Why do many tech startups incorporate in Delaware?

Many tech startups incorporate in Delaware. Why? While its not appropriate for all startup companies, there are a number of reasons why tech startups that require significant investment to scale their business incorporate in Delaware:

1) Delaware corporate law is much more developed and streamlined compared to other states.

Because so many companies incorporate in Delaware, and because they have specialized courts that deal only with corporate disputes, there is much more “legal certainty” about how the courts will treat certain contractual and transactional issues, and it is largely seen as “business friendly.” Many of these are issues that a company won’t face until much farther down the line. But some of them affect startups straight out of the gate. Delaware largely lets companies decide minor issues for themselves. On the other hand, California likes to dictate these small issues. For example, in Delaware you can have as many directors as you want, whereas in California you have to have one for every shareholder up to three. So if you are a startup with three shareholders, you are obliged to have three directors, even if that doesn’t make any sense at all and means a lot of wasted time in getting signatures.

2) Delaware makes things easy.

The Delaware filing office is open until 8PM, and usually filings come back stamped in a day. This is huge for fast-moving capitalization transactions. California, on the other hand, takes weeks unless you pay expedite fees, and often sends filings back for minor non-conformities. Like many other California government agencies, the Division of Corporations can be very bureaucratic.

3) Delaware conforms to investor expectations.

Virtually all corporate lawyers in the US (and many around the world) are familiar with Delaware corporate law, and indeed for many of us Delaware corporate law is probably even more familiar to us than the law of the state we are in! Thus, you don’t have to worry about your investor’s lawyer not knowing the intricacies of whatever state you are in. Most California venture capitalists are reluctant to invest in California corporations, much less a corporation from Wisconsin, New Jersey or Arkansas.

Why shouldn’t you form a Delaware corporation? Cost. If you form a Delaware corporation, you also have to qualify the business in the state in which the corporation is doing business. All told, it probably costs an extra $1-2K to form a corporation in Delaware rather than the state you are in (costs of qualifying in your state + legal fees to qualify + cost of Delaware franchise tax), and you will have some additional costs going forward in terms of franchise taxes, filing and agent fees. However, I often think this is more than than made up in just the first financing transaction you go through. And it will be much more expensive to convert later if that is a route you take. But if you will not raise capital and want to keep things simple, it probably makes sense to simply incorporate in the state you are in.In short, if you are aiming to raise capital to scale your business, incorporating in Delaware is often a smart choice (though like all things there are exceptions).

For Profit, Nonprofit, Benefit and Flexible Purpose Corporations

Corporations generally are understood to be for-profit, and the board of directors and the officers of the corporation are required by law to manage the corporation in the financial interests of the shareholders. In a sense, the financial interests of the shareholders are supreme to any other consideration that the management of the corporation takes into account. For most enterprises this makes sense, but in certain cases corporations are organized to serve interests other than the financial interests of the shareholders. In these cases, an enterprise might consider forming a non-profit, benefit, or flexible purpose corporation.

[Read more…]

Introduction to Corporations

In kicking off my series on different business entity structures, I’ll start with corporations.

What is a corporation?

A corporation is a limited liability entity that exists separately from its legal owners. One or more owners hold shares of stock in the corporation that grants them certain economic rights to the profits and residual assets of any business operated by the corporation, as well as certain voting rights as to the management of the corporation. The corporation is able to enter into its own contracts and legal relationships with other parties, which is part of what protects the shareholders from liability. Except as described below in regards to an “S” corporation, a corporation is taxed separately and in addition to its owners, meaning that when a corporation earns a profit that amount is taxed by certain states and by the federal government. In addition, once the corporation takes those profits and distributes them to shareholders as dividends, the shareholders will also be taxed on that income (which is often colloquially referred to as “double taxation”).

[Read more…]

Considerations in Business Formation – Part II (Initial Capitalization)

I’ve been covering the steps involved in the Business Formation process. To recap, the steps are:

  • Planning
  • Entity selection
  • Filing
  • Initial governance matters
  • Initial capitalization matters
  • Initial agreements among stakeholders

My last post covered the Planning, Entity Selection and Filing steps, which takes us to the point where the state has returned stamped documents establishing a new entity. Now we are at a complex stage: establishing how the business will be managed, initial capitalization, and what the rights of all stakeholders will be going forward.

[Read more…]

Considerations in Business Formation – Part I

In keeping with my promise to start at the beginning, my next few posts will be on business formation and subsequent posts will be on the different business entity types. Today I will focus on a few basic questions surrounding business formation, and the first few steps in business formation.

What does business formation mean in the legal context?

In a legal context, business formation is the process of planning and documenting the initial formal relationships among stakeholders that will govern the ownership and management of the business as it moves forward.  It encompasses planning and executing choices regarding entity structure, governance, capitalization, and tax strategies for the business as well as its founders and investors.

[Read more…]