As of 2019, more than 1.5 million business entities have been formed in Delaware – that’s more than 1.5 businesses per resident of the U.S.’s second-smallest state.
The reason is not that Delawareans are extremely entrepreneurial citizens, of course. Rather, Delaware is the legal home for businesses operating throughout the United States, with nearly 68% of Fortune 500 companies choosing it as their legal starting point, due solely to Delaware’s favorable corporate laws.
While you may have no expectation of needing Delaware’s corporate laws, forming your startup as a Delaware C corporation is especially important if you’re a founder who plans to seek venture capital.
Why a C Corporation? Why not an LLC?
A company can be legally formed as one of a number of different types of entities, including as a Limited Liability Company (LLC), an S corporation, or a C corporation.
LLCs and S corporations are “pass-through entities,” meaning that profit (or loss) is passed through to the owners as income, and is taxable as such. Venture capitalists (VCs) want no part of this as they are not investing solely to have any of the profits or losses of these businesses pass through to them. Instead, VCs want to invest in C corporations, where the profit and loss are ascribed to the business and not the owners, allowing losses to be used to offset future revenues for tax purposes.
Another reason why VCs prefer C corporations is that sometimes the terms of venture capitalists’ limited partnership agreements simply do not allow them to invest in any type of entity but C corporations.
So it follows that startup founders, if they hope to win VC investment, should form their companies as C corporations. Starting as an LLC and converting to C corporation later is possible, but it’s a messy and expensive process.
If a pass-through of the profits and losses to founders is really needed, a C corporation can be formed and an “S election” can be filed with the IRS. Keep in mind, though, that S corporation status is lost the moment a company adds a shareholder who is not an individual or a pass-through entity itself.
But Why a Delaware C Corporation?
Odds are you’re not going to be based in Delaware, and you may have no plans to operate in the state. So why do so many companies choose to form there?
As mentioned earlier, most U.S. companies are incorporated in Delaware as it has the most developed body of corporate law in the country and a very specialized system of courts and judges with its roots beginning in the early 20th century. Later in the 20th century a majority of venture backed private companies viewed their dream exit as an initial public offering (IPO), and so they too incorporated in Delaware. Because both the companies and venture capital investors picked Delaware for IPO reasons, standard industry templates for taking in venture capital financing emerged based on Delaware law. Venture capitalists want the security of investing using the standard business and legal benchmarks found in those templates produced by the National Venture Capital Association (NVCA).
For example, venture capitalists will want to receive preferred stock for their startup investments, and the rights and protective provisions that they require in preferred stock are specified in the same NVCA forms.
It’s certainly possible to form a C corporation in California, New York, or another locale that may be home to a startup’s base of operations, but for those that will seek venture capital, Delaware is the only place to be.
How to easily form a C Corporation in Delaware
StartupProgram.com Professional Services is focused on correctly forming a startup with the goal of winning venture capital. As part of these services, SUP will guide you through the process of forming a Delaware C corporation, and will do all the heavy lifting of creating and filing the necessary documents with the Delaware secretary of state.
But SUP is much more than just incorporation services — with our cap table, you can map out the equity distribution of your company and model how venture capital investments will affect your ownership share, and with StatupProgram.com Academy, we’ll teach you the economic and legal choices you need to form your company, guide it through rounds of financing, and grow it all the way through exit.
Delaware sign image by Famartin, CC BY-SA 4.0, via Wikimedia Commons