Why Venture Capitalists Prefer Delaware C-Corps
Everybody has ideas for a startup these days—a time-saving app; a healthier food delivery service; a way to train your dog through osmosis. Before you start to count your millions, however, you’ll need to form a Delaware C corporation.
Every company that appears on “Shark Tank” is likely already a Delaware C corporation, or is prepared to become one overnight, and that is because the first requirement of every serious investor, angel investor and Venture Capitalist is the same: your company must be a Delaware C corporation before they will even consider investing in it.
Why Investors Prefer Delaware C Corporations Over LLCs?
There are myriad reasons for this. For starters, investors prefer corporations over LLCs because it is difficult to sell or transfer membership or ownership in an LLC; however, it is fairly easy to trade shares in a corporation. In addition, corporations typically offer more consistency on managerial duties and responsibilities.
Why Investors Prefer Delaware C Corporations Over S Corporations?
Delaware C corporations are preferred over S corporations from the professional investor’s perspective. This is because all shareholders in an S corporation must be U.S. citizens, residents and “natural persons.” A Venture Capital firm would not qualify as a “natural person,” thus a VC firm could not invest in an S corporation. Another disadvantage for investors is that S-Corps cannot offer preferred stock—they can only offer common stock.
Professional investors like preferred stock better than common stock, as preferred stock allows the holders’ rights to be negotiated to suit the deal. Thus, preferred shareholders can (if properly structured) get higher dividends, vote more than one vote per share and convert to common stock upon certain events. By negotiating the terms of the preferred stock, Venture Capitalists can reduce their investment risk in a company.
Last but certainly not least, S corporations can only have 100 shareholders, which could also potentially pose a problem for investors.
Why Venture Capitalists Prefer Delaware C-Corps?
Stock is a key aspect of a Venture Capitalist’s investment. C corporations appeal to VCs since Delaware law allows for two or more classes of stock. Typically, a venture funded company will have common stock, founder’s stock and several classes of preferred stock, including some convertible preferred stock which allows an investor to convert stock to common if/when the company goes public.
Delaware C corporations are also able to distribute stock options as incentives to employees, board members and directors, which VCs approve of because smart, successful and innovative employees are an essential element of success in a startup company leading to growth and profitability. Stock options are a proven and inexpensive means of motivating and rewarding ambitious and hard-working employees, board members and directors.
Taxation is another facet of investing with which Venture Capitalists are concerned. Fringe benefits can be deducted as a business expense in C corporations, so a corporation can pay all its employees benefits and subsequently deduct the amount of those benefits from their taxes as business expenses.
Typically, neither the employees nor the owners owe any income tax on the value of many common fringe benefits.
C corporations also pay very low taxes on their retained earnings (the percentage of net earnings retained by the corporation in order to be reinvested into the company), so the profits not paid out as dividends can be utilized to spur the company’s growth. Low taxes on retained earnings is unique to C-Corps.
Finally, any internal legal dispute, such as shareholders suing the Board of Directors, will be fought in the Delaware Court of Chancery, which has a long reputation for siding with the good faith decisions of the Board of Directors over the financial whims of the shareholders.
In fact, Delaware is universally regarded as the best legal forum for any business dispute due to its impartial chancellors and a large body of pro-business case law.
If you’ve already formed your company and you did not form a Delaware C corporation, you can easily convert your LLC or non-Delaware corporation to a Delaware C corporation. Delaware allows all types of companies from any other U.S. state to convert their company into a Delaware C corporation with a simple filing, which can be filed and approved in one day. That’s another advantage of Delaware—fast filings are the norm and expedited service can ensure same day, two hour or even one hour service when you need it.
*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.
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There is 1 comment left for Why Venture Capitalists Prefer Delaware C-Corps
Afzaal Mauthoor said: Friday, July 30, 2021Hi, I am based in UK and have US based VCs interested in investing but require that I am immediately a Delaware C. Would you be able to assist us? Afzaal Can we be UK based and still be directors or do we need someone local to Delaware? Can you point us in the right direction for friendly banks? Afzaal
HBS Staff replied: Friday, July 30, 2021Hi Afzaal, we will have a member of our sales team reach out to you!