Founders grapple with lots of difficult choices. This isn’t one of them. If you’re going to scale a venture-backed startup, incorporate as a Washington or Delaware Corporation. Be a C-corp, not an S-corp. Don’t form an LLC.
Form a Delaware or Washington C Corp.
Delaware corporation is standard across the country. Your lawyer will know Delaware law, and your VC’s lawyer knows Delaware law, no one will be wasting time researching novel state legal issues. Deals will close more quickly, legal fees will be lower, and you can raise capital and get back to business.
The downside is that incorporating in Delaware will add some extra paperwork and extra filing fees. Setting up a Delaware corp should run about $1,000 in filing fees, plus a “franchise tax” that runs $350/year for a pre-revenue startup.
Forming your company in Washington will reduce your initial costs by around $1,000.
A Washington corporation can be converted to a Delaware corporation later, if necessary. However, the legal fees for the conversion will cancel out any of the initial cost savings. Over the long term, it’s generally cheaper to incorporate as a Delaware company than to incorporate in Washington and then convert.
For long-term simplicity, start off as a Delaware corporation. However, if your initial budget is tight, then start out as a Washington corporation.
Avoid incorporating in California.
Where Seattle Startups are Incorporated: DocuSign is a Delaware corporation. Redfin is a Delaware corporation. Moz is a Delaware corporation. Cyanogen is a Delaware corporation. But not every Seattle startup is a Delaware corporation. Zillow is a Washington corporation. You can incorporate in either state and still build a hugely successful company.
You can convert from a DE to WA corp and vice versa. Amazon was originally incorporated in Washington in 1994, and reincorporated in Delaware in 1996. Microsoft was originally incorporated in Washington in 1981, then reincorporated in Delaware in 1986, and then re-reincorporated back in Washington in 1993. Costco is a WA corp, Boeing is a DE corp.
What State Should I Incorporate In? By Yokum Taku, 2009. Investors will insist on Delaware; Delaware has a predictable, fair and well-developed body of corporate law; Delaware corporate procedure is easy to follow.
When Do I “really” Need to Qualify My Delaware-Formed Startup in Texas? By Jose Ancer, 2013. Delaware companies generally also need to “qualify” in the states where they “conduct business.” For example, if your office is in Seattle, and you incorporate in Delaware, you also need to “qualify” in WA by filling out a form and paying a fee.
Corporation vs. LLC
For scaling a venture backed company, don’t be an LLC. I don’t know of any venture-backed startup that is an LLC.
An LLC is great many types of businesses. For a small business with a handful of employees, an LLC is more flexible than a corporation and requires less paperwork. But if you want to raise VC money, your startup will need to be a corporation1, and the conversion process (from LLC to corporation) will be more expensive than simply forming a corporation in the first place.
Startup Company Form: LLC or S-Corp? By Paul Graham in HN Comments, 2007. “Ordinarily a startup should be a C corp. It’s cheaper to be an LLC, but if you plan to succeed, you may as well do things right from the start.”
S-Corp vs. C-Corp.
If you want to raise VC money, don’t elect to be an “S-corp.”
An S-corp is a federal tax election that can sometimes save you money. An S-Corp allows for pass through taxation, while a C-Corp is double-taxed. Don’t worry too much about being “double taxed.” It’s not nearly as bad as it sounds (especially if you have a competent accountant).
The “S election” comes with several restrictions, and these restrictions will hamper a VC investment.
- S Corps are limited to one class of stock. VCs will not like this.
- S Corps can only be owned by natural persons (i.e., an LLC can’t own shares of an S-corp). VCs will not like this.
- S Corps are limited to 100 stockholders.
An S-Corp can be helpful for a small business, but not for a venture-backed startup.
Social Purpose Corporation / Benefit Corporations
A Social Purpose Corporation or Benefit Corporation (“B-Corp”) are for companies that (a) have a social mission and (b) like to file extra paperwork. If you’re business has a social mission, being a B-Corp can signal to customers, employees and investors that you are serious about creating positive social change. Etsy, Warby Parker, and Patagonia are all B-Corps.
For most startups, forming a B-Corp is not worth the extra paperwork and expense.
- B-Corp: Companies with Benefits. James Surowiecki, 2014. “Becoming a B corp raises the reputational cost of abandoning your social goals. It’s what behavioral economists call a ‘commitment device’—a way of insuring that you’ll live up to your promises.”
Summary of Entity Choice Issues
|LLC||flexible; tax pass through|
|C Corp||VCs require it. Pays separate taxes|
|S Corp||tax pass through|
|B Corp||commits to a social mission|
When to Incorporate
When should you incorporate? Incorporate as soon as you know you are going to build a business rather than just play with a side-project.
A corporation is a firewall between your startup’s money and your personal money. If your business gets sued, your personal money is not at stake. If your business runs up big debts, its creditors can’t reach into your personal pockets. (This firewall breaks down if you’re committing fraud - Lawyers call this “piercing the corporate veil.”)
A few hundred dollars for incorporation fees is a small price to pay for this protection. Incorporate early.
Larry Page and Sergey Brinn didn’t incorporate Google, Inc. until they took their first investment. This is not necessarily a good idea, although it seems to have worked out for them.
When do I need to incorporate a company? By Yokum Taku, 2008. Startups should incorporate before they start to generate revenue, create serious intellectual property, hire employees or contractors, issue stock options, or get visas.
Corporate Entities. By Fred Wilson, 2010. “When you start a business, it is important to recognize that it will eventually be something entirely different than you. You won’t own all of it. You won’t want to be liable for everything that the company does. And you won’t want to pay taxes on its profits.”
Legal and Accounting Basics for Startups. By Carolynn Levy and Kirsty Nathoo of YCombinator, for Stanford’s “How to Start a Startup” class.
VCs don’t like LLCs because LLCs have pass-through taxation. Investing in a portfolio of LLCs would make the VC’s tax accounting a paperwork nightmare. ↩