Choosing the right legal structure is one of the first and most important decisions a founder faces. Setting up a corporation, a limited liability company, or any other legal governance structure affects taxation, ownership, and investor readiness. While there is no one-size-fits-all answer, there are well-established trade-offs founders should consider.
The fourth article in Legal Basics for Startups: A Practical Series for Founders outlines the most common startup structures, their practical implications, and how those choices align with long-term growth.
Common Startup Legal Structures
The first legal structure may arise by default. When founders operate without forming an entity, the business is treated as a sole proprietorship. Although this can work temporarily, it offers no liability protection and is not advisable for startups aiming to scale or raise outside capital.
The next step up is the limited liability company (LLC). LLCs provide liability protection and operational flexibility. They are generally taxed as pass-through entities. This means profits and losses flow directly to the owners' personal tax returns. For founders focused on early traction or bootstrapping, LLCs can offer a practical, low-overhead structure.
The C-Corporation is the legal structure of choice for startups planning to raise venture capital. Although "C" and "S" refer to federal tax classifications rather than distinct legal entities, they carry important governance and ownership consequences. Corporations taxed under Subchapter C are subject to more formal governance and separate entity-level taxation, but they support multiple share classes. Unlike S-Corporations, C-Corporations are capable of having shareholders who are entities rather than individuals. These are all features investors expect. S-Corporations are generally unsuitable for venture funding due to shareholder and stock class limitations.
Why Venture Investors Prefer Delaware C-Corps
For startups that expect to raise outside capital from institutional investors, the preferred structure is a Delaware C-Corporation. This is not a matter of tradition; it is about predictability and investor confidence.
Delaware offers a well-established and business-friendly legal environment. A specialized court, the Court of Chancery, handles corporate disputes efficiently and without juries. The judges on this court are highly experienced in corporate law, which gives investors and founders a reliable and efficient forum for resolving conflicts.
Most importantly, Delaware has a robust and well-developed body of case law in corporate governance and shareholders' rights. For investors putting substantial capital at risk, that legal certainty is paramount.
While features like multiple stock classes, preferred shares with liquidation preferences, voting rights, antidilution protections, and equity compensation plans (such as stock options and restricted stock) are not unique to Delaware, its corporate law provides a more established framework for implementing them, especially in the context of venture-backed startups. While LLCs can offer comparable alternatives, these arrangements are less familiar and often require complex tax and legal planning.
The trade-off is often worthwhile for startups seeking rapid growth and outside investment. The C-Corp structure gives investors the tools and protections venture capitalists expect, speeding up fundraising and negotiations.
When an LLC Might Make More Sense
Not every startup begins with venture capital in mind, and Delaware incorporation is not always the right starting point. For founders who are bootstrapping, working with friends and family, or testing a business model, forming an LLC or a corporation in their home state can be a pragmatic first step because of the simplicity offered.
For example, a software developer who launches a product with personal savings and a single cofounder may prefer to use an LLC at the outset. Without outside investors or the need to issue formal equity, founders can focus on building the business without incurring the overhead of corporate compliance. If the product gains traction and they decide to pursue outside funding, they can convert to a corporation later.
LLCs become less practical when investors enter the picture. Institutional investors often reject an LLC's pass-through taxation because of unwanted tax issues. It is also harder to create consistent investor protections for LLCs, compared to protections in the corporation structure.
For many startups, simpler structures may offer advantages in terms of cost, compliance, and tax treatment. If institutional fundraising becomes part of the equation, conversion to a Delaware C-Corp, whether from an LLC or a corporation formed in another state, is generally manageable with planning.
Key Startup Structure Factors to Consider
Founders should assess several factors when choosing a structure:
- How soon they plan to raise capital
- Whether they intend to offer equity to employees
- Their appetite for tax and compliance obligations
- The nature of the business itself
A scalable technology company seeking seed funding, or Series A funding, in the near term is likely better off incorporating as a Delaware C-Corp. In contrast, a consulting firm with modest growth goals may benefit from the simplicity of an LLC.
This is not just a legal or tax decision; it is a strategic one.
Planning for Future Funding Rounds
Founders should think critically about how their legal setup can support future fundraising.
If a startup begins as an LLC, it will likely need to convert to a corporation before taking on venture capital. This conversion process requires time and planning. It involves:
- Creating corporate governance documents
- Issuing stock to founders and probably early employees
- Ensuring that past investments, such as Simple Agreements for Future Equity (SAFEs) and convertible notes, are properly reflected in the new cap table
The key is to have a clear plan for transitioning as funding strategy develops. Having the right structure, or a path to it, sends a powerful signal to investors that the company is prepared for growth and that the founders understand what it takes to raise institutional capital.
Structure with Intention
Entity choice is not a paperwork decision; it is the legal foundation for raising capital, structuring ownership, rewarding employees, and planning an eventual exit. Venture-scale startups will need to adopt the C-Corp model to meet investor expectations. But since less than 1 percent of startups raise venture capital, that structure is not always necessary.
Founders should weigh their near-term needs and long-term goals when making this decision. Nyemaster attorneys help startups structure with intention, so they are ready for what comes next.
To learn more about issues facing startups, read the other articles in this series:
- Avoiding Common Legal Pitfalls for Startups: Lessons from the Trenches
- The Founder's Equity Dilemma: Vesting, Dead Equity, and Cap Table Health
- Convertible Notes and SAFEs: Fast Money, Hidden Costs
- A Startup Guide to Trademarks, Patents, and Trade Secrets
- Term Sheets Decoded: What Founders Should Know Before Series A Funding
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
