By J. Dain Dulaney, Jr.

“But I don’t want to incorporate in Delaware!” is a common reaction that founders have when a new investor – often a venture capital fund or some other institutional investment group – makes an offer to provide financing to their company, but only if the company changes to a Delaware corporation.

There is a lot of misinformation out there concerning this requirement and I’d like both to clear up the misconceptions and tackle the real reasons for the requirement.

Misconceptions About Delaware

The most common misconception that founders have is that institutional investors want the company to move to Delaware because taxes are lower in Delaware. However, the truth is, there’s no tax advantage to being in Delaware.

Delaware’s corporate taxes are about the same as most other states, including North Carolina. In fact, tax-related expenses will likely be slightly higher in Delaware because the company will have to pay tax preparation and annual fees for both Delaware and the state where its operations are located.

Another misconception that founders have is that it’s less expensive to do business in Delaware. Once again, the answer is no. The cost of the company incorporating, paying for a registered agent, and filing to do business in the Delaware certainly won’t be a money saver.

So, Why Delaware?

Institutional investors like for companies to be incorporated in Delaware because it is the only state’s law that all U.S. lawyers, who practice in the area of capital raising, are familiar with. This is because the state’s laws are kept as modern as possible, and there is a strong body of case law formed around Delaware’s corporate laws that clarifies their meaning. Whether your company has investors located in California, Massachusetts or Indiana, the attorneys advising them will all be comfortable reviewing the documents of a Delaware corporation.

These same attorneys would not have the same comfort level for a company incorporated under the laws of North Carolina, for instance, because they would have to research the ways in which North Carolina corporate laws are different than Delaware’s corporate laws. In other words, by being incorporated in Delaware, there are less barriers to raising money from investors outside the state where your company is located.

Why a Corporation?

Institutional investors also often want the company to be set up as a corporation versus an LLC that is taxed as a partnership or S-corporation (both of which are pass-through entities from a tax perspective, meaning that any gains or losses of the company are passed through to the owners, including the investors). Why?

The reasons institutional investors want you to set up your company as a corporation include:

1. Institutional investors often don’t want to complicate their tax situation by becoming a member of a pass-through entity, including that they could be taxed on the entity’s income even in years when no cash is distributed to them to cover the tax;
2. Some institutional investors can’t invest in pass-through entities because their own investors are not allowed by tax law to invest in pass-through entities;
3. Institutional investors are more comfortable structuring the corporate governance of a corporation in a way that protects their interests; and
4. The investor is certain that any funds that are put into the company and any profit made by the company will remain in the company. If the investor put funds into an LLC or S-corporation then any profits would have to be distributed, or taxed as though distributed, at the end of each year.

I do want to clarify that the above reasons are why institutional investors will require a company to become a Delaware corporation. However, until the company has grown enough to be funded by an institutional investor, most non-institutional investors (including angel investors), are increasingly comfortable with the company being structured as an LLC taxed as a partnership, which has initial tax benefits for investors and founders and good flexibility to allow for ownership structures to meet founder’s goals.

I have set up numerous start-ups as LLC’s and if they progress to the point where they receive institutional investor funding, the legal process to convert them to a Delaware corporation is straightforward in most states, including in North Carolina.

Graduation to Institutional Investment

When founders worry about converting to a Delaware corporation because it is a state they are not familiar with and a different corporate structure, I remind them that it’s actually a graduation to the next stage of funding and growth. I congratulate them on growing to the point where an institutional investor is willing to take risk and invest in their growth by requiring them to become a Delaware corporation!