 Entrepreneurs 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, liability of management and governance of the corporation. However, for the tech startup, 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 because:
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. The corporate charter in both Delaware and California can indemnify legal expenses and judgments, with some exceptions. I would go deeper into an explanation of the differences between the two states, and I’d be happy to for my hourly rate, but the issue should be moot to most readers at this point. 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. If you sit on a board of directors of a multi-billion dollar corporation and you vote for a strategic merger at a 200% premium for your stockholders, some stockholder somewhere will sue you. It’s inevitable, because there are hundreds of thousands or millions of stockholders and even at a .001% chance of winning the case, the multi-billion dollar judgment potential gives them some settlement value. Hostile Takeovers – Until your company is publicly traded, federal and state securities laws and your founder agreements will make this a moot point, also. Franchise Tax and Other Costs – In addition to the Delaware franchise taxes, Delaware corporations doing business in California must file a California return and pay the minimum franchise tax of $800. Additionally, they must file as a foreign corporation doing business in California. 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 have an in-state agent for service of process, which usually costs around $90 a year. For the tech startup companies I work with, I typically consider what type of securities are likely to be offered and sold for early stage financing. The intrastate exemption to federal securities laws can make finance transactions and equity compensation packages for employees in the State of California easier and cheaper to accomplish. However, a Delaware corporation in California would not be exempt from federal securities laws. Delaware corporations are also subject to lawsuits in Delaware. On the other hand… California requires a majority share of each class of stock to effect a corporate change like a merger, acquisition, or IPO. A VC firm might prefer a Delaware Corporation, which would be less likely to be required to have a separate class vote. California VC firms (of which there are many) are less likely to insist upon reincorporation in Delaware, but VC funds outside of the state very well might. Delaware laws are appealing for that reason to later round investors, plus they have done deals under Delaware law, meaning the transaction will be more familiar. Delaware is probably the best state for managers of public companies, so a company considering IPO might want to be a Delaware corporation. In either case, you can reincorporate in Delaware by creating a Delaware corporation and merging your California Corporation into it. Of course, this will entail several thousand dollars in legal fees. More often than not, I recommend that California founders incorporate in California and deal with Delaware reincorporation in the face of a multi-million dollar finance deal if the VC insists on it. If the company has ties with other states, expects early investments to trigger federal securities laws, or will likely be dealing with institutional investors in the upcoming months, I give more consideration to incorporating in Delaware.
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