Client’s Question:

I’m in the process of developing a new AI software tool. Do you have a recommended structure for a small startup such as this? As additional background, it is likely that we will raise investment funds from outside investors in the next 1-3 years and I’d like the option to issue shares or options to employees or contractors that we bring on.

Attorney’s Answer:

If it is likely that you will raise funds from outside investors in the next couple years, then I recommend setting up a Delaware corporation for these reasons:

A Delaware corporation is the entity structure typically required by outside investors because this is the most common start-up investment structure (purchasing shares in a Delaware c-corp, as many investors either cannot, or do not, want to invest in an entity taxed as a partnership) and Delaware is favored for its detailed corporate laws and breadth of related case law.

It is straightforward to set up an employee stock plan from which the corporation can issue equity to employees and contractors, compared to an LLC that has many complicating factors around issuing equity to service providers (not impossible, but not straightforward).
If you have a goal of eventual acquisition, selling shares in a corporation can have considerable tax benefits compared to an LLC. The shares could qualify for beneficial QSBS tax treatment, plus they will not be subject to complicated tax code rules around an owner’s basis in the LLC that may affect taxation on the acquisition proceeds.

The downsides to forming a Delaware corporation compared to an LLC or a corporation in your home state are:

Increased start-up costs – If you form the corporation in Delaware, then it also needs to be registered as a foreign corporation in the state(s) from which you are actually doing business, which incurs additional filing fees and more legal time. Also, you will need to hire a DE registered agent since you aren't actually located in Delaware, which is an additional ~$100 per year (in addition to the registered agent in your home state).
Multiple annual franchise tax payments – Each state where a corporation is registered typically charges annual franchise taxes for the privilege of doing business in the state. For example, Delaware franchise taxes are a minimum of $450 per year and California franchise taxes are a minimum of $800 per year. Thus, forming a corporation in Delaware will likely mean you have to pay annual franchise taxes in at least two states (only avoided if the corporation is actually doing business from only Delaware).

The additional set-up and annual costs are arguably outweighed by the ability to raise much more money than this from outside investors, but because of these extra costs we typically wouldn't set up a Delaware corporation unless you were expecting to raise funds from outside investors in the next couple of years.

If you decide that raising outside capital actually isn’t in the foreseeable future for your company, then we should instead discuss forming an entity in your home state – either an LLC (good for small teams that want to include more specificity about each owner member’s role in the governing documents) or a corporation (good for a company that wants to regularly issue equity to employees or contractors and/or keep the door more easily open for outside investment later, by making it simpler to convert to the corporation into a Delaware corporation).

These are the general (not exhaustive) considerations for choosing where to form your company and what entity type to choose. However, every situation can have unique factors at play that could affect this decision from a legal and/or tax perspective. Feel free to reach out to us at hello@archetypelegal.com if you’d like to discuss your plans further or learn more about our services related to company formation, bringing on service providers, raising outside funding, drafting compliant terms and commercial agreements, and other services for start-ups.

Disclaimer: This post discusses a general legal topic, is intended to serve as informational only, and may not reflect the most current legal parameters in your jurisdiction. This informational post is not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Archetype Legal PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post.