Delaware

Should You Convert Your Startup From A California LLC To A Delaware Corporation?

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This article was originally published on Forbes. By: Doug Bend Most California LLCs that are small businesses never convert to a Delaware corporation for five reasons. 1. In addition to paying the California annual franchise tax you would also need to pay the Delaware annual franchise tax. 2. You would also need to have a… Read More

This article was originally published on Forbes.

By: Doug Bend

Most California LLCs that are small businesses never convert to a Delaware corporation for five reasons.

1. In addition to paying the California annual franchise tax you would also need to pay the Delaware annual franchise tax.

2. You would also need to have a registered agent for service of process in Delaware.

3. It often costs more to have a CPA prepare a corporate tax return than a partnership tax return for a multiple member LLC that has not made a tax election. A single member LLC that has not made a tax election does not need to file a tax return at all.

4. It costs several thousand dollars in legal and government filing fees to convert a California LLC to a Delaware corporation.

5. There are additional basic requirements for maintaining a Delaware corporation. For example, Delaware corporations are required to have annual Board and shareholder meetings or written consents in lieu of a meeting whereas this is not the case for California LLCs. Also, if you convert your California LLC to a Delaware corporation you would also have to file the Delaware annual report by March 1st of each year. The annual consents and reports do not take long to complete, but they are not fun and are items you do not have to worry about as a California LLC.

These additional costs and compliance headaches are why most small business owners never convert their California LLC to a Delaware corporation.

But startups are not like most small business owners.

Instead, the conversion is often a necessity if you plan to raise outside third-party financing for your startup; the drawbacks are outweighed by the benefit of the investment round costing less in legal expenses if it is a Delaware corporation instead of an LLC. This is because most of the seed stage financing documents that have been open sourced were drafted for corporations and not for LLCs. For example, many early-stage financing rounds use Y Combinator’s SAFE template, which was intended to be used by corporations.

Also, your investors will most likely require that your company be a Delaware corporation for three reasons.

1. Many investors are more familiar and comfortable with Delaware corporations as more than half of publicly traded companies were formed in Delaware.

2. Corporations are taxed differently than LLCs that have not made any tax elections. If an investor invests in an LLC that not has made any tax elections and the LLC has net profits, the investor might get a K-1 for each tax year and need to pay income taxes on their proportionate share of those profits even if the investor might not have received any distribution payments from the company. In contrast, with a Delaware corporation, the profits and losses from the company stay locked up at the entity level unless there are any distribution payments to the shareholders.

3. Startups that are raising capital are usually looking to grow and scale. It is easier to issue equity to employees, advisors and service providers from a corporation with a stock plan than it is from an LLC.

For all of these reasons, while it is very rare to see a Mom and Pop shop, such as a restaurant or a consulting company, convert from a California LLC to a Delaware corporation, it is why you often see startups make the conversion if they are not already a Delaware corporation before raising investment capital from investors.

As you can see, the cost-benefit analysis for whether to convert your California LLC to a Delaware corporation gets complicated quickly. If you are thinking of making the jump, you would be well served to first check in with your corporation’s CPA and business attorney to help make sure that the transition would be the best decision for you and your company.

Disclaimer: This article discusses general legal issues and developments. Such materials are for informational purposes only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.

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Top 10 Reasons to Incorporate in Delaware

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Why are so many companies incorporated in Delaware? This article gives the top 10 reasons why more than half a million businesses, including more than half of all U.S. publicly-traded companies and 68% of Fortune 500 companies, have incorporated in Delaware. It then outlines the biggest drawbacks to incorporating in Delaware and explains why it… Read More

Why are so many companies incorporated in Delaware? This article gives the top 10 reasons why more than half a million businesses, including more than half of all U.S. publicly-traded companies and 68% of Fortune 500 companies, have incorporated in Delaware. It then outlines the biggest drawbacks to incorporating in Delaware and explains why it is not a one-size-fits-all solution.

What Are The Benefits of Incorporating in Delaware?

1.  Corporate Law Expertise

Delaware has a highly respected court that focuses on corporate issues – the Court of Chancery.  Because of this specialization, the Court of Chancery has a great deal of expertise and familiarity in resolving complex corporate disputes.

In addition, cases in Delaware tend to be resolved faster than in other states.

No corporation wants to be involved in litigation, but it is reassuring to know potential disputes will be more quickly resolved by a very knowledgeable judge with extensive expertise in corporate law.

2.  Extensive Legal Precedent

Corporate case law in Delaware is much more extensive than in other states due to the high volume of corporate cases.

More case law means increased predictability of the likely judicial resolution of a business law dispute.

If there have been several cases similar to the one facing your corporation, there is less uncertainty about the legal outcome which can be key when strategically deciding whether to settle a dispute or invest the time and capital to litigate.

3.  Delaware Corporate Statutes Are Flexible

The Delaware General Corporation Law (“DGCL”) provides a great deal of flexibility in the organization of a corporation and the rights and duties of board members and shareholders.

For example, Delaware allows one person to be the only director, shareholder, and officer of a Delaware corporation, whereas some other states require at least three people to fill those positions.

The DGCL is also frequently updated to take into account new court and business developments.

Although many Delaware statutes have been mimicked in other states, the extensive case law mentioned above is an enormous asset when determining how a Delaware statute is likely to be interpreted.

