’t invest a dime in a limited liability company (LLC) for various reasons:
Reason number one: an LLC does not have stockholders, which means it cannot issue stock. The owners of an LLC are members, not shareholders. Their ownership in the company is identified by how many units – not shares – each member owns. The consequence of this is the LLC’s inability to issue different classes of stock, mainly common stock and preferred stock. This is important because whenever an investor invests in a startup, the first thing they ask for is to get preferred stock in return for their investment, considering that preferred stockholders usually get liquidation preference rights that mitigate their investment risk in the company.
Reason number two is related to reason number one: Since an LLC cannot issue stock, it cannot distribute stock options as incentives to its employees, directors, or officers. Investors love this strategy; they believe that it creates a hard-working, motivated team that will lead the company to growth and profitability.
Reason number three: investors prefer C-Corps over LCCs because it is difficult to sell or transfer a membership or ownership in an LLC. At the same time, it is easy to trade shares in a C-Corp. In addition to that, an LLC cannot go public, while going public can be an option for C-Corps. Investors would instead invest in companies that can go public because their shares will be available for purchase through brokerages whenever they make an initial public offering.
Lately, Startup lawyers have been recommending new startups to incorporate an LLC instead of a C-Corp to avoid the double taxation and the complex administrative requirements C-Corps are subject to.
Double taxation means that C-Corps are taxed at the corporate level. Then the shareholders are taxed on any dividends they receive. This is not very significant for Startups, especially early-stage ones, because they barely make any dividends in most cases. Additionally, a Delaware C-Corp can benefit from many tax incentives that can help save on some taxes. For example, C-Corps pay very low taxes on their retained earnings, which are the net earnings to be reinvested in the company. This means that any profits that are not paid out as dividends can boost the company’s growth. This is an example of an advantage that is only available for C-Corps.
As for the complex administrative requirements, handling them can be worth it, especially if you are looking to raise your startup’s external investment. Although It remains possible for an LLC to raise funds from investors, it’s significantly harder to do so, mainly because investors insist on working only with C-Corps. If you’re not looking to raise capital, then an LLC is most likely the perfect choice for you.