Alexei Vella
When you look closely at this year’s gener8tor graduates, something unusual jumps out: Four out of five startups in the business accelerator’s 2015 Madison class are Delaware C-Corporations, despite being based in other states. That’s right: A company can incorporate in one state but be based in another. It’s more common than you might think.
Being a Delaware C-Corp means two things: The business was incorporated in Delaware, and it was established as a corporation, not a “flow-through” entity like a Limited Liability Company (LLC).
Why do companies pick Delaware?
“Legal reasons,” says Richard Yau, co-founder of Bright Cellars, a wine delivery service that’s part of gener8tor’s latest class. The company is a Massachusetts-based Delaware C-Corp that is contemplating a permanent home in Wisconsin. “Lawyers are familiar with Delaware corporate law. It’s a standard business thing.”
Joe Boucher, a Madison-based attorney with decades of experience advising businesses, agrees.
“Delaware created up-to-date legislation and a business court over 100 years ago to get businesses to locate there,” says Boucher. “The volume of cases that Delaware has creates more certainty.”
But while Boucher says he understands why companies choose Delaware over states with murkier legal systems, he thinks it makes little sense to start out as a corporation. To see why, it’s necessary to know how the entities differ: With a corporation, taxes are applied to a business itself; with an LLC, taxes are applied to its owners.
Most startups founder — some studies estimate the failure rate is around 90% — and even those that prosper rarely make money in their incipient years, says Boucher. For the owner of a business formed as an LLC, an unprofitable year yields a “tax loss,” an asset that can be used against other current or future income. But for a corporation, the tax loss stays with the company, and is lost if the business goes bust. Beginning as an LLC is essentially a hedge.
“I’ve been doing this for 40 years and 98% of my clients don’t make any money for the first three to five years,” Boucher says. “Why should I tell them to trap those losses in a C-Corporation? My advice to young companies is to start out as a LLC. At such time as the company projects to turn a profit, you then convert to a C-Corp. I can do it in two seconds.”
If going into business as a corporation disadvantages founders, who benefits when companies have this structure? Lawyers, for the reasons Yau and Boucher give. But also well-heeled investors with portfolios spanning dozens of companies. People who invest in a corporation only have to pay taxes when it gets bought, goes public or pays a dividend. But investors in LLCs must pay taxes every year on a K-1 form, the equivalent of a W-2 for flow-through entities.
“Simplicity is a C-Corp,” says Boucher. “If you’re an investor from a big fund, you don’t want all these [tax forms] coming every year from 50, 60 companies. Your tax return is way more complicated.”
Troy Vosseller, who co-founded gener8tor in 2012, says companies must be Delaware or Wisconsin C-Corporations to participate in the program.
“For most businesses, LLC is the way to go,” says Vosseller. “But we’re only working with companies with high growth potential. And for any company that anticipates it will raise institutional venture capital — money being managed by full-time professional investors — often times those funds have strict rules about only investing in C-Corporations. We want our companies out there thinking and believing.”
