by Christine Mortensen on April 16, 2014
We asked our community what legal questions we could have answered for you and Heather Harper, who is speaking at our upcoming Law Summit on May 3rd responded:
What are the benefits of forming an LLC in Illinois vs a foreign LLC in Delaware? Even though the initial filing is more expensive, if you are just starting out does the more simpler tax filings, etc. make up for it? If you file as an Illinois LLC will venture capitalists be ok restructuring the company into a Delaware Corp in order to invest? Or will this create an unnecessary barrier?
This question presents several discreet questions. Let’s unpack them:
1. Delaware LLC or Illinois LLC
This question specifically asks if there are benefits to organizing a limited liability company in Delaware over Illinois, our home state.
Let’s take the easy part first – cost and administrative burdens. It certainly costs more and will require more filings to form an entity in Delaware. The “Certificate of Formation” in Delaware will set you back $90 plus $50 to get a certified copy to make your Illinois filing (there are additional fees to expedite your request, which most people do). If you operate your business outside Delaware, you will also need to hire a registered agent in Delaware to receive process for you. These services typically range from $99 – $250 / year. If you also do business in Illinois, you will also need to file an “Application for Admission to Transact Business” in Illinois. This filing costs $500, plus additional fees if you would like to expedite the request. The cost to organize your Illinois business in Delaware as a limited liability company will cost between $750 – $1,000 in filing fees and administrative costs without legal fees or any of the important stuff like an operating agreement. You will also be required to pay annual fees and make annual filings to maintain your LLC in both jurisdictions, as well as maintain a registered agent in Delaware.
Clients will often ask me if it is easier to convert a Delaware LLC (vs. an Illinois LLC) into a Delaware C corp. The short answer is – not really. It’s a pretty simple process in either case. Entity reorganizations are governed by straight-forward state statutes. Moving from an Illinois LLC to a Delaware LLC will require making a conversion filing in Illinois, but it isn’t difficult or expensive.
It is clear that there are added expenses and filings, which will increase your administrative and legal spend. It also isn’t much easier to start as a Delaware LLC if you hope to eventually raise capital from VCs and anticipate you will eventually need to convert to a Delaware C corp. So why do companies choose to form in Delaware?
First, the default rules in Delaware may more closely approximate the intention of the parties because they are based on a corporate model rather than a partnership model. For instance, under Delaware law, control in a member-managed LLC (the default if you don’t specify otherwise) is allocated in proportion to the percentage interests of the members (6 Del C §18-402) whereas under Illinois law each member has “equal rights in the management and conduct of the company’s business” and certain actions require unanimous consent of the members (805 ILCS 180/15-1(a) and (c)). It’s risky to rely on default rules. Even default rules that more closely approximate founder intentions fall short of describing the expectations and consequences in a way that avoids founders’ disputes such as a claim that a co-founder isn’t pulling her weight.
Second, Delaware law allows more freedom of contract than Illinois. For instance, in Illinois, there are several legal protections that cannot be limited by an operating agreement. An operating agreement cannot:
- unreasonably restrict a member’s right to examine the books and records of the company
- vary the right to expel a member by judicial action for (a) wrongdoing that materially and adversely affects the business, (b) wilful or persistent material breaches of the operating agreement, and engaging in conduct that makes it not reasonably practicable to carry on the business with the member.
- vary the requirement to wind up the limited liability company’s business if an event occurs that makes it unlawful for the business to continue operating or, upon judicial decree if, (a) the economic purpose of the company is likely to be unreasonably frustrated, (b) another member has engaged in conduct that makes it not reasonably practicable to carry on the company’s business with that member, (d) it is not otherwise reasonably practicable to carry on the company’s business in conformity with the articles or organization or operating agreement, or (d) the managers or members in control have acted or are acting in a manner that is illegal, oppressive, or fraudulent.
(805 ILCS 180/15-5(b))
Illinois also does not allow members to eliminate or reduce a member’s fiduciary duties, but may set forth the standards by which the performance of the obligation is to be measured, if the standards are not manifestly unreasonable (805 ILCS 180/15-5(b)(7)). Delaware, on the other hand, allows the members to restrict or eliminate fiduciary duties as long as the operating agreement does not eliminate the implied contractual covenant of good faith and fair dealing (6 Del C §18-1101(c)).
As you can see, there are many nuances to the distinction between Delaware and Illinois law. I have only named a few. Your decision to form in Illinois versus Delaware should be a conversation that balances cost and the relative benefits and burdens of these different laws.
2. Converting an Illinois LLC into a Delaware C Corp
I mentioned in the first question, statutory reorganizations have made this move easy and relatively inexpensive. From an administrative and legal point of view, the process is negligible, especially since the tax benefits of an LLC can save many founders (especially bootstrapping founders) far more in taxes than a potential reorganization down the line.
3. Image Issues / Credibility with Investors
Founders often wonder if investors will look negatively upon a company that decides to form in its home state rather than Delaware. In my opinion, investors will care that you made rational legal choices with the resources you had at the time. Legal protection such as a founders’ agreement, vesting documents, documents that protect IP, and a clean cap table are all solid building blocks for a quick conversion and easy legal transition into a Delaware C Corp. In Chicago, many startups won’t begin with the goal of raising outside capital. Others will have that goal in mind, but will need to work another job while proving the concept in their spare time. In those situations, the LLC is a far superior result for tax reasons. Who can blame you for making a decision that reduced your costs and made it more affordable for you to start the business of your dreams?
Have more legal questions? Get them answered at our Startup Law Summit on May 3rd.
About the Author
Heather F. Harper is a Clinical Assistant Professor of Law and the supervising attorney for the Entrepreneurial Law Clinic at Chicago-Kent College of Law. Heather teaches Entrepreneurship Law and serves as the legal adviser to the Interprofessional Projects Program (IPRO) at Illinois Institute of Technology (IIT).
DISCLAIMER The content in this article is for informational purposes only and does not constitute legal advice. Readers should contact a qualified attorney to obtain advice with respect to any particular issue or problem.