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Do you need to convert your startup from a California LLC to a Delaware Corporation?

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By Doug Bend, founder of Bend Law Group, PCa law firm focused on small businesses and startups.

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

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

2. You must also have a registered agent to serve the process in Delaware.

3. It often costs more to have a CPA prepare a corporate tax return than a corporate tax return for a multi-member LLC that has not made a tax choice. A single member LLC that has not made a tax choice is not required to file a tax return at all.

4. It takes several thousand dollars in legal and government fees to convert a California LLC into a Delaware corporation.

5. There are additional basic requirements for maintaining a Delaware business. For example, Delaware corporations are required to hold annual board and shareholder meetings or written consents in lieu of a meeting, while California LLCs are not. If you convert your California LLC into a Delaware corporation, you must also file the Delaware Annual Report by March 1 of each year. The annual approvals and reports do not take long to complete, but they are no fun and are items that you as a California LLC do not have to worry about.

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

But startups are not like most small business owners.

Instead, the conversion is often a necessity if you intend to raise outside funding for your startup; the disadvantages are outweighed by the advantage that the investment round will cost less legal fees if it is a Delaware corporation rather than an LLC. This is because most of the startup funding documents that are open source are prepared for corporations and not LLCs. For example, many early-stage funding rounds use Y Combinator’s SAFE template, which was intended to be used by businesses.

Also, your investors will most likely require your company to be a Delaware corporation for three reasons.

1. Many investors are more familiar and familiar with Delaware companies as more than half of publicly traded companies are incorporated in Delaware.

2. Corporations are taxed differently than LLCs that have not made tax elections. If an investor invests in an LLC that has made no tax elections and the LLC has net profits, the investor can receive a K-1 for each tax year and must pay income tax on his pro rata portion of that profit, even if the investor may not receive distribution payments from have received the company. In contrast, with a Delaware corporation, the company’s profits and losses remain locked in at the entity level unless there are distributions to shareholders.

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

For all these reasons, while it’s very rare for a Mom and Pop store, such as a restaurant or consulting firm, to move from a California LLC to a Delaware corporation, it’s why you often see startups doing the conversion when they are not a Delaware company until they have raised investment capital from investors.

As you can see, the cost-benefit analysis of whether or not to convert your California LLC to a Delaware corporation gets complicated quickly. If you’re considering taking the plunge, check with your company’s CPA and corporate attorney first to make sure the transition is the best decision for you and your company.

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