Why should I incorporate as a Delaware corporation?

TLDR: There are many benefits to forming a C corporation in Delaware.

The typical VC-backed start-up company is a Delaware C corporation. This means that the corporation is formed under the laws of the state of Delaware (despite being headquartered anywhere in the world), while the “C” refers to the tax status of the corporation. There are a number of reasons that start-ups choose to form a Delaware C corporation.

Why Delaware?

• Delaware has a fair, predictable, and well-developed body of corporate law: Delaware’s corporate code is the most established corporate law in the U.S., and Delaware’s legislature is active in ensuring that the laws remain up to date. Delaware also is home to the Court of Chancery, which is a special court with judges that are experts on corporate law issues. Both the Court of Chancery and Delaware Supreme Court (which hears corporate law appeals) are known for the timely resolution of corporate disputes.
• Company directors are afforded a high degree of protection by Delaware law: A corporation’s board of directors has ultimate decision-making power to set policy and steer major corporate actions. These decisions are sometimes challenged. Although Delaware corporate law requires directors to act in the best interest of the company’s stockholders, Delaware courts will generally, absent evidence of fraud or self-dealing, defer to the good-faith business judgments made by the directors. Delaware corporate law also allows corporations to indemnify their directors in case the directors are sued in their capacity as directors.
• Complying with formal procedural requirements is easier in Delaware: Delaware law is more permissive in terms of corporate formalities. For example, the Delaware corporate code allows corporations to have one director, which is helpful for start-ups in the early stages of the business. Filings in Delaware can be made electronically and they are processed quickly by the Secretary of State. The Delaware corporate code is generally well understood by business people, lawyers, and investors, and there are fewer surprises in the law compared to other states.

Why a C Corporation?

• Standard legal documentation: A corporation is the standard legal entity formed by businesses that plan to scale. Silicon Valley law firms have largely standardized the corporate formation documents for start-ups. If there isn’t a need to customize, you can form a corporation quickly and inexpensively. Equity issuance documents have also been relatively standardized, which means that corporations are able to add stockholders easily.
• Established corporate laws: Compared to newer legal entities such as limited liability companies (LLCs), the law relating to corporations is well established (especially in Delaware). These laws cover the ownership and management of a corporation and the relationships among the stockholders, board of directors, officers, employees, debtholders, and other stakeholders.
• Simpler taxation: Taxation of a C corporation is simpler. Compared to a partnership, a limited liability company, or an S corporation, income and losses are not passed directly through to the stockholders of a corporation. This “double taxation” of income in a C corporation—first at the corporate level, and then at the stockholder level when income is distributed to the stockholders—can be viewed as a disadvantage. In the start-up company context, however, most venture capital investors and institutional investors are able to invest only in C corporations. This is because such investors are usually organized as partnerships or LLCs themselves, and investing in other pass-through tax entities severely complicates such investors’ tax situations.
• Investors insist on Delaware C corporations: For the above reasons, sophisticated venture capital investors will insist that you organize your company as a Delaware C corporation, even if you’ve already formed your company elsewhere. Transitioning to a Delaware C corporation can be a costly and time-consuming process if you’ve been operating for a significant amount of time and need to make the transition at the time of a financing or public offering. Note, however, that even if you incorporate in Delaware, you still need to comply with the laws in the state(s) where you conduct business. These requirements may include qualifying to do business as a “foreign” (i.e., out-of-state) corporation in those states and paying taxes in those locations. Despite these requirements, unless a special situation applies to your company (discussed below), resist the urge to form your company anywhere other than in Delaware or as anything other than a C corporation to save on start-up costs—doing so is a false economy if you plan to scale.

Of course, there are situations in which a Delaware C corporation might not be the best entity choice. If, for instance, you will be conducting most of your business in one location or outside of the U.S., it may make sense for your company to incorporate in a more tax-favorable jurisdiction, whether that’s another state or offshore. Legal and tax advisors should be consulted in such cases before you form any type of company.

Also, in certain circumstances, you may want to form an entity that avoids the corporate level of taxation of a C corporation. For instance, if you anticipate that your company will be closely held for the entirety of its existence, will have limited financing needs, and will generate substantial profits immediately, then you may want to consider the tax benefits of an S corporation or an LLC.

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