For any founder, deciding on the best entity structure and where to incorporate your start-up are critical decisions. You want a structure and business environment attractive to investors and venture capital firms. Many investors and venture capitalists say a Delaware C-corp is a good option. Whether it is a good option for your start-up depends on many factors.
This article will discuss C-corporations, why many favours Delaware, and possible pitfalls for non-US founders.
- What is a C-corporation?
- What makes a C-corp attractive to founders and investors?
- Why Delaware?
- Steps to set up your start-up in Delaware
- Potential pitfalls for non-US investors
What is a C-corporation?
Simply put, a C-corp is a type of corporation formed under Delaware laws. The “C” refers to the company’s tax status, not the type of business entity.
A Delaware C-corp is an excellent option for start-ups because of the legal and tax benefits. Typically, a start-up wants to grow and needs large amounts of investment capital to achieve its goals.
What makes a C-corp attractive to founders and investors?
- Limited liability protection
Founders and investors invest millions of dollars and often quote limited liability protection as one of the main benefits of a Delaware C-corp. A C-corp is an entirely separate entity, unlike a partnership, where business owners put their personal assets at risk if the business loses money or is sued.
C-corp owners, shareholders, directors, and officers’ liability is limited to the value of the capital they invested in the business. Their personal assets are protected from any business liabilities.
- Easy-share trading
The goal for many start-ups is to “go public’, making a Delaware C-corp a very suitable option to start with.
A C-corp can continuously sell and issue new shares to investors. It can also issue multiple classes of shares. Typically, a start-up will issue preferred and common shares. Venture capital firms like different classes of shares since it gives them flexibility when negotiating deals.
- Share incentives
Start-ups use share options as an incentive to attract and retain talent. A Delaware C-corp can issue stock options to their employees. They can make lots of money if they sell their shares when the company goes public.
- Raising capital
A Delaware C-corp is the entity preferred by most venture capital firms. Most US start-ups use Delaware C-corps.
Delaware is generally considered an investor-friendly jurisdiction and very popular with US VC investors.
You do not need to have an office in Delaware to incorporate your business in Delaware. If you are located outside of the US, you must appoint a Delaware-registered agent. You will use the agent’s address, and the agent will receive all relevant legal documents on your behalf.
The agent will assist you in complying with all Delaware legal requirements. As long as you comply with all the legal requirements, setting up a C-corp in Delaware is relatively straightforward. Delaware boasts that it can be done in a day or two.
The cost of incorporating in Delaware is also very affordable. C-corps are the cheapest of all global options for investable companies for start-ups.
Steps to set up your start-up in Delaware
- Choose a name for your corporation.
- Check with the Delaware Secretary of State if the name is available – the Delaware Division of Corporations keeps a register of all business names. The name may not be the same as an existing registered business name. Other specific rules include that the name may not be offensive, you cannot use “bank” or “trust” without special permission, and it must contain specific terms such as “company”, “incorporated”, “foundation”, etc.
- File a Certificate of Incorporation with the Delaware Division of Corporations – you must provide the company’s name, purpose, number of shares and registered agent. Once this certificate is returned to you, your corporation is active.
Once incorporated, you must comply with all the ongoing legal requirements, such as:
- Issue shares to the founders and prepare shareholders’ agreements.
- Appoint officers to run the day-to-day activities of the company.
- Adopt Delaware Corporation bylaws. Delaware corporate law is flexible and stipulates the following:
“… bylaws may contain any provision, not inconsistent with law or with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees…”
In essence, your corporate bylaws determine how your company will operate. It sets out the relationship between board members, officers, and shareholders. The content of the bylaws may vary (as long as it complies with the law) and depends on what the initial board members want to include.
- Obtain an Employer Identification Number from the Internal Revenue Service. If you want to open a US bank account or hire employees in the US, you need an EIN.
- File an annual report with the Delaware Division of Corporations and pay the annual franchise fees.
- Pay annual fees to your registered agent.
- Keep accurate financial records.
Aside from ease of set-up, the main reasons why Delaware is a popular jurisdiction include the following:
- Favourable and predictable legal system
Delaware has a well-developed body of corporate law. Business owners enjoy protection from personal liability by a “corporate veil,” making Delaware very attractive to start-ups.
Its separate Chancery Court is highly respected for its business expertise. The judges are experienced business lawyers who know how to deal with disputes effectively.
The combination of well-established laws and a highly sophisticated court system makes for a particularly favourable legal jurisdiction to do business in. It provides predictability which is attractive to investors.
- Flexible corporate governance
Delaware allows flexibility in structuring corporate governance and management, which is attractive to VCs. Corporations can choose which operating procedures work for them. There are only a few requirements, all designed to protect investors.
Founders are free to make decisions to grow the business whilst enjoying protection against personal liability. Founders will not be held liable for ethical business decisions, even if the outcome means losses to the shareholders.
- Investor familiarity
Many VCs are familiar with Delaware C-corps and prefer investing in this entity type because of its standardised legal structure. Investors feel comfortable investing large amounts in a Delaware c-corporation.
Delaware provides a higher level of privacy for corporations compared to other states. For example, you don’t have to disclose your directors’ and officers’ names. You only need a registered agent.
- Access to capital
Delaware is recognised as a business-friendly state, which may help attract additional investors and facilitate access to capital.
Overall, the combination of a predictable legal system, flexible corporate governance, investor familiarity, privacy, and access to capital make Delaware C-corps a popular choice among US VC investors.
Potential pitfalls for non-US investors
Now, if the founders are US citizens, the start-up operates in the US, and you manage the company in the US, registering as a Delaware C-corp makes much sense. However, it may not be so straightforward for non-US investors considering investing in a Delaware C-corp.
Non-US investors may face several potential pitfalls. Here are a few to be aware of:
- Tax implications
A Delaware C-corporation is a taxable entity. It pays 21% corporate income tax on worldwide earnings. Shareholders must then pay personal income taxes on their dividends. Non-US investors may be subject to US tax withholding requirements on dividends and capital gains earned from the investment, which could impact the overall return on investment.
The corporation must also pay an annual Delaware franchise tax based on the value of its corporate shares.
- The legal system
US laws will apply to you and your business even if you otherwise operate entirely outside the US. Although Delaware has a predictable legal system, any company incorporated in the US is exposed to litigation in the US. You might need to retain a lawyer familiar with Delaware and federal laws. Foreign investors might also be reluctant to invest in a system where they don’t fully understand their rights and obligations.
- Regulatory compliance
If you don’t have an office in Delaware, you need to hire a registered agent in Delaware. This recurring annual fee could add additional costs. You must also file annual reports, even if you also file somewhere else.
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There are advantages and disadvantages to operating as a Delaware C-corp. You should seek professional advice to consider the pros and cons before deciding whether to incorporate your start-up as a c-corp in Delaware.