When you are starting a business, there is a lot to consider and keep straight. Besides worrying about things specific to your business, you need to think about how you want to register your business. When making this decision, you should take into account a few different factors.
Different registrations approach various issues better than others. You should think about what the best approach is for tax purposes, protecting your IP, liability, and costs of incorporation, among other factors.
The differences between incorporations can be confusing. Here are some key differences.
Limited Liability Company (LLC): An LLC is a business structure specific to the United States where the owners of the business are not personally liable for the company’s debt. The specific regulations surrounding LLCs vary from state to state but the general principle is the same.
C Corporation (C-Corp): A C Corp is a legal structure for a corporation where the owners and shareholders are taxed separately from the entity. C Corps are the most common among corporations and are subject to corporate tax income tax.
S Corporation (S Subchapter): An S Corporation is another form of registration similar to a C-Corp. This kind of corporation refers to a type of business that meets specific Internal Revenue Code requirements. This is beneficial to corporations with 100 shareholders or less by allowing them to be taxed as a partnership.
When Should a Startup Incorporate?
The general rule for when a startup should incorporate is as soon as possible. Often, the legal cost of incorporation is one of the first real expenses that startup founders face, at a time when funds are scarce compared to later down the road.
TechCrunch notes their top five reasons to incorporate a startup sooner rather than later as follows:
- It will establish Co-Founder ownership and avoid any fights between founders
If you decide not to incorporate right away, the process is likely going to get more complicated. When roles are not legally defined from the beginning, more people will get involved and it may lead to fights between founders, which is detrimental to any company.
- Buy stock at very low prices
The earlier you incorporate your company, the sooner stocks on it can be purchased. If a company is incorporated earlier rather than later, it is more likely that the founders will be able to purchase stocks at very low prices than if all the intellectual property and more is established.
- Incorporating early will help avoid adverse tax consequences
If you incorporate right before receiving a large sum of funding, then you risk getting a sizable tax bill later on. Additionally, if you incorporate earlier then your company is cheaper to purchase than when it is more established later on.
- Keep your intellectual property safe and sound
This is one of the most important reasons to incorporate early. The safest course of action is to start developing IP assets after incorporation. This way, all of the IP and other assets belong to the company from the start which keeps the process simple.
- Protect your personal liability
As long as corporate formalities are kept and the company is subsidized well, shareholders’ personal assets are safe from creditors if the startup takes a turn for the worse.
Making sure that all of the assets and property is signed in the name of the company ensures that personal assets and personal liability are protected.
The path forward for your startup depends on many factors specific to your situation, but generally, the easiest thing to do is to incorporate your startup as early as possible and then develop your business plan further from there.
Delaware Corporation
A Delaware corporation is a very popular and prestigious type of legal entity involved in incorporating companies. It is called a Delaware Corporation because, in order to classify as a business incorporated under this category, the business must be incorporated in Delaware.
Your business does not have to be located in Delaware, in fact, it can be located anywhere. Delaware corporations can conduct business in all 50 states and in more than 50 countries around the world.
Delaware corporations are prestigious and have been speculated to be worth 5% more to investors than companies incorporated elsewhere.
More than 50% of all publicly-traded companies in the United States, including giants like Google, AT&T, Walmart, General Motors, Ford, and Berkshire Hathaway, are all incorporated in Delaware.
Delaware Corporations are structured differently than other incorporated companies are. The Delaware general corporation has a formal governance structure that is defined under the Delaware General Corporation Law, Title 8 of the state code. It consists of three tiers:
- One or more Shareholders (the owners) – Those who make the major decisions.
- One or more Directors (elected by the owners) – Those who make the large decisions.
- One or more Officers (elected by the directors) – Those who make the day-to-day management decisions.
This structure is consistent with all Delaware Corporations. There are four main types of Delaware corporations:
- General Corporation
- Close Corporation
- Non-stock Corporation
- Public Benefit Corporation
Why Do Investors Like Delaware Corporations So Much?
Delaware has been the premier state of formation for business entities since the early 1900s. According to the Government of Delaware’s website, today, there are more than 1 million business entities incorporated in Delaware, and more than 60% of Fortune 500 companies are incorporated in Delaware.
