Archive for the ‘Company Creation’ Category

What is the Best State of Incorporation?

Question: What preferences do venture capitalists have for different possible states of incorporation?

(Jason) Most venture capitalists have 3 preferred states: Delaware, whatever state the company is in and whatever state(s) the VCs are located in. I’ll spare you the longwinded legal answer (I actually had a class in law school that was all about different states of incorporation and I’m still scarred from it), but Delaware law is well-settled, generally business friendly and most lawyers in the U.S. are adapt at dealing with DE law. If you are planning to consummate an IPO, you’ll have to be a DE company, as no bankers will let you go public unless you are.

The disadvantage of being a DE company if you are not in DE, is that you’ll have to pay some extra taxes (not much) and potentially comply with two sets of corporate laws. For instance, if you are located in California and are a DE corporation, you’ll have to comply with DE law and some of CA law too, despite you being a DE corporation.

Perhaps the coolest thing about being a DE company, is that they accept faxed signature pages and can approve changes in corporate documentation faster than any state that I’ve worked with. This is particularly helpful when you are trying to close a financing or merger deal on a short leash. I tell people that it’s worth the extra few hundred bucks a year to be able to use your fax machine.

As for the other two choices: the physical state of location of the company and he state(s) where the VCs have offices, it’s pretty self explanatory. Assuming the company is not in a state where the VC has never invested (and is unfamiliar with how the laws work) then it’s perfectly fine to be incorporated in that state. Similarly, whatever states the VC has offices in, they are generally amenable to being subject to those laws as well, so incorporating in those states is fine too.

Remember, the issue here is that the VC will join your board and be personally liable under that state’s corporate laws. The laws vary much more by state than most people realize. I’d say 75% of our companies are DE corporations.

Can VCs Invest In S-Corps or LLCs?

Question:  Do VC and Private Equity Funds have to invest in C-Corps, or can they invest in S-Corps and LLCs?

Our Take:  Most often, C-Corps rule the day.  S-Corps can only issue one class of stock meaning that VCs and PEs can not get get the benefits of liquidation preferences and other preferred terms. 

For a complete discussion, check out a prior post on the issue.

What is a Typical Capital Structure Like?

(We got two questions that were similar)

Question 1: Is it normal to have the founders to have Class A shares, angel investors to have Class B shares, and a Class C pool for employee options. Liquidation preferences have classes B and C funding concurrently, with class A funding last?

Question 2: Is there any reason to issue a new class of company stock when creating an employee pool if the liquidation preference and voting terms are the same as an existing class?

Our Take: Neither of these structures is typical in a VC-backed company. Generally, founders and employees own common stock of the company and VCs (and sometimes angel investors) hold preferred stock. If the company has multiple rounds of financing, assume that each round will be a separate class of preferred stock.

In the first question scenario, the employee option pools would be paid ahead of founders. Regardless if the founders also own employee stock, we’ve never seen this structure.

The second question scenario makes us ask “why?” If the preferences and voting are the same, why go through the issue of creating a separate class? In some states, regardless of what the voting provisions of the company charter say, each separate class of stock gets voting rights for certain transactions.

Now, there is an exception – and it’s an important one. If there is only one class of stock and both employee options and investors hold the same class of equity, one can run very afoul of option pricing mechanics. The options will need to be priced at the valuation paid by investors, which is suboptimal for incentivizing employees. For this reason, we always make sure that investors purchase a separate class of stock apart form the class used for employee options.