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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.
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.
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.
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.
THE AUTHOR OF THIS BLOG ARTICLE IS NOT A LAWYER AND HARVARD BUSINESS SERVICES, INC. IS NOT A LAW FIRM. THE ARTICLE ABOVE IS NOT INTENDED AS LEGAL ADVICE AND SHOULD NOT BE TAKEN AS LEGAL ADVICE. THIS SHORT ARTICLE IS STRICTLY TO MENTION SOME ASPECTS OF DELAWARE’S CORPORATION LAWS AND/OR LAWS RELATING TO OTHER FORMS OF ENTITIES WHICH YOU MAY NOT BE FAMILIAR WITH. WE RECOMMEND THAT YOU CONSULT WITH A LAWYER BEFORE FORMULATING A STRATEGY WHICH WILL BE SUITABLE FOR YOUR SPECIFIC CASE.