4. Attorney Familiarity

Most corporate attorneys are familiar with Delaware business law.  This means your attorney can likely provide more efficient and cost effective assistance if your company is incorporated in Delaware as opposed to a less popular state.

5.  Investors Prefer Delaware Corporations

Angel investors and venture capitalists usually prefer to invest in companies incorporated as a C Corp in Delaware.  If you are serious about receiving investments from these types of investors, you may want to incorporate in Delaware.

 6. Investment Bankers Prefer Delaware Corporations

Many investment bankers insist on a company being incorporated in Delaware before they take it public. If your goal is eventually having an initial public offering (IPO), you may want to incorporate in Delaware rather than converting to a  Delaware corporation later.

7. Sending a Message to Investors

If you incorporate in Delaware, you send a message – “This is a national company.”  From a marketing perspective, this could be important for your customers and investors.  You also send a signal to investors that you understand their preferences and are serious about receiving investments.

8.  Greater Privacy Protections

Delaware does not require officer or director names to be disclosed on formation documents.  This provides a layer of anonymity that is not available in some states.

9.  Quality Customer Service and Quick Turn Around Times

The Delaware Secretary of State’s Office has made it a priority to provide expedited filings. In fact, you can have your filings guaranteed to be processed in less than an hour.

In contrast, California has a 24 hour processing option, but it is not guaranteed to be completed within 24 hours and the rush processing fee is significantly more expensive than in Delaware.  This can be critical if you need to close a deal very quickly.

10.  Less Expensive To Relocate The Corporation

The annual franchise tax in Delaware can vary depending on a variety of factors, but it can be as low as $125 per year with reporting fees.  In contrast, California’s annual franchise tax is $800.

If you incorporate in California and later move the corporation to another state, you still have to pay the $800 annual franchise tax. If you incorporate in Delaware and later move, the annual franchise of your “home state” (where you initially incorporated) could be as low as $125.

What Are The Drawbacks to Incorporating in Delaware?

1. Annual Costs For A Registered Agent for Service of Process

If you incorporate in Delaware, you will be required to have a registered agent for service of process.  The annual fees for this service vary, but companies such as Biz Filings and Legal Zoom charge $129 to $149 each year.

2. Extra Franchise Taxes

If you incorporate in Delaware you will not only have to pay the annual franchise tax in the states in which you are “doing business,” but also in Delaware.

For example, if your company is headquartered in California, but you incorporated in Delaware, each year you will not only have to pay the $800 annual franchise tax in California, but also the annual franchise tax in Delaware.

3.  Extra Reporting Requirements

If you incorporate in Delaware, you will have a second layer of reporting requirements.  For example, if you incorporate your company in Delaware, but are headquartered in California, you would have to comply with the reporting requirements in both states.

If the benefits of incorporating in Delaware described above are not important to your company, you may want to avoid the extra expense and time of being incorporated in Delaware.

If you incorporated your company in Delaware, what have you found are some of the biggest advantages and disadvantages?

Disclaimer: This article discusses general legal issues and developments. Such materials are for informational purposes only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.

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How Many Shares Should You Authorize For Your Delaware Corporation?

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When forming a corporation in Delaware you will need to indicate on the certificate of incorporation the total amount of stock the corporation is authorized to issue.  How do you decide how many shares you should authorize? There are two schools of thought on this decision: Only Authorize 5,000 Shares. By March 1st of each… Read More

When forming a corporation in Delaware you will need to indicate on the certificate of incorporation the total amount of stock the corporation is authorized to issue.  How do you decide how many shares you should authorize? There are two schools of thought on this decision:

Only Authorize 5,000 Shares.

By March 1st of each year you will have to file an annual report and pay a franchise tax in Delaware.  The tax is calculated based on the authorized shares for the company by using either the Authorized Shares Method or the Assumed Par Value Capital Method.

The Authorized Shares Method is based on the number of authorized shares and is calculated as follows:

  1.   If the company is authorized to issue 5,000 shares or less the annual franchise tax is $175;
  2.   If the company is authorized to issue 5,001 to 10,000 shares the annual franchise tax is $250; and
  3.  For each additional 10,000 authorized shares the annual franchise tax is increased by an additional $85.  The maximum annual tax under the Authorized Shares Method is $200,000.

You may, therefore, decide to authorize the company to only issue 5,000 shares so you pay the minimum amount of Delaware franchise tax each year ($175).

Authorize Millions of Shares.

The second school of thought is to authorize millions of shares, typically 10,000,000 shares.

The rationale is that individuals who receive 1,000,000 shares feel like they are receiving something of greater value. They may be more motivated than individuals who receive 500 shares, even if the shares represent the same percentage of ownership in the company.

In addition, having more shares provides more flexibility in allocating shares on vesting schedules.

The drawback is that in Delaware having more than 5,000 authorized shares results in a higher annual franchise tax.

If you authorize millions of shares, you will most likely calculate the Delaware annual franchise tax using the Assumed Par Value Capital Method.  The calculations under this method can be complicated, but the Delaware Secretary of State’s Office provides a good explanation and examples of how to determine the tax here.

Please contact us at (415) 633-6841 or info@bendlawoffice.com to discuss how many shares you should authorize for your Delaware corporation.

Disclaimer: This article discusses general legal issues and developments. Such materials are for informational purposes only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.

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