Selecting Entity Type for Incorporation

Before you’re ready to incorporate, you’ll have to decide how to structure your company, and selecting an entity type and where you incorporate is the next step. Here, I’ll describe the most popular options for startups looking to fundraise in the US and why they’re attractive options.

Corporations

Generally, because startups are expected to be high-growth companies, incorporating as a corporation rather than an LLC or any other entity type makes the most sense. Among the benefits of corporations are: 

• the availability of employee incentive stock plans, making it easier to hire and retain top talent
• ease of structuring preferred equity investments and thus the ability for VCs to exit through their equity positions, and
• minimizing potential personal liability provided that certain requirements are followed. 

In fact, most VCs require their portfolio companies to be corporations for all the above reasons, as opposed to LLCs or any other entity type.

Delaware C-Corporation 

There are a few key reasons startups incorporate in Delaware, the principal ones highlighted here: 

• Investors also usually expect a startup to be a Delaware corporation as it’s become an industry standard for most companies, and other entrepreneurs, attorneys, and VCs are familiar with its structure. 
• Delaware corporate law is well established and generally favorable to companies, so when it comes to resolving disputes, Delaware law provides stability and predictability. 
• Filings with the Delaware Secretary of State are quick and straightforward, both with incorporation and filing yearly franchise taxes. 

There is also the issue of the minimum number of Board members required. California requires at least 2 board members when there are 2 shareholders, and at least 3 board members when there are 3 or more shareholders, while Delaware requires at least 1 board member regardless of the number of shareholders. Most startups choose to have the minimum number of Board members allowed for voting reasons and for faster decision-making in a rapidly changing environment, making the California shareholder requirement potentially burdensome. 

California C-Corporation

Despite the benefits of incorporating in Delaware, there are still some scenarios where it may make sense to incorporate as a California corporation. The first reason is for tax reasons. A company incorporated in Delaware will pay Delaware franchise taxes, but it may also have to pay California corporate taxes if the company’s primary operations and at least 50% of its shareholders are located in California. That means the company would pay corporate taxes in 2 different states. In that scenario, it may make sense to incorporate in California and it’s worth checking with an attorney on this at the incorporation stage or at a later point to fully understand the tax implications. 

Conclusion

These are only a few of the reasons it makes sense for most startups looking to raise capital in the US to incorporate as Delaware corporations, and not LLCs, partnerships, or other types of entities. These other entity types have varying tax obligations, restrictions on the number of shareholders, and voting rights in the management of the business, which may restrict the growth of a startup and its ability to raise capital in the future.

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