Delaware C Corp: Everything You Need to Know
Delaware C Corp laws are different from the laws found in many other states across the country
When a business owner incorporates, the owner is, according to state law, substituted for a new business that can perform all of the same functions, such as buy things, sign contracts, sell things, and hold its own positions on issues, yet is unique from the owners and assumes liability for its own actions, as opposed to holding the owners accountable for the actions and performance of the business.
The second benefit to incorporating is gaining the ability to assign the ownership stakes of a company between multiple individuals.
Starting from the beginning with shares distributed, and corporate structure aimed toward investments saves money, and time in the long run.
Dividing cofounder assets such as equity is a simple and easily-learned task for C-Corporations. This is through issuance of stocks, though it is significantly harder to understand, implement, and maintain than an LLC.
It’s critical to make sure that IP, known as intellectual property, which can mean anything from the legal ownership of a company name or logo to patents or even lines of computer code that help an app or digital product operate, belong to the entity or company, and not the owners, is protected. This is especially true in the case of startup companies with a lot of growth and upward mobility.
These businesses focus on innovation, and new technologies, and could effectively be rendered obsolete if their trade secrets were not protected adequately. These companies seek to introduce disruptive, groundbreaking techniques or technologies, and are not content to reuse the business models of old, as that is counterintuitive to modernization.
Incorporation on the part of business owners helps to ensure that intellectual property is the sole intellectual property of the startup, and not the individual owners, which ensures that the contributions of each founder will remain with the business even in the event of their leaving.
Ensuring that ownership of IP and other digital assets belongs to the company further guarantees that the company cannot be held hostage in negotiations or legal situations based on their past behaviors, and also provides justification for the sake of contributor equity, and also ensures that anything created by the IP itself can be legally thought of as part of the company’s value, which is one of the primary mechanisms that investors use to determine whether or not to buy into, and how much to spend on, a startup or a business.
A C Corporation is not a business entity type, but a tax status used for unique purposes. All corporations are C Corporations by default, unless they choose to re-register as another type of corporation, which requires filing Form 2553 with the IRS, which can grant an entity S Corporation status. Further, a company can file a 501(c) application with the IRS to facilitate a request for non-taxable or tax-exempt status.
These C corporations are entirely separate entities from their owners, shareholders, and employees, and therefore, c corporations offer very limited liability protections to directors.
The biggest and most critical differences between LLCs and c corporations are the ways in which they allow owners to divide ownership stakes, and manipulate the ways in which their incomes are taxed.
Though it is possible to develop acute workarounds an LLC can use to divide its ownership, notably through profits, which is a signal of the intention to divide profits at an unspecified or specified later date, starting when the commission was first granted, and corporate interests, which is a representation of the portion of the value of a given company should it be liquidated, though these don’t comfortably translate to ownership or stock ownership in the traditional, obvious ways that the ownership structure of a C corporation does.
LLCs lack the ability to grant their owners and members with enough options. What they lack is a common incentive structure that startups often give to their employees and staff that basically represents the ability to buy and sell ownership dividends of the company at a discounted price whenever it’s deemed advantageous, and since virtually any successful startup company with demonstrable growth will likely seek investment on a professional level, these structures have yet to be remade into more analogous c-corporation ownership units or shares.
As a direct consequence of this relatively direct divisions in a C-corporation, tax laws generally treat the ownership aspect somewhat differently. Taxes as they’re levied on LLCs are often lower, because C-Cops are charged more tax -- double, specifically. This is why so many business owners believe they should operate under an LLC when they’re first starting out.
LLC income is not taxed at the company’s level, but instead taxed at the same level for any of its owners. C-corps are taxed on the corporate level, and then taxed again at the individual level when payments are issued as dividends. Startups reinvest capital -- all of it in many cases -- in opportunities for growth for many years, particularly when starting out, instead of paying dividends. Therefore, this tax burden would rarely apply.
Many companies aren’t based in the state of Delaware and, because of this, the state developed regulatory tax laws, one of which is known as the Delaware General Corporation Law, which helped the state court systems adopt rulesets that are more friendly to corporations than almost any other legislative district in the United States. Therefore, so many companies, despite having their headquarters located somewhere else, choose to do much of their business in the tax world in the state of Delaware.
The laws in Delaware are highly favorable to companies that start there, and therefore, investors favor companies that were incorporated in that state, due to the many additional protections and options those companies have. In the eyes of an investor, that all translates to competitive advantages, which further translates to a higher potential return on their investments.
