Ask PG/YC: Why a Delaware C-Corp?

[rjett]

Why are most start-ups structured as Delaware C-Corps as opposed to LLCs? I am in the early stages of my start-up and we are trying to decide the best route to take to incorporate. Today, my co-founder spoke with a lawyer who specializes in technology companies, and the advice given was to begin as an LLC without a doubt. I haven't really heard the reasoning behind this verdict, and I was wondering why most tech start-ups (at Y-Combinator at least) are actually structured as Delaware C-Corps. Any useful insight or advice would be much appreciated.

[sachinag]

At first glance, I wanted to say your lawyer is an idiot. But then I took a deep breath and came to my senses. He's not an idiot, but he doesn't know what a startup (in the HN/YC sense) is. Most "small businesses" are never candidates for VC funding, etc. A startup, in my mind, is different than a typical small biz precisely in that it is considered as a potential VC investment from the get-go.

Here's why you do a DE C-corp: it gives you the most flexibility and the most certainty of outcome. Only C corps can have different classes of stock (a necessity for the preferred stock that VCs prefer), and DE is the best because they provide very wide latitude to management and have a great and well-understood corporate legal system with lots of caselaw. This means that everyone knows what the rules of engagement are going in, and the judges in the Chancery Court (if it ever gets that far) know what they're doing.

An example: when I was in VC, we negotiated a term sheet with a non-DE C-corp. The term sheet was accepted, and we drafted the amended and restated articles, investors rights agreement, blah blah. But, when we filed the amended articles with the non-DE Secretary of State, the SOS office rejected them. We had negotiated a voting structure that offended this state's rules for voting vis a vis ownership. This held back closing for months, as we had to re-incorporate in DE, and tens of thousands extra in legal fees. In DE, never would have been a problem. And because in VC, almost everything is DE, it never occurred to us to think that the SOS office would reject the Articles.

[cch]

You should really ask an attorney about the cost/benefit of different options, but here are a few as I understand them, and why VCs generally demand a C corp structure. Standard disclaimer--I don't know what I am talking about and you are an idiot to believe anything I say.

Tax is a big one, and the reason I think that VCs don't like LLCs. LLCs are "passthrough" entities for tax purposes, like partnerships. They don't pay taxes....the members (shareholders) of the LLC pay taxes on their portion of the LLCs earnings or losses. For VCs and other institutional investors, this creates a nightmare from an accounting point of view.

C Corps are technically "persons" for tax purposes, and pay their own taxes. Much simpler....VCs are not in business for tax credits, they want capital gains when the successful investment is sold.

Governance--C corps have existed for a long time and there is a considerable body of law around them. Delaware is preferred because its laws are considered optimal (not sure of the details why), and its fees are low.

LLCs are very flexible...many of the governance elements are crafted into the Operating Agreement that controls the LLC, which is why LLC docs are much longer than the incorporation docs. I have always found that LLCs are more expensive to set up because of this.

So.....if you are going to take outside institutional investment, save time and start with a C corp...might as well do Delaware since every lawyer speaks Delaware law.

If you are not taking professional money, then you may prefer the tax efficiency of the LLC. You get tax benefits while you are losing money, and you eliminate one layer of income taxes when you are making money. This is assuming you distribute the excess cash--if you don't, then you have to pay taxes anyway, but you don't have the cash to help. For this reason, most LLCs make what is called a tax distribution to help members cover their tax liability.

There are other structures (sole proprietorship, S corp, partnership) that have pros and cons depending on exactly what your aspirations are for the business, but C corps and LLCs dominate.

[DenisM]

Most investors hate pass-through taxation that is attached to LLC. They, being passive members, are not eligible for tax pass-through but you as an active member are, so it is in effect places money from their pockets into yours.

Delaware incorporation is a superstition. They do come in handy if you plan to litigate on corporate law (e.g. shareholders vs. management) because their case law is much more thorough and their judges are very experienced. However, if you incorporate there as opposed to you home state you will still have to register in your home state as a "foreign corporation", so you will in effect double your paperwork. It also carries risk that you will have to travel over there to appear in court. Not worth it for a small Internet start-up with simple ownership structure.

So with that in mind, talk to a lawyer and an accountant.

[pelle]

For most people I think LLC's are the best choice as they are very simple and suit bootstrapping perfectly. However if you are going for VC relatively quickly it may be worth while getting a c corp.

I wrote a couple of posts about this a while back

http://stakeventures.com/articles/2005/06/01/legal-structure...

http://stakeventures.com/articles/2006/02/13/why-the-llc-is-...

This post explains why it might not be a good idea and why an S-corp might be a better choice:

http://www.rothcpa.com/archives/001617.php

[hooande]

I've heard that most Y Combinator startups are set up as Delaware C-Corps because most investors prefer to work with Delaware C-Corps. Being in Delaware provides them with more legal protection as investors and the C structure gives them more control. Some VCs will ask founders to restructure as C-Corps as a condition of investment, so pg recommends that Y Combinator startups just start out as C-Corps from the start (anticipating further investment).

If you're looking for VC money or major investment, it's probably a good idea. If you're going to try to be self sustaining for several months/years then an LLC might not be the worst thing (or you'll have to pay taxes twice, once for the business and once for yourself)

[fdschoeneman → hooande]

I think it's corporations that have to pay tax twice, not LLC's... Or maybe I'm reading what you wrote wrong? But seriously, llc's are much easier than s or c corporations to manage, and frankly your chance of hitting the IPO lottery are pretty bad, statistically. You'll save time and money on the llc and as long as you manage things properly a decent lawyer ought to be able to switch you to c or s corp status should you hit the big time.

