Back With A Vengeance: The U.S. C-Corp

1.1The strange attraction of double taxation

C-corporations are the most prevalent form of corporations in the United States.

They are different from “pass-through” Limited Liability Companies (“LLCs”) in that their owners or stockholder are taxed separately from the corporation. Inversely, this means the taxing of profits from the business is at both corporate and personal levels. In contrast, in the LLC there is no tax on profits at the entity level, only at the Member (individual shareholder) level.

So why would not all companies want to be LLCs? There are a number of reasons investors and most prominently Venture Capital prefer C-Corps above LLCs:

1. VCs do not like the pass-through taxation of LLCs which would pass the business’ income through to them. They’d rather have the entity pay the tax. Also, VC firms often have “tax-exempt” investors (the Limited Partners in their funds) who could have tax issues if business income passes through to the owners.
2. VCs like preferred stock in exchange for their investment which give them a preference over other shareholders in receiving dividends and distributions. Other structures such as S corporations are not allowed, under tax laws, to issue a class of preferred shares. LLCs do not issue shares and whilst preference rights could be provided for as a separate class of Member interests, this is more complex.
3. C-Corps allow for the issue of stock options to management and employees as part of an Employee Stock Option Program (ESOP). Such ESOP would be more restrictive in e.g. an S-Corp and impossible in LLCs since the latter does not issue stock.
4. When a C-Corp eventually exits via a trade-sale or by going public, its stock is generally freely transferable, In contrast, there are restrictions on the sale of LLC interests and S corporation shares.
5. Corporations have been around for longer than LLCs, which are a more recent company type. So there may be some force of habit at work when investors prefer the C-Corp over the LLC, however C-Corps do have a much longer legal pedigree: possibly anything that could have been litigated in Delaware, where most C-Corps are established, has been litigated and forms part of a large body of case law related to C-Corps.

So the short of it is that if you want to attract equity investors including VC for your project, you’ll be expected to have incorporated a C-Corp.

Where to start?

1.2In the beginning there was incorporation

All that needs done to form a C-Corp is to file a Certificate of Incorporation with the Delaware State Registry.

By way of example, here is a link to the Certificate of OtoCo Inc., the recently formed development company for the OtoCo project, which was prepared with the help of Cooley, who acted as the Sole Incorporator.

There are many permutations but at a very minimum, the Certificate of Incorporation, in addition to the chosen name for the new entity (Section I), needs to make specific reference to who will be the registered agent for the Company and where it will have its registered office, which has to be in the State of Delaware (Section II).

Section III basically says that the new entity will be doing whatever it set out to do as long as it is legal. In other words there is no requirement to specify the activity of your new company.

Section IV is more substantial. It authorizes the total number and class of stock that can be issued by the Company. There is plenty literature in relation to the optimal capital structure for a fast-growing C-Corp and what nominal value to set for its stock. Lots of this is tax-driven, since Founder stock (the number of Common Stock earmarked to the Company’s Founders) needs to be acquired by them. As a result, the nominal value per share is typically kept very low ($0.00001 is not unusual). Important here is that the number of authorized shares leaves room for an ESOP and future funding rounds. In addition, Founder stock is typically subject to vesting (see below).

The remainder of the sections of the Certificate of Formation are mainly governance related and include operative sections related to its Board for Directors (Sections V and VI) and how the Certificate can be changed (Section VII).

Section VIII then lists the name of the “Sole Incorporator” who needs to sign the Certificate of Incorporation before it can be filled with Delaware State, which will be the forum of choice for all legal action related to the Company (Section IX).

Note that such Sole Incorporator does not have to be the first shareholder of the Company, and can be any natural person. This way the names of shareholder(s) do not appear on public record. Neither does the Certificate of Incorporation mention the name of the first officials of the Company including its Director(s). C-Corps are therefore quite anonymous in how they file.

We have put together a list of questions in spreadsheet format that should help you focus the mind on the key issues to consider and research further before you file your Certificate of Incorporation:

Please note: Delaware is currently experiencing delays for regular filings but for a small extra charge (around US$ 50) all new incorporation filings can be done within 24 hours.

1.3Remaining documents

The remaining documents related to your new C-Corp will all be private, i.e. there is no need for any filing with Delaware State.

