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  • Commercial Law Advisors

What Form Of Entity Should Be Used During Incorporation? Whether Delaware Corporation Is Recommended

Businesses of all nature ranging from a grocery store to the next start-up unicorn require a legal status to begin the money-making race. Every business, from a mom-and-pop flower shop to the next billion-dollar tech giant, first has to legally establish itself as a company. When it comes to selecting the right business entity for your business idea, there are many options. There’s no one best choice for the type of business entity you legally choose, just the best choice for your particular company based on your goals.

A Private Limited Company is one where the shareholders right to transfer shares is restricted. The number of shareholders is limited to 200. Also, the very name of a private limited company denotes that an invitation to public to subscribe to any shares or debentures or any other type of security is barred. A traditional partnership firm has every partner jointly and severally liable for all the acts of the firm done as the partner.

A Limited Liability Partnership (LLP) is a midway between the limited liability of a company and the flexibility of a partnership. The major difference between a company and a LLP is in the internal governance structure. A company is regulated by the Companies Act, 2013 whereas an LLP has a contractual agreement between the partners and the Indian Partnership Act, 1932. An LLP has certain advantages over a traditional partnership. An LLP can exist even with changes in its partners. It can enter contracts and hold property because it is a separate legal entity like a company. The LLP is liable to the full extent of its assets but the liabilities of the partners are limited only to their contribution in the LLP. An individual partner is thus protected from being jointly liable for wrongdoings of other partners.

Foreign Direct Investment is also allowed under automatic approval route in most sectors for a private limited company. This distinguishes a Private Limited Company from an LLP where Foreign Direct Investment is allowed after prior approval of Reserve Bank of India (RBI) and Foreign Investment Promotion Board (FIPB).

It is also not mandatory for a startup to hold annual meetings of shareholders for a private company. Instead it should be a strategic move if the company decides to go public eventually. It is an assumption that LLPs do not hold the partners personally liable. However, even in a Private Limited Company, the directors and shareholders not personally liable for the company. It is a separate legal entity. Barring certain circumstances, there is liability only to the extent of their share capital. An LLP has lesser compliance requirements than a company. However, as an organisation, an LLP has lesser credit worthiness than a company.

LLPs lack a way to grant options but startups prefer issuing those to employees and advisors. Thus taking the form of a Private Limited Company would facilitate this. Also, the assumption that LLPs have tax benefits is flawed because the additional burden of the companies to pay dividend distribution tax is eliminated after the amendments made to Indian laws with respect to taxation to scrap the dividend distribution tax with effect from 1 April, 2020.

Most start-ups are incorporated with a parent company in Delaware. The tiny state of Delaware has a smooth regime of business laws free of regulatory hurdles. Companies should consider incorporating a parent company in Delaware if

  • their product will be sold in the U.S, or

  • the Company is looking to raise funding outside India; or

  • the Company is looking to bring on-board strong management with experience in growing technology companies at a fast pace; and/or

  • the potential acquirer or exit is likely to be in the U.S.

It is recommended for the founders to consider a parent company in Delaware. If the aim is to form a US company for the need to open a bank account in US without opening a US branch, then the state of Wyoming, US, should be approached as it has lower annual state fees. This is one of the shortcomings of Delaware Corporation. However, the advantages surpass the flaws by a great margin. If a startup aims to obtain US investment or Venture Capital funding, then Delaware Corporation is most uniformly accepted by the majority of investors. Delaware jurisdiction has judgements supporting the statutes thereby making the applicability easier. It is speedier and less expensive increasing the ease of set up, ability to issue stocks with tax benefits. It also considers universal corporate law. This ensures lower transaction costs. Also, most standard forms of document for Venture Capital funding are based on Delaware law.

The companies should have a default option of registering a parent company in US. This is primarily because registering in US provides a startup the much needed broader horizon of the developed regions. It accentuates the credibility of the company in the international market. It attracts range of investors and at the same time is tax beneficial.

To register a company in USA from India, the following steps should be taken. First, appoint a register agent. Second, choose a company name. Third, provide names of directors and members along with the KYC documents such as Passport and Identity Proof. Fourth, the Federal Employer Identification Number is issued by the US Internal Revenue System. Employer Identification Number helps in opening a bank account in the US. Fifth, a bank account should also be opened in the home country (e.g. India). Thereafter, all the required annual compliances shall have to be followed along with other tax compliances.

In case the startup is already formed as something other than a Delaware corporation but wants to change to Delaware Corporation, it should opt for one of the following choices. First, conduct a merger with the Delaware Corporation. Second, convert the entity to a Delaware corporation. This is recommended over a merger if the state allows conversion. Third, start a new Delaware Corporation. This is feasible for startups as they are a new entity and termination before the year end can help in avoiding federal taxes or while filing franchise.

Thus one can conclude that start-ups should register as private limited company and also register a parent company in Delaware, US, to avail its benefits.

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