One other problem with a Delaware corporation, specifically, is that if you're in California, you may be subject to their tax in addition to Delaware.

Also, one other point. Investors love Delaware corporations because they know them and also because they tend to be favorable to the investor. You probably want to read that last sentence again. Also I watched a presentation by some lawyers from Reed Smith who argued That California may actually be preferable to non-investors.

But the best piece of advice I can give you is to pick one and go forward quickly without dwelling too much.

fred

[tmarman → fdschoeneman]

I think you were both saying the same thing. C-corp is taxed on its profits, and then employees are taxed on their wages. S-Corps and LLCs are pass-through entities where the profits are "passed along" to the individual owners, so you only pay once. Obviously, there are some benefits with a pass-through entity but also some real concerns for outside investors.

[noodle]

preface: i'm not an expert and i've not started any companies.

you incorporate in delaware because it has, by far, the most robust and established corporate laws and legal system.

you go with c-corp because they're the easiest entity to run with established legislation with respect to selling interests and tacking on investors. if you want to get funding and stuff, c-corp is the way to go. from what i've seen, you "can" do it with an LLC, but the laws and protections and precedents aren't really established for that route yet, and most VCs want something safe and inexpensive.

[sgibson12]

Here's an article describing some of the differences between C-Corp, S-Corp and LLC. http://www.mynewcompany.com/entity.htm

I'm not an expert either and am approaching this decision with my business partner shortly. Here's what I understand so far.

If you're accepting funding, go with C-Corp since VC's will insist upon it. If you're not accepting funding or angel funding (friends/family) etc. then LLC will be the cheapest and least red tape. VC's prefer C-Corp because it requires you to maintain more paperwork, reports, filings, etc. (though I'm not sure exactly what that entails).

Regarding Delaware, Here's an interesting article on Nevada vs. Delaware. It advocates Nevada for "tax reasons." http://www.val-u-corp.com/whynev.html

Anyhow, I hope that helps. (and that people more knowledgeable in this area respond).

[tmarman → sgibson12]

The problem that I mentioned in my comment with this is that Nevada's body of precedent is not nearly as well-established as Delaware's, so you're going to pay to litigate otherwise settled issues in Delaware. Often, even if the other state is more founder-friendly, it's often better to use Delaware because you'll save on legal costs across the board (more lawyers able to do DE work, less cost litigating, less question marks and uncertainty).

Of course, that varies from state to state and certainly depends on the kind of business and cap structure, where you're doing business, etc.

[tstegart]

I don't think his lawyer is an idiot. We don't know what rjett told him. Sure, if you're immediately going to get funding, a C-Corp in Delaware is great. If you're just starting your own company, an LLC saves you a ton of dough. There's no reason to pay to incorporate in Delaware if you're not going to raise funds right away or if you're not sure how well it will go. Not all start-ups will take VC capital. Some states also allow for a lot of variety for LLCs. An LLC might be the best bet depending on the circumstances.

[tmarman]

Some excellent discussion above.

There are really two decisions to be made here - the choice of entity and the choice of state.

Delaware is the choice for two big reasons: it is generally considered one of the most "founder/board friendly" venues, and it has one of the well-established bodies of law so you don't pay to litigate issues. Another important side effect is that any lawyer in any state is qualified to validate coprorate structure, whereas in another state you need to find a local lawyer. I wrote a little about this in the past: http://bit.ly/31lbT2.

As for choice of entity, well, that's complicated which I went into a little more depth with here: http://bit.ly/cIpSL.

S-Corp and LLC are both known as "pass-through" entities which as mentioned by cch don't pay tax directly - the members/owners do. This also means that the members/owners can't file their personal taxes until the corporation files its own. This is generally best for closely held companies where you don't want to bring a lot of people on, give options, and you're operating with tax losses (to take advantage of the write-offs on your personal tax). Plus, unlike a C-Corp, you're not double taxed.

On the other hand, VCs can't and won't invest in anything but C-Corps (http://bit.ly/mKx08) - so if you're thinking about going this route, it may be better to just do c-corp right away and minimize your legal expenses.

My summary in that first article:

"If you're actively seeking VC funding (VCs will only invest in C-Corps) and don't anticipate significant tax losses (which is probably the case with many technical startups), then C-Corp is usually a good choice. If you want to take advantage of the pass-through taxation, Imke has a good discussion on choosing between an LLC and an S-Corp. Partnerships are ok initially, but best avoided given the lack of a liability shield."

[Xichekolas]

Usually Delaware is chosen for C-Corps because the state of Delaware has a special set of courts for corporate law and have an extremely detailed history of rulings with expert judges that special in corporate law.

[Hoff]

Yes, Compaq Federal LLC, HP Hood LLC, Capri Capital Partners LLC, MacroMarkets LLC, Bain Capital Partners LLC, etc. are all small outfits. Some of these have been in multi-million deals, others in billion-dollar deals.

Talk to a lawyer. Seriously. The incorporation decision and details and protections are based on state laws and do vary, and the decision depends on where your are going with your startup. A good lawyer makes this process far easier.

[challenjer]

Key point: LLC's can't offer stock options. If there's any hiring planned, you're going to want to offer options.

[Allocator2008]

Myself I am not an expert either, but I believe it is easier to raise funds thru issuing stock and so on as a C-Corps than an LLC. An LLC is normally for "small business". If that is your objective, then that might work. However if you want to envision doing multiple VC funding rounds and try to sort of get into the "major league" then I think C-Corps is better.