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).

SEC Invites Comment on Definition of Accredited Investor

SEC Definition of Accredited InvestorHat Tip to Joe Wallin for noting the SEC has requested public comments as to whether and how they should revise the definition of “accredited investor.”

As I’ve previously noted, for most tech startups it’s very important that they only sell stock to accredited investors. It comes down to this: the securities laws impose a number of onerous obligations on startups whenever they sell securities to someone who is not an accredited investor. [Read more…]

Venture Capital Deals: Founders’ Equity Sapped by Preferences

There is a terrific article on venture capital deals by Steven Davidoff in yesterday’s New York Times’ Deal Book titled In Venture Capital Deals, Not Every Founder Will Be a Zuckerberg. Davidoff examines a case recently litigated in Delaware courts where a company, Bloodhound Technologies, was sold for $82.5 million eleven years after its first funding round. The five founders of the company only received $36,000 in the sale, whereas the management team at the time of the sale received $15 million and the VCs received virtually all of the rest (~$66 million).

How does this happen? The terms venture capitalists negotiate when they make  investments can, over time and successive investments, give the investors the power to push the founders out of management and gain control of the company. Moreover, the “liquidation preference” in preferred stock allows investors to get their money back before anyone else gets anything, and they will often then “participate” in the remaining proceeds. In some circumstances investors negotiate preferences that are even more than what they put in, or can, as they did in the case of Bloodhound, negotiate a “cumulative dividend” that grows over time (cumulative dividends are rare, but preferences and terms that give investors control leverage are not). [Read more…]