Why Startups Should Choose the Delaware C-Corp.
What do companies like Uber, AirBnB and DoorDash all have in common? Each secured millions of dollars from venture capital firms and investors as startups. They are also all incorporated as Delaware C-Corporations.
Delaware C-Corps are the most popular entity choice for startup companies looking to attract investors. Angel investors and venture capital firms prefer to do business with Delaware C-Corps because of significant legal and tax benefits.
Why are Delaware C-Corps a good option for startups? We dive deep into what Delaware C-Corps are, how to create one, and how incorporating as a C-Corp can benefit your business.
What Is A Delaware C-Corporation, Exactly?
The “C” in C-Corp refers to a corporation’s federal tax designation. The IRS designates Delaware Corporations as C-Corps by default. However, a corporation can elect to be taxed as an S-Corporation by filing IRS Form 2553.
Many entrepreneurs get confused when trying to incorporate a C-Corp on their own. The Delaware Secretary of State provides forms to set up a “Corporation”, but not a “C-Corporation”. This is because a C-Corporation is not a distinct type of business entity. It is simply a type of tax designation.
Why Are Most Startups Delaware C-Corps?
The Delaware C-Corp is the best option for startup up companies because of specific legal and tax benefits. These benefits make it relatively easy to grow the company by trading corporate stock while protecting founders and investors.
Companies are not required to have any ties to Delaware in order to incorporate in Delaware. This means that companies located all over the world are able to take advantage of the stability and protections provided by Delaware’s General Corporation law.
Startup companies are typically high growth ventures. These types of businesses focus heavily on research and development to create new products and services with the goal of meeting emerging markets. In some cases, startups develop products for markets that do not even exist yet. These businesses require large amounts of investment capital to support rapid growth in addition to the reinvestment of business profits.
Delaware C-Corporation Benefits.
Benefits of incorporating as a Delaware C-Corp include:
- Limited Liability Protection for Investors and Founders
With hundreds of thousands of dollars being committed to startup companies, it is important that investors and company founders protect their personal assets from any business liabilities. By structuring a company as a Delaware C-Corporation, the parties involved can limit their liability to only their investment in the business. In other words, investors and founders can only lose as much as they put in.
- Business Friendly Legal Environment
Business and legal professionals refer to Delaware as the world’s premier forum for corporate law. Delaware’s advanced corporate laws, upheld by its dedicated business court, provide predictability in judicial outcomes. Corporate circles refer to this as the “Delaware Advantage”.
Delaware’s General Corporation Law allows capital allocators to feel comfortable investing large amounts in Delaware corporations. Likewise, company founders and board members enjoy the freedom to make important decisions to grow the business while protecting themselves from personal liability. Delaware courts are known for applying the “Business Judgment Rule”. Delaware does not find corporate managers personally liable for the losses of shareholders if an honest business decision results in a poor outcome. These protections are conditional on there being no evidence of self dealing by those involved.
Delaware’s acclaimed business court, called the “Court of Chancery”, has developed over 200 years worth of legal precedent. The Court’s judges, called “Chancellors”, are appointed by the state governor rather than elected, and have a record of consistently respecting the rights of business owners and investors. The high volume of corporate disputes met by the Court of Chancery, built on its depth of case law makes judicial outcomes for Delaware corporations predictable and equitable.
- Tax Advantages
Incorporating as a C-Corporation provides startups with some distinct tax advantages compared to incorporating as a S-Corporation. The most significant advantage for startup companies is the ability to roll forward financial losses. A Delaware C-Corp can account for some of its current losses in future periods to offset future gains.
A startup typically generates large financial losses in its early years as it burns cash from investors trying to develop products. Successful startups will eventually reach a tipping point where the business model becomes profitable.
At this stage, a C-Corp can account for some of its previous losses and avoid paying income taxes on its newfound profits. This allows the company to reinvest profits back into the business while only paying the relatively low corporate tax rate.
Why Do Investors Prefer Delaware C-Corporations?
In addition to strong liability protection, venture capitalists and other institutional investors prefer Delaware C-Corps because they provide more flexibility in corporate governance.
- Easier to Trade Shares
Compared to other entity types, a Delaware C-Corp can more easily transfer shares of its corporate stock. A C-Corp is also able to continuously issue more shares of its stock to sell to new investors.