So, just what is it about Delaware Corporations that investors and business owners like so much?
The structure of the Delaware Corps is actually not “management friendly” nor “stockholder-friendly”. Instead, the goal is to provide both managers and investors with laws that are optimal for engaging in ethical and profitable business.
This is done by balancing the need for managerial flexibility with strong tools to hold managers accountable for using that flexibility to advance the best interest of the investors.
Should a Business Start Up as an LLC?
Many founders think that it is a strategic method to start their startup as an LLC and then move to a C-Corp. The two key differences between an LLC and a C-Corporation are the ability to divide ownership and the way in which income is taxed. According to Gust, so many founders believe that they should first start their startups out as LLCs first, then move to a C-Corporation.
The taxes on LLCs are lower because C-Corps are charged double tax, so many founders believe they are saving money by first starting out as an LLC. However, this is not a great idea. C-Corp profits are taxed higher because they are taxed as a corporation and then also taxed at the individual level.
Incorporating your startup as an LLC and then transitioning to a C-Corporation is not a good idea.
This transition comes with a high cost in legal fees and will complicate the process of operations, potentially causing conflict between founders or other higher-ups. As this article has covered, there are different profit sharing and structures in place between LLCs and C-Corps. Starting as one and transitioning to another may seem like it makes sense for some founders and some do it, however, it is a smart idea to incorporate one time.
Why Do Investors Prefer Delaware Corporations?
With so many incorporation structures to choose from, the choice can be complicated, especially if there is not an obvious benefit to one over another for a particular startup.
One factor that should help influence and persuade founders to consider a Delaware Corporation is the fact that investors prefer Delaware Corporations. To heighten your chances of investments, it is a great idea to take investor preferences into consideration.
Why is it that investors prefer Delaware corporations over S Corps, LLCs, or other C-corps? The main reason comes down to stocks. Stocks are a key aspect of Venture Capitalist’s investments. Delaware law allows for two or more classes of stock.
A venture-funded company will often have common stock, founder’s stock, and several classes of preferred stock which includes some convertible stock which allows an investor to convert stock to common if the company goes public. This is a huge advantage for investors and many see this as very valuable.
In addition to the stock system in place, Delaware Corporations are also able to distribute stock options to people on their team. This includes stocks in the form of incentives for employees or as a reward to board members and directors.
Stock options are a proven way to motivate and reward team members and generally, an investor is looking to make sure the company they are putting their money into is going to succeed not just financially, but also as a team.
What is the Best Incorporation for a Startup?
Taking into consideration all of the differences and characteristics of various incorporations, generally, the best path forward for startups is through a Delaware corporation. Despite the name, this is not state-bound incorporation.
Most companies are not physically based in Delaware and as a result of this, Delaware has developed a series of tax and regulatory laws and court systems that present more of an advantage to corporations than anywhere else in the country. This is one of the main reasons that Delaware is a favorable place to incorporate, for both companies and for investors.
Another great characteristic of Delaware Corporations is that in addition to being an option for companies located in other states, it is an incorporation option for companies around the world.
A foreign corporation can establish a branch within the United States to conduct its business activities, even though most foreign corporations choose to form subsidiary companies for both tax and nontax reasons.
The Delaware corporate law structure does not impose restrictions on ownership or management of a Delaware company by a non-resident, but all Delaware corporations need to enlist the services of a Delaware Registered Agent to act as a liaison between your company and the State. This will ensure that the legal process and all other requirements are fulfilled smoothly.
Key Takeaways
This article extensively covered various kinds of corporations, the pros, and cons to some, and the reasons why investors prefer which incorporations they do. Here are some key takeaways to consider when incorporating your startup.
- Incorporating earlier is always better than incorporating later.
- Converting from an LLC may seem like it makes sense, but it is generally better to incorporate as a C-Corp in the first place
- Delaware corporations are extremely popular with companies and investors and are definitely worth thinking about for your startup
- Investors prefer Delaware corporations over LLCs, S-Corps, or other C-corps.
Incorporating your startup is not a small feat and there is a lot to be taken into consideration. Hopefully, this article helped clear up some questions and the road ahead is clearer than it was before the start of our explanations.
