When it comes to registering your startup, you’ll need to address two important decisions: (1) incorporating in Delaware versus your state of residence, and (2) choosing between an LLC and a C-Corp. This guide explains why, in 99% of cases, a Delaware C-Corp is the best choice for venture-backed startups.
Small Business vs. Startup:
Before diving into the details of incorporation, let’s clarify the distinction between a small business and a startup. This distinction will determine your funding strategy, growth potential, and the best legal entity for your business.
Key Differences:
- Growth Potential:
- Startups: Aim for rapid growth and scalability, often pursuing innovative solutions to disrupt or create new markets.
- Small Businesses: Focus on steady, incremental revenue growth, often targeting local or regional customer bases in established markets.
- Exit Strategy:
- Startups: Plan to scale quickly and exit through acquisition or IPO, often resulting in substantial financial rewards for founders and investors.
- Small Businesses: Typically aim to build long-term, sustainable businesses with stable cash flow and eventual acquisition.
To Determine if You’re a Startup:
Ask yourself:
- Is there a viable path to generate $100M in Annual Recurring Revenue (ARR) within five years?
If the answer is "no," your business likely aligns more with small business characteristics. Small businesses often benefit from LLC structures due to their simplicity and pass-through taxation, while venture-backed startups almost always require the scalability and tax advantages of a C-Corp.
Why Incorporate in Delaware?
Delaware is the gold standard for incorporation, offering unique advantages that make it the preferred choice for startups and established corporations alike.
Key Benefits of Incorporating in Delaware:
- Established Corporate Law: Delaware has a well-developed legal framework and a Chancery Court that exclusively handles equity-related cases. This provides fast, predictable outcomes for businesses.
- Investor Familiarity: Venture capitalists and their legal counsel expect startups to incorporate in Delaware because its laws are well-understood and investor-friendly.
- Governance Flexibility: Delaware’s corporate governance laws are designed to accommodate startups as they scale, offering flexibility in structuring ownership and equity.
Why C-corp. vs an LLC?
In 99% of cases, I recommend registering your startup as a Delaware C-corp.If you're planning on raising venture capital and issuing equity awards to service providers, I recommend opting for a standard Delaware C-corp. In my many years of legal experience, I've seen only a few startups formed as LLCs. And here are the examples:
- When a startup is not a startup.
The first scenario is when a startup is not really a startup but a small business. The fact that an LLC is not subject to double taxation may make it a more attractive entity choice for a small business, especially if the founder knows the small business won't grant many service providers equity or have a lot of investors (or any institutional investors).
- When the QSBS does not apply, and founders want to distribute profits to themselves.
Typically, high-growth startups don't make distributions as they reinvest cash into their growth. However, there are rare exceptions. For instance, I've seen a web3 startup that generated more than $100M from the outset, and the founders wanted to distribute some of that cash to themselves. Since they've already exceeded the $50M threshold, the QSBS exemption no longer applies. This situation is extremely rare, and investors generally resist it. Unless you're a highly sought-after startup generating substantial revenue right from the start, you would need to convert your LLC into a C-corp if you later decide to seek venture capital. This conversion can be a complicated and costly process, requiring the involvement of lawyers and tax professionals.
A few disadvantages to consider when registering your startup as an LLC:
- The process of issuing equity awards becomes complicated. In an LLC, you would need to issue membership units to individuals, which would be taxed as ordinary income rather than capital gains.
- Foreign investors might be required to file a U.S. tax return. An LLC is taxed as a partnership, meaning the tax liability is passed on to its members. Consequently, your investors could potentially establish a permanent presence in the U.S., necessitating any foreign investors to file a U.S. tax return – a situation many investors find undesirable.
- Legal fees can increase significantly. If you pursue equity financing as an LLC, you can expect legal fees to be much higher than those for a standard C-corp. In a regular equity financing, I typically use standard NVCA documents. However, when I represented an investor investing in a high-profile startup that generated over $100M in revenue from the start and was formed as an LLC, all those NVCA documents had to be incorporated into the operating agreement and subscription agreement. This necessitated almost drafting from scratch and meticulously reading every word. You don't want a lawyer charging $1k an hour to scrutinize every single word of your 80-page investment documents. It was the most complex and expensive equity round I've managed – good for lawyers (we made a substantial profit), but not so advantageous for the business folks involved.
