Business owners often ask whether they should be incorporating in California (or their home state) or if they are better protected by incorporating in Delaware or some other jurisdiction. Their concerns are often focused on taxes, limitations on personal liability and governance of the corporation. However, for venture scale startups, the question may best be centered around finance, as I will explain below.
Why do companies choose to incorporate in Delaware?
Delaware is a favored state for incorporation for large corporations.
- It has historically offered the best franchise tax rules and been the most pro-management;
- It has offered the best protection for board members against derivative suits (lawsuits initiated by shareholders on behalf of the corporation);
- There is less protection for minority shareholders than California (e.g., cumulative voting is not required and staggered boards are allowed); and
- Delaware offers limited statutory protection against hostile takeovers.
These sound important, and they are for large corporations, but they mean very little before your company is ready for an IPO or later rounds of equity financing.
Derivative Lawsuits – These lawsuits are brought by shareholders, on behalf of the corporation. The board members are sued individually for the harm they have done to the corporation. This is different than being liable for the corporation’s debts, which the corporate entity generally protects against. After directors found themselves being personally sued for billions of dollars in connection with mergers and acquisitions, legislators stepped in and created indemnification statutes. Delaware was the first, but all 50 states now have these statutes in place. People tend to prefer the language of Delaware’s statue over California’s, but the same principles apply. If the directors exercise reasonable care in their duties, and do not intentionally or recklessly engage in actions harmful to the corporation, they may be indemnified for any lawsuits waged against them in their duties as directors.
If your corporation is only held by a few people, you don’t run the same type of risk of derivative actions that would necessitate an inquiry into the nuanced differences of California and Delaware indemnification statutes.
Franchise Tax and Other Costs – In addition to the Delaware franchise taxes (minimum $275 or $400 per year), Delaware corporations conducting intrastate business in California must file a statement of qualification in California and pay the minimum franchise tax of $800. The Delaware corporation must pay to file in Delaware and must pay to run the corporation in California, which amounts to extra money in filing fees and extra administrative duties. The Delaware corporation must also maintain a registered agent in Delaware, which usually costs around $100 a year.
On the other hand…
This favoritism has led to some important practical benefits, which are that: (1) Delaware now has a more robust canon of case law regarding corporate issues, leading to predictability of legal outcomes; (2) corporate transactions have been executed under Delaware law, meaning that the documents for the transaction are more readily available and familiar to investors and their counsel; and (3) VC partners, who may serve on the board of their portfolio companies, are more familiar with director liability under Delaware law.
Furthermore, California requires a majority share of each class of stock to effect a corporate change like a merger, acquisition, or IPO, whereas Delaware corporate law allows all classes to vote together. Delaware laws are therefore preferrable to investors, who would not want exit options to be blocked by a single class (Common stock held by founders and employees). Delaware is generally the best state for managers of public companies, so a venture scale company with a viable chance of doing an IPO in the future might want to be a Delaware corporation.
This blog does not constitute legal advice and does not establish an attorney-client relationship. If you need legal advice, please contact a lawyer directly.