I am Founding a Startup and Hoping to Raise Venture Capital Funding in the U.S. Which Type of Entity Should I Form?

    • MoFo ScaleUp Team

As a startup founder, you’ve got a list a mile long of complex choices that you need to get right—finding the right co-founders and key team members, perfecting the pitch, and fine-tuning the MVP tend take the limelight—but one critical choice is picking the optimal type of business organization for your new venture.

At the highest level, when deciding on which type of business entity to form, founders should consider issues such as 1) legal liability for the business’s obligations, 2) tax treatment, 3) equity incentivization of employees, and 4) financing efficiency.

For most founders, the decision usually comes down to picking either a corporation or a limited liability company (“LLC”).

Corporations provide their owners with limited liability and make incentivizing employees with equity relatively simple. Moreover, most VC firms require their portfolio companies to be set up as corporations because corporations: (1) are the most efficient vehicle for structuring preferred equity investments, (2) are more straightforward in terms of attracting and retaining talent via equity incentives such as stock options, and (3) do not have the flow-through taxation aspects that partnerships and LLCs have.

As far as tax, corporations by default get “double-taxed,” meaning that the corporation itself gets taxed on income, and stockholders also pay taxes on any dividends. However, startups and emerging companies rarely pay dividends, and so stockholders generally do not incur tax liability until funds are distributed to them, which usually happens when there’s an exit event (other than taxes associated with 83(b) elections). See client alert.

In short, any concerns of being over-taxed by this “double taxation” feature are not particularly relevant for the average startup.

On the other hand, an LLC is a legal entity that provides its members, you guessed it, limited liability. Like stockholders in a corporation, members in an LLC are generally not liable for the LLC’s obligations.

The ownership structure of an LLC can get tricky though, especially if employees and other service providers find their way onto the cap table (noting that equity compensation is usually a key component of attracting people to work with a startup). Unlike with corporations, where optionees and stockholders are bound by the certificate of incorporation and bylaws by default, in order to be bound by an LLC’s operating agreement members or equity holders actually need to become parties to the operating agreement. Aside from the logistical complexities, most founders are reluctant to show rank-and-file employees all of the rights, preferences, and privileges that founders and investors may have. Given the taxation and general structure of LLCs, establishing and properly maintaining equity incentives can be significantly more costly and error-prone than in the case of a corporation.

Finally, an LLC is by default a “pass-through” entity, meaning that profits and losses flow through as tax obligations to its members, much like a partnership. This aspect of an LLC structure is disfavored by VCs since investors are reluctant to invest in “pass-through” entities where they may be attributed periodic profits without being guaranteed distributions—VC funds are designed to profit from exits of their equity positions, not deal with day-to-day operating profits and losses of portfolio companies.

While there isn’t a one-size-fits-all answer, founders who want venture capital financing are likely to be best served by setting up a C-Corporation in the State of Delaware. In fact, VC firms usually mandate such a structure as a condition to investing.

So, you mentioned Delaware… why Delaware?

In addition to choosing which type of entity to form, founders must also pick a state to form/incorporate the company in.  While founders are free to pick from any of the 50 states, an overwhelming majority of startup companies (and public companies) choose to incorporate in Delaware. In fact, about 68.2% of Fortune 500 companies (Amazon, Disney, and Google, to name a few) formed/incorporated in Delaware, and approximately 79% of all U.S. initial public offerings in 2022 were registered in Delaware.

So, why Delaware? One reason is that investors generally prefer Delaware because of its popularity and resulting familiarity amongst other investors, entrepreneurs, and lawyers alike. Investing in startups is a risky business, and unsurprisingly, investors like to reduce uncertainty and transaction friction. Because Delaware provides a familiar playing field for everyone in the startup space, it has become the de facto state for formation/incorporation.

Another reason Delaware has gained popularity over time is due to its well-developed, familiar, and generally Company-favorable corporate laws. Due to the long-standing history of the Delaware General Corporation Law (the “DGCL”) and the abundance of precedent from Delaware’s Court of Chancery, a special court in Delaware that decides corporate law issues, Delaware law can provide stability and predictability in resolving disputes. As it happens, those laws and decisions have turned out to generally be Company/management favorable, as opposed to stockholder favorable, further contributing to its popularity.

Apart from familiarity amongst key players in the space and its Company-favorable laws, practical considerations, such as simple filings and quick turnaround times, also make Delaware the preferred place to form for sophisticated parties, not to mention that, when structuring preferred equity financings, companies and VCs alike tend to favor the NVCA (National Venture Capital Association) forms (National Venture Capital Association – NVCA), which are modeled on Delaware corporations.

Disclaimer This article has been prepared for informational purposes only and does not constitute legal or other professional advice. You should consult a legal professional for questions pertaining to your specific situation.