- Accounting fees are also likely to rise. Annual tax compliance and accounting service fees will generally be higher in an LLC (typically, you can anticipate an additional $10k per year)
Founder FAQ:
Founder: “If I start my company in Delaware, do I need to move there?"
No, but you’ll need a Delaware registered agent (typically $50/year). If you operate in another state, you may also need to register your Delaware corporation as a foreign entity and hire a registered agent there.
Founder: "Why not an LLC? Doesn't it have fewer formalities and no double taxation?"
While it’s true that an LLC has fewer formalities and avoids double taxation, one of the most significant advantages of using a C-Corp is the favorable tax treatment it offers to both you and your investors, particularly in relation to Qualified Small Business Stock (aka QSBS).
Founder: "What is QSBS and why should I care?"
QSBS is a special stock that meets the requirements of Section 1202 of the Internal Revenue Code (IRC).
If you acquired QSBS after September 27, 2010, you might qualify for a 100% exclusion of the gain from the sale of your stock.
- The 100% gain exclusion applies to federal tax only. Some states, like California, do not follow this federal tax treatment. Nonetheless, a 100% federal tax exclusion is a significant benefit.
- The exclusion is limited to the greater of $10 million or 10 times the holder's adjusted tax basis, up to a maximum of $500 million.
Example:
If you purchased founder stock for a nominal price near $0 and sold it for $10M after five years, you would not pay any federal capital gains tax if it qualifies as QSBS.
Founder: "The max benefit is $10 million?"
It’s possible to increase this maximum amount by gifting shares to other taxpayers, each of whom has their own $10M limit.
Example:
If a founder owns $30M worth of QSBS, they could gift $20M to two other taxpayers, each of whom would have their own $10M exclusion limit. If all eligibility requirements are met, this could result in a total exclusion of $30M.
However, it’s critical to consult a tax professional before making any decisions regarding QSBS or gifting shares.
Founder: “Sounds amazing. How do I qualify for QSBS?”
The requirements are somewhat complicated, but most early-stage startups meet them:
- U.S. C-Corp: The company must be a C-Corp, not an S-Corp, LLC, or partnership.
- Original Issue: Stock must be purchased directly from the company.
- Gross Assets: The company must have no more than $50M in gross assets before and immediately after the stock is issued.
- Active Business: At least 80% of the company’s activities must involve a qualified trade or business (professional services like law, consulting, and financial services do not qualify).
- Five-Year Holding Period: QSBS must be held for at least five years before the sale.
Founder: “Can I reinvest gains from QSBS without paying taxes immediately?”
Yes, Section 1045 allows both founders and investors to defer capital gains taxes by rolling over QSBS proceeds into new QSBS within 60 days of the sale.
Example:
A co-founder sells their shares in a startup for $5 million after holding them for more than six months. Within 60 days, they reinvest the $5 million into a new startup by purchasing QSBS. The $5 million in exit money is not taxed immediately, as the co-founder deferred their capital gains tax under the QSBS rollover provision. If the new QSBS is held for five years, they may qualify for the full Section 1202 exclusion on the gains from the new stock. This provision provides flexibility for founders and investors to continue supporting startups while avoiding an immediate tax burden.
Founder: “What can go wrong with QSBS?”
Even if you meet all requirements, QSBS can be disqualified in certain scenarios:
- Substantial stock repurchases, especially those exceeding the de minimis thresholds. If the company repurchases stock during the restricted period, the stock may lose its QSBS eligibility. Learn more in our QSBS Checklist.
- If the five-year holding period is not met.
- If the company exceeds the $50M gross asset limit.
It’s vital to work closely with your legal and tax advisors to ensure compliance.
Founder: “If I already registered my startup as an LLC, what can I do to take advantage of the QSBS?”
To qualify for the QSBS, your startup would need to convert from an LLC to a C-corp.As long as the assets of the LLC are valued at $50 million or less at the time of conversion, the gain exclusion is determined based on 10 times the fair market value of the assets of the LLC at that time. This is due to a rule that treats the basis of property as equal to its fair market value when it is contributed to the C-corporation.The same rule applies if the startup were formed as a C-corp but the founders contributed valuable IP or other assets to the C-corp at the time of formation.For example, if the startup is worth $49.9 million at the time of conversion, the maximum QSBS gain exclusion (across all founders) is $499 million, compared to the standard $10 million limit. However, note that capital gains tax would apply to the first $49.9 million in proceeds before the QSBS exclusion kicks in.
