When we looked at starting our company, especially those planning on raising money, there was a smorgasbord of types of companies available. https://dwightyellen.com/summary-of-entity-forms/ But the requirement for every VC fund, angel investor, or any serious investor is always the same: you must form a Delaware C corporation.
But I Thought LLCs Were So Flexible!
Well, they are. But over many, many years investors have grown used to being to trade shares in a corporation. Corporations have more consistent management provisions than LLCs.
Why Do Investors Prefer C Corporations S Corporations?
All shareholders in an S corporation must be U.S. citizens, residents and “natural persons.” And there can be only 100. A VC firm would not qualify as a “natural person,” a VC firm could not invest in an S corporation. Another disadvantage for investors is that S-Corps can only offer one class of 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, receive a liquidation preference, vote more than one vote per share and convert to common stock upon certain events. Using preferred stock VCs can minimize adverse exposure in a company.
Why Do Venture Capitalists Prefer Delaware Corps?
Stock is a key aspect of a VC’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 convertible preferred stock which allows an investor to convert stock to common if/when the company goes public.
Delaware C corporations can also 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 deduct those benefits from their taxes as business expenses.
Long History of Analyses of Corporate Law
Finally, any internal legal dispute, such as shareholders suing the Board of Directors, will be fought in the Delaware Court of Chancery, with a long reputation for siding with the good faith decisions of the Board of Directors over the financial whims of the shareholders.
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 incorporated somewhere else, all is not lost. You can easily convert your LLC or non-Delaware corporation to a Delaware C corporation. Delaware allows many 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.
Feel free to contact me with any questions you may have.