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What Business Entity Is Best For A Startup

Written June 4, 2017

Woman in a meeting

We hate to give a lawyer answer, but . . . it depends. Are you selling cookies or software? Do you think you'll be seeking venture capital down the line? How many people are starting the business?

If you're seeking funding, the answer is *almost* always, a C Corporation that is incorporated in Delaware.

Local businesses (cookies) incorporate for liability protection. If someone trips and falls in the store, the owners can't personally be sued.

Startups (software) incorporate for much more than liability protection.

The incorporation of a startup provides:

  • the framework under which founders are issued equity (ownership) in the company; and
  • the transfer of intellectual property from the founders to the company.

A countless number of problems arise if this is not done properly. Agreements between founders, vesting schedules, and technology assignment agreements, can absolutely be the difference between the success or failure of your startup.

“Isn't an LLC or S Corporation Better for Tax Purposes?"

You've likely heard of double taxation and pass-through taxation. Generally, neither are applicable to the startup because startups are not profitable. Double taxation applies if a corporation makes a profit, which is taxed at the corporate level, and then distributes the profit to the shareholders in a dividend, which is taxed at the personal level. As you are aware on a daily basis I’m sure, most startups aren't profitable and once they are, they don’t necessarily pay dividends. Further, founders salaries are deductible as a business expense and so there’s no double taxation there either. Pass-through taxation allows the owners of a business to deduct the losses of that business on their personal income taxes, but this only applies if the business has income. Most startups I’ve worked with have no income to take the deduction from or the income is so low that the financial benefit doesn’t outweigh the other factors which make a C corporation the best entity choice. Another reason to avoid forming your company as an S corporation is that S corporations cannot take investments from business entities. If you accept funding from a business entity, your corporation automatically converts to a C corporation and you cannot revert to an S corporation for five years. S corporation status can be an important tax mechanism down the line so it doesn’t make sense to waste it at a time when you’ll likely be taking funding from business entities.

“Why Delaware?"

The short answer is because that’s what VCs want to see. Some will go as far as to say they won't even entertain a pitch from a company that's not incorporated in Delaware. They have good reason to feel that way. Delaware corporate law is THE corporate law. The statutes are thorough and have a ton of caselaw interpreting them, which means the laws are very clear. No one winds up paying lawyers exorbitant fees to structure a deal.

make sure your new venture is legally sound

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