The Delaware Limited Liability Company Compares Favorably to the Delaware Corporation
When starting a business, you probably have a lot of questions, including “Is an LLC a corporation?” and “Where should I incorporate?”. You do not have to incorporate in your home state if the laws there are unfavorable to protecting you. Instead, you can shop around and opt into another state’s laws without having to relocate. Over a million companies have decided to form in Delaware where most choose the Limited Liability Company. Delaware laws will govern the internal affairs of your business (the liability shield and disputes between owners and managers) when your business is incorporated in Delaware. Delaware is the gold standard for Corporation and LLC law. Both the Delaware Corporation and LLC are great because both offer protection to their owners from claims of company creditors. Nevertheless, there is a difference between an LLC and corporation and many entrepreneurs and property investors prefer the Delaware LLC structure. By analyzing the Delaware law advantages of the LLC over the Corporation, you can determine if the LLC is better suited for your purposes. This is typically the case because of the Delaware LLC’s operational simplicity and flexibility.
Is an LLC a Corporation?
An LLC is a different legal entity from a corporation. Delaware LLCs and Corporations share certain features, but they differ in key aspects. The Delaware LLC is the most popular choice because of its simplicity and superior liability shield. A contract called an LLC Operating Agreement governs an LLC. It is like a step-by-step instruction manual for the owners. A corporation has far more rules and requirements. A corporation is owned by shareholders, managed by directors, and operated day-to-day by officers. The corporation is incorporated, meaning many rights are restricted and set forth in the statute rather than in a private flexible contract.
Why Form a Corporation in Delaware?
The process of starting a Delaware Corporation begins with an incorporator signing and filing a Certificate of Incorporation with the Delaware Secretary of State. The incorporator then signs Minutes to adopt Bylaws and elect the initial Directors. Next, the initial Directors issue stock to the Shareholders and appoint the Officers of the Corporation. Going forward, the Shareholders elect the Directors each year and the Directors appoint the Officers each year. Directors control most major directional decisions, while the Officers carry out the plan established by the Directors.
Both the Officers and Directors have a fiduciary duty to act in the best interest of the Shareholders. Nevertheless, they are protected by the “Business Judgement Rule.” Provided they are not self-dealing, this rule protects the Officers and Directors. It gives them the freedom to take risks without the fear of being sued personally by the Shareholders for decisions that result in a loss. Shareholders do not make management decisions. In a Corporation, a single-person can wear all the hats and serve as the sole Shareholder, Director, and Officer (President, Secretary, and Treasurer).
Corporations are not very flexible. Statute and the Corporation’s own Bylaws limit what Shareholders, Directors, and Officers can do. Corporations, by default, do not have restrictions to prevent the other Shareholders from transferring their ownership to an adversary or others whom are not liked. To prevent unwanted stock sales, Corporations must have a separate Stock Purchase Agreement, outside of the Bylaws.
While entities may hold title to stock as a Shareholder, entities may not be corporate Directors or Officers. Only natural persons may be Officers or Directors.
Why Form an LLC in Delaware?
A Delaware LLC is more modern and flexible than a Corporation. The LLC is a hybrid, drawing upon some of the best characteristics of both a Delaware Corporation and a Partnership. What makes the Delaware LLC unique and powerful is two-way liability protection. This is available in few other states’ LLC laws or in any state’s Corporation laws. While the first shield protects owners from creditors of the business, the second shield protects the business from the “outside in” to prevent a creditor of any Member from foreclosing on business assets or taking over the debtor Member’s interest in the company.
Instead, the Member’s creditor can only obtain a “charging order” as a lien on distributions to the debtor Member without giving the creditor an ownership right in the LLC. The importance of this feature cannot be overemphasized. Only giving a creditor a right to dividends is very undesirable to the creditor. The creditor would much rather liquidate a company and get their money back. The charging order remedy stretches out payments to the creditor on a schedule. The only time payments are made is when the Manager decides to distribute profits. This can save the company and the jobs of its Members who work for the company. It can even let the debtor Member continue to work and be paid as an employee while this charging order is in place. Once the charging order is paid-in-full, the creditor goes away!
To form a Delaware LLC, the Members engage a service company to act as the authorized person to sign the Certificate of Formation for filing with the Delaware Secretary of State. Every Delaware LLC must have its Members agree upon an Operating Agreement. The Operating Agreement can be written, oral or implied. This Operating Agreement is very important because it specifies the ownership and management rights within the LLC. One example of a common provision in Operating Agreements, not found in any Corporation’s Bylaws, are transfer restrictions. Operating Agreements may have a right of first refusal on the sale of any company’s Membership interest to outsiders. If the Operating Agreement needs to be changed in the future it can be amended and restated by its Members.
The Delaware LLC can be run by its Members directly or by a third-party Manager whom the Members designate. These Members and Managers can be entities and do not need to be individuals. Some may not be aware that in Delaware LLCs, the Members are allowed to waive fiduciary duties of the Managers. This is not available in a Corporation. Waiving the fiduciary duties encourages management to run the company without the fear of reprisal. Often companies seeking outside investment, for example, private equity deals, prefer to give management as much freedom as possible. This is to prevent investor lawsuits that challenge management decisions in court.
Unlike a Corporation where the right to access books and records is unwaivable, a Member’s rights to access information can be reduced in a Delaware LLC Operating Agreement. Only the basic contractual duty of good faith and fair dealing cannot be waived. Therefore, an LLC Operating Agreement can be customized to fit almost any deal or business arrangement you desire. It is important to draft the Operating Agreement clearly because, once it is agreed upon, courts will enforce it strictly. The Delaware Court of Chancery treats business owners as adults who should be able to understand the deal they agreed upon in advance, even if it may be unfair in retrospect. The court presumes Members to be sophisticated parties and expects them to sleep in the bed they make for themselves at the outset.
In short, due to the operational simplicity and contractual flexibility coupled with the two-way liability protection, the Delaware LLC is often preferred over the Delaware Corporation.