By Doug Bend, Founder of Bend Law Group, PC, a law firm focused on small businesses and startups.
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Most California LLCs that are small businesses never convert to a Delaware corporation for five reasons.
1. In addition to paying the California annual franchise tax you would also need to pay the Delaware annual franchise tax.
2. You would also need to have a registered agent for service of process in Delaware.
3. It often costs more to have a CPA prepare a corporate tax return than a partnership tax return for a multiple member LLC that has not made a tax election. A single member LLC that has not made a tax election does not need to file a tax return at all.
4. It costs several thousand dollars in legal and government filing fees to convert a California LLC to a Delaware corporation.
5. There are additional basic requirements for maintaining a Delaware corporation. For example, Delaware corporations are required to have annual Board and shareholder meetings or written consents in lieu of a meeting whereas this is not the case for California LLCs. Also, if you convert your California LLC to a Delaware corporation you would also have to file the Delaware annual report by March 1st of each year. The annual consents and reports do not take long to complete, but they are not fun and are items you do not have to worry about as a California LLC.
These additional costs and compliance headaches are why most small business owners never convert their California LLC to a Delaware corporation.
But startups are not like most small business owners.
Instead, the conversion is often a necessity if you plan to raise outside third-party financing for your startup; the drawbacks are outweighed by the benefit of the investment round costing less in legal expenses if it is a Delaware corporation instead of an LLC. This is because most of the seed stage financing documents that have been open sourced were drafted for corporations and not for LLCs. For example, many early-stage financing rounds use Y Combinator’s SAFE template, which was intended to be used by corporations.
Also, your investors will most likely require that your company be a Delaware corporation for three reasons.
1. Many investors are more familiar and comfortable with Delaware corporations as more than half of publicly traded companies were formed in Delaware.
2. Corporations are taxed differently than LLCs that have not made any tax elections. If an investor invests in an LLC that not has made any tax elections and the LLC has net profits, the investor might get a K-1 for each tax year and need to pay income taxes on their proportionate share of those profits even if the investor might not have received any distribution payments from the company. In contrast, with a Delaware corporation, the profits and losses from the company stay locked up at the entity level unless there are any distribution payments to the shareholders.
3. Startups that are raising capital are usually looking to grow and scale. It is easier to issue equity to employees, advisors and service providers from a corporation with a stock plan than it is from an LLC.
For all of these reasons, while it is very rare to see a Mom and Pop shop, such as a restaurant or a consulting company, convert from a California LLC to a Delaware corporation, it is why you often see startups make the conversion if they are not already a Delaware corporation before raising investment capital from investors.
As you can see, the cost-benefit analysis for whether to convert your California LLC to a Delaware corporation gets complicated quickly. If you are thinking of making the jump, you would be well served to first check in with your corporation’s CPA and business attorney to help make sure that the transition would be the best decision for you and your company.