Start with a Delaware C-Corp If Raising VC
When building a startup, you will face many surprising curves, so when the best path is the straight, well-traveled road, take it.
But first, two quick caveats:
- First, I am a serial venture-backed entrepreneur, not a lawyer. My blogpost is not legal advice. Get competent counsel from an experienced attorney.
- Second, this advice applies to high potential startups who plan to seek venture capital. Other businesses can and often should choose different forms of business organization.
Why am I so passionate about a topic as dry as the choice of the form of business organization when founding your startup? It is based on a lesson learned in the crucible of raising my first ever venture round. I almost lost the company because I went with the cheaper Michigan C-corporation option when I filed our Articles of Incorporation three years earlier. That error had my lead VC threatening to walk away and cost me about $80,000 in legal fees to fix. Suddenly a few hundred dollars in startup cost savings did not seem like a good deal at all!
Before I unpack the nuance of why this decision turned into such a crisis for me, let us start with a little groundwork. There are five primary forms of business organization: Sole proprietorship, partnership, limited liability corporation (LLC), S corporation, and C corporation. The right type for your business depends on various factors such as the type of business, number of owners, and tax and liability considerations.
If you plan to raise angel and venture capital, you are assuming you will have multiple owners and that you will require significant investment before becoming cash flow positive. Your investors will expect you to choose a form of business organization that:
- Facilitates multiple rounds of funding from numerous investors
- Limits personal liability for business debts
- Leverages a well-developed and understood corporate and business law framework.
Your investors will expect to realize their financial returns upon the sale of the company rather than the payment of dividends, minimizing the double taxation concerns. These factors point toward a C-corporation as the best-fit form of business organization for the aspiring venture-backed startup.
A C-corporation is a legal entity created by filing Articles of Incorporation with the state. Entrepreneurs often default to filing Articles of Incorporation in their home state because it seems straightforward and cheaper. However, the savvy entrepreneur who plans to raise venture capital knows that VCs feel more comfortable with the well-known, business-friendly legal framework of a Delaware C-corp. VCs can enforce their preference by making the conversion to a Delaware C-corp a condition of closing the VC-led round for anyone who makes the mistake of choosing another option. To eliminate this hurdle, form the company as a Delaware C-corp right from the beginning. Delaware charges a bit more than other states; however, by keeping the initial number of authorized shares low (you can raise it later), you can minimize the cost.
Here was the tricky bit that almost killed my company. I had formed the company as a Michigan C-Corp because my local attorney advised me that Michigan’s legal framework was very similar to Delaware’s, and Michigan’s fees were lower when cash was very precious. It was a rookie mistake. I made it. I did not realize that my local attorney, who only did the occasional venture deal, did not understand the downside like someone who advises venture-backed companies all the time.
The kicker came when the lead VC indeed put the closing condition of being a Delaware C-Corp into my term sheet. The terms also included a down round valuation. That frustrated some of my angel investors, and they threatened to invoke an obscure Michigan law provision that provided investors in Michigan C-corps the right to be bought out if the company moves its incorporation to another state. That effectively meant that, while I was trying to raise money to keep the company going, my existing investors could ask for their already-spent money back if I converted to the Delaware C-corp as required by my term sheet.
The lawsuit threats that a few of my existing investors made nearly convinced the lead VC to back out of the term sheet that was going to keep us alive. Resolving the issue required several weeks worth of tense negotiations with three teams of lawyers on conference call after conference call (all three at my ultimate expense) to eliminate the lawsuit threat and get the Delaware C-corp in place.
This isn’t about whether you can form legal entities like LLCs or partnerships. You can. But, by choosing something other than a Delaware C-corp, you will be adding complications to your investor negotiations that add little or likely no net value. You don’t know what challenges your company will have to overcome. However, saving a few hundred dollars is not worth the risk of finding yourself in a precarious position.
If you plan to raise venture capital, remember this: The VCs are most comfortable with Delaware C-corps. This is a time to follow the straight, well-traveled road rather than get creative. There is no upside to deviating from the regular route. If you are tempted to choose a non-standard answer, ask yourself why? What is the business value you expect to realize that makes it worth creating an issue you then must defend or resolve? Keep it clean. Keep it simple. Save your creativity for the real company-defining problems and make your business form choice simple and straightforward. Ever since that trauma-filled experience, if I plan to raise venture funding, I only use a Delaware C-corp.
13 Comments
Ben
Just a quick comment about one reason why incorporation in Delaware might be important… I was involved with a shareholder lawsuit a few years back. The case was originally heard by a judge here in Washtenaw County. I saw the judge frequently mentioned in the news; he oversaw murder cases, child custody cases, etc. In other words, he was an experienced judge although not one focused on business matters.
When our case went to trial, my attorneys told me they felt the judge had made some pretty big mistakes. And, in fact, hundreds of thousands of attorney bill dollars later, the Michigan Supreme Court agreed with my lawyers on at least some of their points, overturning the original judge’s ruling.
As I understand it (and I am, admittedly, not well educated on the subject), Delaware has chancery courts – courts specializing in business matters. My guess is that had our case originally been heard by a business-centric judge, it might have gone much quicker and at far less legal cost.
Anyhow the details of my specific case are a long, twisted,exxpensive story but the net is that while I always knew that big corporations were incorporated in Delaware, I think I finally understand at least one reason why.
Jen Baird
Ben, thank you for sharing your harrowing story! That emphasizes a point I have made a couple times now on this blog — the importance of seeking out environments (Delaware’s legal system) and legal professionals with deep expertise in your chosen endeavor space. Delaware has invested in the legal infrastructure and expertise that helps businesses quickly resolve disputes. I am sure that your experience might well have been different in Delaware — and it justifies why the VCs make a big deal out of it and why you, as CEO, don’t want to be making the case to them that “it doesn’t matter.” These are hard lessons we have had to learn. Let us hope others can sidestep them!
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