Should you convert your startup from a California LLC to a Delaware corporation?

By Doug Bend, Founder of Bend Law Group, PC, a law firm focused on small businesses and startups.

Most California LLCs that are small businesses never convert to Delaware corporations for five reasons.

1. In addition to paying the annual California franchise tax, you will also have to pay the annual Delaware franchise tax.

2. You would also need to have a registered agent for process service in Delaware.

3. It often costs more for a CPA to prepare a corporate tax return than a partnership tax return for a multi-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 Delaware LLCs are not. California. Additionally, if you are converting your California LLC to a Delaware corporation, you will also need to file the Delaware annual return by March 1 each year. Consents and Annual Reports don't take long to complete, but they're no fun and are things you don't have to worry about as a California LLC.

These additional costs and compliance issues are why most small business owners never convert their California LLC to a Delaware corporation.

But startups aren't like most small business owners.

Instead, conversion is often a necessity if you plan to raise outside third-party funding for your startup; the disadvantages are outweighed by the advantage of the investment cycle which costs less in legal fees if it is a Delaware corporation instead of an LLC. This is because most of the seed-stage funding documents that have been open-sourced were written for corporations, not LLCs. For example, many early-stage funding rounds use Y Combinator's SAFE model, which was intended for corporate use.

In addition, your investors will most likely require your business to be a Delaware corporation for three reasons.

1. Many investors are more familiar and comfortable with Delaware companies, as more than half of publicly traded companies were started in Delaware.

2. Corporations are taxed differently than LLCs that have made no tax election. If an investor invests in an LLC that has not made tax elections and the LLC has net profits, the investor may get a K-1 for each tax year and must pay taxes on their proportionate share of these profits even though the investor may not have received distribution payments from the company. In contrast, with a Delaware corporation, the profits and losses of the corporation remain locked in at the entity level, unless there are distribution payments to shareholders.

3. Startups that raise capital are generally looking to grow and scale. It is easier to issue stock to employees, advisors and service providers of a company with a stock plan than of an LLC.

For all of these reasons, if it's very rare to see a Mom and Pop store, such as a restaurant or consulting company, change from a California LLC to a Delaware company, that's why you often see startups make the conversion if they are not already a Delaware company before raising investment capital from investors.

As you can see, the cost-benefit analysis of converting your California LLC to a Delaware corporation gets complicated quickly. If you're considering making the leap, you'd do well to check with your company's CPA and business lawyer first to make sure the transition would be the best decision for you and your business.

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