First, while LLCs are extremely common setups for traditional small businesses, they are less preferable structures for startups. This is because startups often compensate their early hires by issuing them restricted stock. Startups also raise funds from investors by creating multiple equity classes, complex preferences/rights, etc. The LLC organizational structure is not quite the right fit for these activities. If you choose to remain an LLC and partake in these very typical startup activities, you will end up spending more money on accountants and lawyers to finagle the complexity of accomplishing these goals within the confines of an LLC, than you would if you had just started out as a C corporation.
Second, the tax advantages of an LLC are not often realized by startups. As you may know, LLCs are pass through entities, whereas C corporations are taxed twice (“double taxation”). Being a pass through entity would make a difference for a startup only if they were making substantial profits from the get-go, as the startup would not be taxed once on net profits and then a second time on distributions. However, this is not usually the case with startups. Startups do not often make a lot of money at inception, and startup founders do not often take distributions. Rather, startup founders often devote distribution monies into pipeline growth projects for the company.
To the extent that a founder does not know at inception whether it will behave like a traditional startup (i.e., pay early hires in equity and raise institutional equity investment) one day, it still makes more sense to organize as a C corporation and then file an S election to be treated like a pass through entity (just like an LLC), than to organize as an LLC. The reason is because the S election can always be revoked once the founder definitively decides that the company will be a traditional startup. Revoking an S election is much easier and less time consuming than converting to a corporation (across state lines).
Third, here are some reasons why a startup founder should incorporate in Delaware, rather than his or her home state:
- Delaware corporate law is much more developed and streamlined compared to other states.
- Delaware has specialized courts that deal only with corporate disputes, and Delaware laws are generally "business friendly."
- It is incredibly easy and quick to fax file your Certificate of Incorporation in Delaware, which is advantageous for startup founders who often incorporate often contemporaneous with raising funds.
- Finally, setting up as a Delaware corporation conforms to investor expectations. At least in California, most VCs are reluctant to invest in local California corporations, and prefer Delaware corporations. (Please note: VCs in other states may have a less stated preference for Delaware corporations, and may find local corporations acceptable.)
While it costs more in terms of filing fees and franchise taxes to form a corporation in Delaware rather than the state you live in, the increase in Delaware filing fees (an additional $200 during the incorporation process) and annual franchise taxes (around $400) is nominal in light of the legal and accounting expense to convert your company into Delaware from another state, later on down the road.
So what does it mean if you mistakenly organized as an LLC in your home state, rather than a C corporation in Delaware? It’s not the end of the world. You can convert across entity and state lines before promising equity to anyone. However, if you are organized as an LLC in a state like California where the California Secretary of State takes 3 weeks minimum to turnaround filings, the process should be done way in advance of raising money.
Smith Shapourian & Mignano, PC is available to answer any questions or concerns you may have regarding business entity conversion. Please contact us for a consultation.
This blog does not constitute solicitation or provision of legal advice, and does not establish an attorney-client relationship. This blog should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction. You should always consult a suitably qualified attorney regarding any specific legal problem or matter in a timely manner, as statutes of limitations may bar your claim.