When venture capital firms invest in startups, their goal is typically to help the company grow to a point where its corporate stock can be traded publicly. Early investors in private companies can realize a significant return on their investment when a company completes an Initial Public Offering, or “IPO”, and they can sell their shares on the open market.
- Stock Based Compensation Incentives
Delaware C-Corporations can also issue stock options to their employees. Startups use stock options as an incentive to attract talented individuals to the company. Early employees in a startup can make large amounts of money by helping the company grow and selling their stock options when the company goes public.
Another advantage is that a C-Corp can issue corporate stock to other business entities. This can be a useful tool for startups to complete certain business deals using equity in the company instead of cash or debt.
- Multiple Classes of Stock
A Delaware C-Corporation can issue multiple classes of stock. Venture capitalists prefer a company to have multiple classes of stock because it gives them more freedom to negotiate certain deals.
Startups backed by venture capital firms typically issue two types of stock: preferred stock and common stock. Preferred stock often comes with more privileges, like a higher dividend or an increased number of votes per share. Common stock is the type of stock typically issued to the public. Common shareholders either have reduced voting privileges, or in some cases, no voting privileges at all.
C-Corps can also issue convertible preferred stock. Convertible stock allows investors to swap their preferred shares for common shares, making it easier to trade their shares when the company goes public.
How To Form A Delaware C-Corporation.
Incorporating as a C-Corp in Delaware requires the following steps:
Step 1.) Choose a Name for Your Delaware Corporation
There are several things that company founders need to consider when choosing a name for their Delaware Corporation.
The first point to consider are naming requirements. A corporation’s name must comply with naming guidelines put in place by the Delaware Secretary of State. A corporation’s name must include an approved corporate ending. Some of these endings include:
- Fund, or;
Certain words cannot be included in a corporation’s name. For example, the name cannot contain the words “bank” or “trust”, unless the company is authorized as a bank.
Step 2.) Choose a Delaware Registered Agent
The majority of companies incorporated in Delaware are not actually located in Delaware. The law requires corporations located outside of the state to appoint a Delaware registered agent.
The role of a registered agent is to receive important legal notices, like lawsuits or subpoenas, served to the company. The registered agent must maintain a physical address (not a P.O. box) in the state of Delaware and be available during normal business hours.
Most Delaware corporations hire a Delaware registered agent service rather than opening an entire office in Delaware. Not only can a Delaware registered agent service help your company meet its legal requirements, they can also help manage and track important documents.
Step 3.) File a Certificate of Incorporation
The next step is to file a Certificate of Incorporation with the Delaware Secretary of State. The Certificate of Incorporation is the public document that officially creates the new corporation.
A Delaware Certificate of Incorporation needs to include the following information:
- The name of the company;
- the name and address of the registered agent, and;
- The total amount of authorized stock and the par value per share.
Step 4.) Prepare Internal Documents
A startup’s founders will need to prepare specific internal documents in order to set up a corporation properly. These documents include:
- The Executed Minutes of Incorporation to elect one or more directors;
- The corporate bylaws to govern the company’s internal affairs;
- The Unanimous Action of Directors to elect officers and issue stock to initial shareholders, and;
- Stock certificates issued to shareholders.
Step 5.) Draft a Stockholder Agreement
A Stockholder Agreement is a type of internal corporate document that establishes the powers and rights of stockholders. A Stockholder Agreement can place certain restrictions on when, how, and to whom a company’ stock can be transferred to.
Any corporation with more than one shareholder should have a Stockholder Agreement. Stockholder Agreements can help prevent future disputes related to valuations, buybacks and stock transfers to unwanted third parties.
Is A Delaware C-Corp Best For Every Business?
The Delaware C-Corp is not always the best choice for every type of business. A small “mom and pop” shop may not be able to take full advantage of the Delaware C-Corp. In addition, some of the extra legal requirements for C-Corps, like holding an annual meeting of shareholders, may actually be a burden on the business
The Delaware LLC tends to be the best option for most businesses that are not looking to take on outside investors. The Delaware LLC is currently the most popular business entity in the United States. This is mainly because Delaware LLCs are more flexible and easier to manage than corporations.
A Delaware LLC can always convert to a Delaware C-Corporation later on. Depending on the growth projection of the business, founders may be better off starting a company as a Delaware LLC and converting to a C-Corp once they are ready to raise funding.