
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.
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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.

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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.

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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.

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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/2005/06/01/legal-structures-
for-bootstrappers)

[http://stakeventures.com/articles/2006/02/13/why-the-llc-
is-...](http://stakeventures.com/articles/2006/02/13/why-the-llc-is-the-ruby-
on-rails-of-legal-entities)

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>

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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)

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fdschoeneman
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

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tmarman
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.

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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.

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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
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.

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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.

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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."

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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.

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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.

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

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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.

