“What” and “Where”? Initial Issues to Consider When Forming A New Entity

Founding a company can be an overwhelming experience, but for those founders looking to raise capital from angel or venture capital investors, deciding where to incorporate and selecting an entity type are two choices that deserve careful consideration.

Form of Business Entity

There are three basic forms of entities: partnerships, limited liability companies and corporations. Corporations come in two flavors: S Corporation and C Corporation. Virtually all angel- and venture-backed startups are C Corporations, because the other entity forms are imperfect for one reason or another.

Partnerships are “flow through” entities, meaning that the tax attributes of a partnership is passed on to its partners. This structure can be tax efficient, but no venture capital firm or angel investor wants the tax and accounting headaches from multiple investments, particularly if the investor has foreign investors. Also, partnerships lack a liability shield, meaning the individual partners of a partnership are on the hook for the liabilities of the entity.

Limited liability companies effectively limit the liabilities of its members, but like a partnership, a limited liability company is a “flow through” entity and thus an unacceptable entity in which to invest for venture and angel investors.

S Corporations are also “flow through” entities, and even more problematic, an S Corporation may issue only one class of stock, meaning it cannot issue the preferred stock that investors demand. Moreover, all stockholders of an S Corporation must be natural persons, and while some angel investors are natural persons, venture funds are almost exclusively limited liability companies or partnerships.

Delaware, Delaware, Delaware

Founders can incorporate anywhere, but most often the choice boils down to incorporating in the state where the founders reside or in Delaware. Most startups in Silicon Valley opt to incorporate in Delaware. There are several reasons for this, a few of which are outlined below.

•    Flexibility. Delaware corporate law is among the most flexible body of corporate law, giving
the company the ability to allocate rights among the various corporate constituencies as the
parties see fit. California’s body of corporate law, to cite a contrary example, is more rigid.
For example, California requires a series of votes for certain corporate actions (such as a
merger) that require only a single vote of all stockholders in Delaware.

•    Customer Service. The Delaware Secretary of State is customer friendly. Charter
amendments and requests for good standing certificates are turned within one day, and for
a small fee, service can be expedited. The secretary of state in other states do not always
offer the same kinds of services. Moreover, the Delaware Secretary of State does not
review charters for substance, meaning there is very little chance that a charter filed the
morning of a financing will get bounced back (as has been known to happen in states such
as California). It’s white knuckle time for a founder that needs to close a financing in order to
meet a payroll obligation, and when you absolutely, positively need to a response from the
secretary of state, you want to be in Delaware.

•    Body of Law. The Delaware Court of Chancery (the court that has jurisdiction over
corporate law matters in Delaware) is uniquely experienced and has generated a large body
of law that makes results more predictable, which reduces risk.

•    Long Arm Statute. If your company is located in California, it may not be possible to entirely
escape California corporate law. California has a long-arm statute (Corporations Code
Section 2115) that purports to apply numerous requirements of the California Corporations
Code on foreign entities with substantial ties to California, such as cumulative voting. The
courts in Delaware have already ruled that the California long arm statute is an
impermissible intrusion over Delaware corporations. It is not clear how a California court
would rule on the legality of 2115, however, in May 2012 a California court published an
opinion suggesting that 2115 is good law.

Dealing with “Dead Equity”

“Dead equity” refers to company stock owned by individuals and entities no longer contributing to the company. In general, there are two types of dead equity seen on emerging company cap tables: Departed founders/employees. A co-founder or early employee leaves a company or no longer significantly contributes […]