Essentially, authorities do not get involved with how you manage and govern your company as long as it is conducting a lawful activity and abides by the General Corporation Law of Delaware and other applicable laws and statutes.

This means that when it comes to its governance and operations, you can still play god (with lowercase g) in your own company :-).

However most of the remaining documents will have self-imposed restrictions to make your company “investable” i.e meet expectations of investors as to how you deal with issues ranging from Founder stock vesting to IP transfer, Board matters, etc.

This results in a significant stack of remaining documents post-incorporation, all of which are listed below and which we have made available on an as is basis via the corresponding links. Please note that all templates are provided for Delaware C-Corps who operate from California and have California-based employees.

1. Action by written consent of Sole Incorporator (1 page)
   This document confirms the appointment of the first Director and resignation of the Sole Incorporator.

Model C-Corp Bylaws (24 pages)

These Model Bylaws are essentially the rulebook for your Delaware Corporation. Please have independent counsel review and advise on suitability.

Certificate of Secretary re Bylaws (1 page)

This is a largely mechanical resolution that confirms the appointment of the corporate’s Secretary and the Company’s Bylaws.

Common Stock Certificate (2 pages)

This is the rather anachronistic-looking C-1 form used to document ownership of the indicated number of Stock and its class per Stockholder. This antiquated ritual could easily be replaced by tokenizing stock and using blockchain as ledger of ownership. However, for now most captable software such as Carta will require the duly signed C-1 forms as a proof of who holds how many shares and investors insist on C-1s to make sure the ownership of the company they invest in is properly documented.

Form of Employee Confidential Information and Inventions Assignment Agreement ( 8 pages).

This agreement seeks to make sure that anybody who is employed by the Company transfers all confidential information to the company together with any “inventions” they may have related to the project. It is intended to be used for employees who reside in California. However, several California courts have recently expressed doubt as to whether employee non-solicitation provisions are enforceable.

Indemnification Agreement (14 pages)

This too is driven by California laws and seeks to indemnify employees who otherwise may not be willing to enter into an employment agreement with the Company.

Initial Action by the Board of Directors (10 pages)

This is an important operative resolution for your Company that documents the appointment of various officials, the sale of its stock to Founder, and various other operating provisions such as fiscal year, principal office, etc.

Model Escrow Instructions (4 pages)

This agreement is part of the legal mechanics related to the Restricted Stock Purchase Agreement (see below) by Founder.

Restricted Stock Purchase Agreement (11 pages)

This is a crucial agreement for any Founder whose “Founder stock” will be subject to vesting terms, typically monthly over 4 years (sometimes after an initial portion vested immediately). The reason this is referred to as “Founder stock” is that the restrictions on such stock are typically different from stock to employees, which typically vests over 4 years with a 12 month cliff (i.e., no stock vests before the first year of employment). Founder stock may also have different “acceleration terms”, meaning rights to accelerated vesting upon the occurrence of certain events such as an acquisition of the company or a termination without “cause”. It is important to read up on all these levers before you engage with investors.

Stock Assignment Separate from Certificate (1 page)

This assignment form is part of the mechanics of the above Restricted Stock Purchase Agreement and allows the Company to exercise its repurchase option under the Agreement.

Stockholder Consent of Indemnification Agreements (2 pages)

This Consent is required to make sure each Stockholder agrees that the Company enters into Indemnification Agreements with its officers and directors, using the format of the Indemnification Agreement in (6) above.

Technology Assignment Agreement (4 pages)

This agreement effectuates the transfer of all technology and Intellectual Property (described in its Exhibit A) from the Company’s Founder(s) to the Company. Effectively, you will be required to relinquish all claims to your ideas in return for receiving stock!

1.4Good to go

Once the above documents have been executed, there is a further checklist of things to do to get your project all ready.

These range from getting an Employer Identification Number from the IRS (which U.S.-based Founders can get online) so you can open a bank account for your new entity and start hiring, to filing “Section 83(b)” notice with the IRS if you are a U.S.-based founder for any stock that is subject to vesting (within 30 days of Founder’s stock purchase).

Otonomos can help with the preparation and filing of your Certificate of Incorporation, the generation of the remaining documents and other ancillary services related to your Delaware C-Corp.

Quoted from the entry

“Simply order your C-Corp online here or schedule a 30 minutes initial call to have us walk you through the process and answer any questions you may have.”

— Otonomos, 24 February 2022