Should I Incorporate in California or Delaware?
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Authored by Bryan Springmeyer Bryan Springmeyer is a California corporate attorney who represents startup companies. The information on this page should not be construed as legal advice. |
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, 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.
[Read: Registering and operating a Delaware corporation in California]
Why do companies choose to incorporate in Delaware?
Delaware is a favored state for incorporation for large corporations because:
- 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. 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 contractual restrictions on transfer will make this a moot point, also.
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.
The intrastate exemption to federal securities laws can make certain finance transactions and equity compensation a bit easier and cheaper to accomplish. However, a Delaware corporation in California would not benefit from the intrastate exemption to federal securities laws. Delaware corporations are also subject to lawsuits in Delaware.
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. In either case, a company can "reincorporate" in Delaware through conversion, asset transfer, or by creating a Delaware corporation and merging the California corporation into it. Of course, this will entail some expense on the legal front.
When founders are considering incorporating a company that is not venture scale, I usually recommend California incorporation. If they later decide to pursue a venture scale model, they can deal with reincorporation in Delaware in the face of a multi-million financing. If the company is pursuing a venture scale model, 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 from the outset.