Despite the fact that LLCs are quick and easy to start, Delaware C-Corps are the unequivocal standard for venture-backed startups. To ensure founders are making informed decisions for their companies, this post brings together our collective knowledge on the major pros and cons of incorporating as an LLC versus a Delaware C-Corp.
Key features of an LLC
An LLC, short for limited liability company, allows founders to limit their personal liability (just like with a corporation) in running a business while also benefiting from certain tax advantages, discussed below.
Ease of formation
One reason some founders will choose to form an LLC is that it is simply a quick and easy process. However, the effort saved in forming an LLC, in the beginning, is often outweighed by the complications and expenses this decision incurs down the road as the company scales (especially if following the venture-backed life cycle).
As mentioned above, LLCs offer certain tax advantages that corporations do not. The prevailing advantage is known as pass-through taxation, which means there is not any entity-level tax and instead all of the profits and losses of the LLC pass through to the members (owners) who are then taxed at their individual rates. Corporations, on the other hand, are taxed on the income the business generates and the owners are still taxed at the individual level when they receive distributions from the corporation, for example—this is where the term double taxation comes from.
While this may sound like a no-brainer reason to form as an LLC—to take advantage of losses the LLC incurs in the early days on your personal founder tax returns—as we’ll see later in the post, there are other factors to consider in the grand scheme of running a business, such as whether or not you plan to raise venture capital, in which case forming, or having to “flip” to, a Delaware C-Corp will likely be required.
LLCs offer more personalized and nuanced structural choices from which certain businesses benefit such as real estate companies, investment firms, and small businesses. However, for startups, where growth is often paramount, these same LLC customizations can translate to unnecessarily intensive legal work as a company begins to scale and require more sophisticated administration (leading to higher legal bills and operational headaches) related to matters like employee equity issuances.
As my colleague, Lyman Thai wrote in a Legal Insights post:
“Governance structures in corporations are generally standardized and well-understood no matter the size of the corporation, but LLC governance structures are almost endlessly customizable. Many of the routine tasks that are accomplished in corporations are less straightforward in an LLC and require significant legal and tax structuring. Among other examples, issuing stock or options to employees in a corporation is a relatively simple and well-understood process. In an LLC, however, this process requires creating and issuing ‘profits interests’ to employees with additional administrative costs due to employment and tax issues.”
Key features of Delaware C-Corps
Like LLCs, corporations allow founders to limit their personal liability in running a business.
While there are several different types of corporations (e.g., S-Corporation and C-Corporation), the Delaware C-Corporation, in particular, has become pervasive in the venture-backed startup space. Just over a century ago, the state of Delaware made a conscious effort to become a favorable entity formation state for businesses. The effort was successful and the result is that Delaware now has a steady, time-tested body of corporate law—which all adds up to businesses having legal predictability compared to other states’ corporate law that is just developing.
Better suited for raising venture capital
A large part of the reason why Delaware C-Corps are advantageous for startups is that they are attractive to venture capital firms, and have become the standard for the type of company these firms invest in. Reasons that venture funds prefer corporations to LLCs include the ease of selling and transferring ownership, the more consistent corporate governance processes, fewer tax complications, and scalability without customization such that funds can have a standard investment playbook.
Most, if not all, institutional investors (i.e. your typical VC fund) are not willing to invest in an LLC or are unable to do so due to prohibitions in the fund’s formation documents.
Whether a fund does twenty or two hundred deals a year, negotiating the financing of a corporation has become fairly standardized, making these types of deals predictable and streamlined. Asking a fund to undergo this process with an LLC increases deal complexity for them and increases the transaction costs. Many funds will require you to convert to a Delaware corporation in order to receive investment, which can be a complex process that merely delays getting funds into your bank account. For example, Y Combinator requires you to be a Delaware corporation in order to receive their investment and participate in the program. We have handled a lot of entity conversions in connection with startup’s admission into Y Combinator and it is rarely a simple and painless process.
Little or no custom legal work
Delaware C-Corps are set up “right out of the box” to support the processes and actions that a hyper-growth company will undergo, so there is less custom legal work required during the company’s lifecycle. One of the most common instruments used for raising seed capital, for example, the Y Combinator SAFE, is written for an investment in a corporation, not an LLC. If you’re an LLC using SAFEs to secure capital, you now have to customize that document accordingly—which can affect time, legal costs, and the entire success of your fundraising round. For example, the form of SAFE refers to stock (which only exists in a corporation) whereas an LLC cannot issue stock and instead has either units or membership interests. Thus, you can’t just download a SAFE from YC’s website and plug and play the form with your LLC.
The last key feature to point out here is that Delaware C-Corps are much more scalable than LLCs. For example, as you get more members in an LLC, there are a lot more compliance issues to deal with and structural customization that needs to happen in order to make it work. This is not to say that it can’t be done, it’s just that it will become more time-intensive which means higher legal spend.
Something founders don’t always consider when forming a startup is the eventual process of issuing equity to employees and the various tax consequences that come with different entity types. Issuing equity to employees in a corporation is a very tried and scalable process.
With LLCs, depending on how you structure your incentive plan, this can create a lot of administrative problems (as Lyman noted above) for your employees, and in the likely event that your startup eventually flips to a Delaware C-Corp you could end up wiping employee equity off of your cap table due to complicated tax issues.
Choosing between LLC and Delaware C-Corp
If you plan to grow and scale a startup, hire hundreds or even dozens of employees, and raise venture capital, forming as a Delaware C-Corp is the easy choice. Forming as a corporation may seem like slightly more work in the beginning, but it can save you headaches as you grow. While a Delaware C-Corp appears more rigid and offers less customization than an LLC, this will save you from paying for complex legal work, later on, to make the LLC work. When the time comes to raise from institutional investors, you’ll be a much more attractive investment prospect that incurs fewer complications for your new investment partners.
Check back for the next post on this topic where I’ll explain how startups can determine if they need to flip to a Delaware C-Corp.