Founder: “So it’s best to start as an LLC and before hitting $50M in gross assets convert to a C-corp.?”
No. Generally, this strategy isn’t recommended unless your startup won’t need to raise capital from venture funds for a while (because VC funds will push you to convert into a C-corp), or if you are a serial, sophisticated founder who can time the C-corp conversion to coincide with the maximum QSBS benefit. And even then, things might go wrong with this strategy. Here are some examples:
- Your startup isn’t a home run. A home run in the venture world is typically considered to be a 10x return on investment (ROI) or greater. In the example above, the first $49.9 million of gain is subject to capital gains tax. So if the company hits a “single” or “double,” rather than a “home run,” this approach could result in a higher tax on the founders upon exit than would be paid if the company were originally formed as a C-corp, and all shares qualified for QSBS treatment.
- You have to sell your shares before the 5-year holding period. Waiting to convert to a C-corp will delay the start of the five-year holding period. So, if you wait too long to convert and sell your stock in a taxable transaction before the five-year holding period expires, you could lose the QSBS benefit entirely. While there are a few potential exceptions regarding the "tacking" of holding periods and "rolling over" in a tax-free exchange, these fall outside the scope of this post. To learn more, it's best to consult with a tax professional.
- Investors might be unhappy. Because the value of the company at conversion counts toward the $50 million asset limit, the founders are effectively using up some of this limit. So, there may be less ability to provide the QSBS benefit to other investors. In order to minimize the loss of QSBS benefit for investors, it's important to consider whether the extra basis can be gradually reduced through depreciation or amortization over time.
- Service providers might be unmotivated. Once you convert to a C-corp with the higher valuation for purposes of maximizing the QSBS benefit, the company’s valuation for purposes of granting employee equity will likely be higher as well.
- Congress might get rid of the QSBS. In 2021, Congress proposed to reduce the 100% gain exclusion to 50%, but it did not pass. Who knows what happens in the coming years.
Overall, starting as an LLC has its downsides. LLCs are less common and may be less understood by investors and employees. Additionally, setting up and managing an LLC can be more expensive from both legal and tax perspectives. For example, the company is required to provide K-1s to members and treat members as self-employed.Given the complexities involved, it's advisable to seek assistance from an experienced accounting firm to ensure the conversion is executed properly, which can be a significant expense.
Founder: “Do investors care about whether my startup is a C-corporation?”
Yes, they care a great deal and generally expect you to register your startup as a C-corp for the following reasons:
- QSBS treatment. A C-corp is essential for the QSBS treatment, which can save a lot of money on taxes. If your investors qualify, it allows them to take $10M or 10 times their investment free of capital gains tax. This significant sum makes investors pay close attention to the QSBS and require the company to covenant in the investment documents that it won't jeopardize the QSBS qualification.
- QSBS rollover. Section 1045 allows investors who have held QSBS for more than six months to defer recognizing gains from the sale of the stock if they reinvest the proceeds in another QSBS within 60 days from the sale. By doing so, they defer capital gains taxes until the newly acquired QSBS is sold. This rollover provision offers a tax deferral opportunity for investors who wish to continue investing in startups without immediately recognizing and paying taxes on their gains.
- UBTI rules. You may already know that venture funds have their own investors, often referred to as limited partners or LPs. Many of these LPs are tax-exempt entities such as pension funds or endowments. Another factor that influences why venture investors generally prefer investing in C-Corps over LLCs is the Unrelated Business Taxable Income (UBTI) rules imposed by the IRS. UBTI can be generated from an LLC's business operations, and tax-exempt entities might have to pay taxes on this income. Conversely, C-Corps do not generate UBTI for their investors.
These are the reasons why venture funds will push you to convert an LLC into a C-corp. before investing.
Founder: “How to Set Up a Delaware C-Corp”
Here are your options:
- DIY Route: Start with our free startup launch checklist or watch this free YouTube guide.
- Startup Launch Package: If you’re building a venture-backed startup, ensure everything is done right from the beginning with this lawyer-assisted package. It includes incorporation, equity issuance, incentive plans, cap table setup, templates, and an investor-ready data room.
Final Takeaway
For startups planning to raise venture capital and scale quickly, a Delaware C-Corp is the clear choice. Its benefits—ranging from QSBS tax exclusions to scalability and investor appeal—make it the gold standard for founders.
Disclaimer: This post is for informational purposes only and does not constitute legal or tax advice. Consult professionals for tailored guidance.
