Kathryn McCall argues venture-backed startups should incorporate as Delaware C-corporations, not LLCs. Delaware corps add credibility with investors, simplify equity grants, and offer 24-hour filing. LLCs create problems: complex operating agreements, no standard stock options, and costly conversions later that can kill a funding round.
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All right. So common legal mistakes that startups make. What do I see all the time? So forming the wrong entity, failing to protect the intellectual property, failing to set up vesting schedules for your founders and employees, failing to define roles and ownership, and failing to comply with the securities laws. So these are the ones that I see all the time and even from seasoned entrepreneurs. So forming the wrong entity. We just spent some time talking about the corporation. You basically want— if you're going to follow the traditional startup, get VC funding route, you want to be a corporation. There are many different types of entities, but the world of startups and venture capitalists is the world of corporations. If you form a Delaware corporation, it adds a certain credibility to who you are. It means you're taking your startup seriously. Most corporations are formed in Delaware. A lot of investors like Delaware. You've incorporated in Delaware. Investors generally want to invest in a corporation, not another form of entity, and they especially like the Delaware corporation. It's easier to issue equity. To your co-founders, employees, and investors in a corporation. So I know that a lot of people talk about, well, maybe I should be an LLC, a limited liability company. Everybody tells me an LLC is better. It's more flexible. I get pass-through tax treatment. Well, essentially, your investors won't like pass-through tax treatment and you really do want to be a corporation. Investors like corporations. It's easier to issue stock. And most likely your investor is going to make you convert into a corporation anyway. So why not just be a corporation from the beginning and avoid the time and expense of converting into a corporation? So the disadvantages is, yeah, it takes, you know, some more documentation to form a corporation. But again, if you're working with an attorney or somebody familiar with doing it, it's not that big a deal. Some people get really worried about this whole double taxation. So double taxation means the company, the corporation pays taxes on its earnings. Then if it distributes any of those earnings to the shareholders, the shareholders pay taxes on those earnings. But think about it. When was the last time a startup made a profit and distributed earnings to its shareholders?
Correct.
Like, you're just not going to do it. And essentially you're going to take all— if you do make a profit, you're going to take that profit and plow it back into the startup to fund the growth. And your investors aren't investing in your startup to get a little bit of money at the end of the year. They're investing in your startup so that you'll go public or be acquired and they'll make a lot of money. And that might not be for 5 or 6 years. So this whole thing about, oh, I don't want to pay the taxes, I'm worried about the taxes, is a little false because you're really not going to be distributing any of those earnings to yourself anyway and you're going to be operating at a loss. Now, there are some people out there who will say, oh, but I want the loss to claim on my income taxes. I've seen companies go through hoops to try and get the losses or do these things, and it really does them no favors in the long run. It makes things more complex, and investors don't like it. So we talked a little bit about the Delaware corporation. This is, again, just kind of hammering that point home of why a Delaware corporation. And one of the other reasons about Delaware is they run 3 shifts of people. So I can file something in Delaware at 6 o'clock on the West Coast and it will get filed that day. You try and file something in California and they're like, yeah, we'll get back to you on that. You know, Delaware, I pay them an extra $1,000 and I get it back in an hour. If you're trying to close a financing, that can be key. And let's see. We talked about the double taxation. Skip on. Everyone says I should form an LLC. Once again, I don't know who— I think it's some accountant running around Silicon Valley telling people they need to be an LLC because I started getting all these, I need to be an LLC, I need to be an LLC. And it's like, not really.
It's just popular. And I know on some, like when you're trying to form on some of the online companies, it's cheaper too, especially when you're just a startup. If you're a startup and you're trying to spend as little money that you have, it does become easier. So, it became— it seems like it's become—
Become a—
yeah. And I know in the entertainment industry, a lot of record labels and businesses are LLCs.
Yeah. Well, and it just really depends upon what the purpose of— for your startup and what you're trying to do. But, you know, in general, you're going to want to reinvest all that liquidity back back in. And an LLC, it's really tough to add new members. In a corporation, you want to raise funds, you sell shares to VCs, they become shareholders. In an LLC, it's a lot more difficult and complex to add members, get their— issue them units in your LLC. It becomes really complex. And it's really hard— the world of Silicon Valley and startups in general, is, you know, you hire employees and you issue stock options. And everybody is wondering how many stock options, what sort of stock option did you get? Well, in LLC you can't really do stock options. So you can do this thing called profits interest. Nobody really understands it. It's really, really complex, convoluted, which is more expensive. Still not convinced? The reason why I keep saying investors and VCs don't like LLCs, An LLC, we talked about the pass-through tax treatment. So all the profits and losses of the LLC pass through the LLC and are declared on all the members' tax returns. Well, guess what? A lot of VCs don't want that. They don't want to complicate their personal taxes. They don't want that pass-through tax treatment. And it could be an instance of in their charter they're not allowed. They have a prohibition against investing in any sort of pass-through entity. So you may not be able to do it. Investors are generally less familiar with how to use an LLC structure to protect themselves. They know about corporations. They know what to do. And, you know, looking at documents, I can flip through, yeah, yeah, yeah, yeah, that's what this is, that's what this— boom, boom, boom, boom. Really easy, really quick. LLC, what the heck? You know, it's flexible. Like you said, people like it because it's flexible. But because it's flexible, there's tons of different ways to do things. How does it all work? The operating agreement, like what I just touched on for an LLC, can be really complex, really difficult to navigate, which again, more time, more money. And investors— I'm sure you've heard this— investors are really fickle. I always tell my clients, never give your investor a reason to say no to you. There's plenty of reasons for them to say no. Don't just hand it to them on a plate. So they're flipping through, you know, this startup, oh, that looks interesting.
Yeah.
Oh God, they're an LLC. Oh, this one. Oh look, they're a Delaware corporation. They've just passed you by. Don't ever give them a reason to pass you by. Yeah, you can convert from an LLC to a corporation, but you don't want them to make that snap judgment. You know, you don't want to have to convince them of how worthy you are so then they'll say, okay, we'll go with you, but you got to convert and that's going to take extra time and money. Don't give them that reason. LLC— so that's one of the reasons that forming an LLC could result in a loss of money for your startup. There's a lot of provisions in LLC agreements that say that you have to distribute earnings to the members to help them pay for the taxes. But as a startup, you want all your earnings to go back into the company. You don't want to distribute it out.