Why You Should Incorporate
Individual startups, while they may have special circumstances that they are beholden to which may suggest that they have value available to them by using an LLC format, such as immediate, steady profits, or potentially incorporating in another state, often end up being counseled to incorporate as a Delaware C-Corporation.
This incorporation process is a critical and unavoidable first step in establishing the other components of any new company’s operations. Any agreed-upon best types of legal entities for startups, which are preferred by investors, experienced founders, and most startup lawyers, is a Delaware C-Corporation.
Daniel DeWolf at Mintz Levin stated that “Incorporating as a C-Corporation in Delaware is the gold standard for high growth startups and it provides limited liability, ease of use, ease of setup, the ability to issue stock options, and tax benefits upon sale for many qualified small businesses.”
Even in this post-bubble era, incorporating in Delaware is a popular choice for many early-stage, quickly-accelerating tech startups. There are, however, some downsides to incorporating in the state of Delaware. There are extra filing fees associated with starting up there, there is an annual Delaware Franchise Tax, there are registered agent fees, as well as the additional costs of retaining corporate lawyers in Delaware who can assist in the event of an unexpected or complex legal matter.
Some international companies and non-United States citizens also prefer to incorporate, and do certain aspects of their tax business, in the state. This helps them establish a presence in the United States, and it also helps them gain quicker and easier access to American resources, which can be anything from raw materials used in the construction of a product, to American venture capital and intellectual properties.
You do not need to be a United States resident in order to form a corporation in the state of Delaware.
The state has something called the “Court of Chancery,” which is a special type of court dedicated to hearing solely corporate disputes, and tends over legal matters on the corporate level exclusively.
The corporation law, which has been formed in Delaware, is well-known, and is often viewed as favorable to business owners and entrepreneurs, and many corporate lawyers are likely familiar with the precedence and structure set forth by corporate laws in Delaware -- even courts in other states look toward Delaware and their well-established corporate law structure for guidance in ruling on their own cases.
The state of Delaware tends to be very pro-owner and pro-managements, and offers many protections for the board members of a given business entity from derivative lawsuits, which are lawsuits initiated by stockholders on behalf of a corporation.
Delaware is home to many classes of stock, and state law gives their preferred stock investors in a given corporation certain voting privileges and rights, as well as control over the corporation. Even though, in other states, it may be the case that there are different types and classes of stock, many VCs are insistent that the Delaware corporate form is mandatory, and may require a business to convert their business entity to a Delaware C corporation before conducting any further business or investing.
A lot of companies who go public are formed in Delaware, and that’s owed to the flexibility and legal protections companies that formed there are privy to.
The state of Delaware permits single-member board of directors, which is different from the state of California, which requires that the number of directors on the board of directors at a given company is equal to the number of shareholders the business has (up to three).
At the funding round, the California Secretary of State is required to review and approve all filings before they become legally effective, whereas Delaware is not a review state, which accelerates the funding process, and literally makes it more profitable for a business to operate there and incorporate there than most other places.
The standardization of these corporate entities, stock founder purchase agreements, and investor terms across the technology industry has effectively driven down the cost of formations, as well as the amount of time needed for the preparation of legal documents, making Delaware formations a major staple among high-growth tech startups in Silicon Valley, San Francisco, and others.
Venture capitalists are pragmatic, and thus, tend to prefer Delaware C-corporations when they are making their investments. Many technology companies, as a result, from their companies in Delaware, unless they have the expectation that they will have no need to seek out venture capitalists in the future. This is a rare occurrence, though it does happen.
The further West you go in the United States, the closer each state’s corporate law structure seems to mimic Delaware’s. The state of Delaware doesn’t require director or officer names to be unmasked on their formation documents, either.
Due to these rights and protections, over half of all publicly-traded companies in operation today were incorporated in Delaware, as well as over half of the Fortune 500.
Venture funds require an owner to be a Delaware C-Corporation entity, so if the owner or directors of a given business are planning to acquire venture funding at any point in the future, the owners may as well consider forming that company in Delaware from the start.
Without a doubt, corporations formed inside the state of Delaware are much more robust, privileged, and protected than corporations formed elsewhere, and are the preferred corporate structure for both venture capitalists and angel investors alike. A business owner would do well to form their business in Delaware if they planned on acquiring funding at any point. It’s a logical next step for many businesses.
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