It has become an industry standard for large companies and startup business ventures to incorporate in Delaware. There is a long history behind the rise of Delaware to prominence as the state for corporate organization. This trend continues, as Delaware provides a number of advantages for certain types of companies. The benefits that Delaware offers to incorporators include:
Pro-Management State Laws – Delaware law is notoriously pro-management in nature. Most notably, the state has a very strong “business judgment rules” when determining whether officer or director actions violate a duty owed to shareholders. Also, there are fewer shareholder protections, such as cumulative voting is not required and staggered boards are allowed.
Hostile Takeovers – There is limited statutory protections against hostile takeovers.
Franchise Taxes – Delaware has an established an predictable method of calculating franchise taxes based upon shares authorized.
Chancery Court – Delaware has a dedicated chancery court for the resolution of internal business disputes and certain litigation. This allows complex business law matters to be decided by a business law expert (a chancellor), rather than an unsophisticated jury.
In this article, we visit each of these Delaware benefits and compare them to the state of the law in California.
Are Management Protections and Protection from Hostile Takeovers Worth It?
When shareholders have a legal claim for breaches of duties of loyalty or care by officers or directors, the sole legal remedy is often a derivative lawsuit. This means that shareholders sue one or more officers or directors to recover damages. Any damages recovered go to the company and not the individual shareholders. The officer or director is left defending actions for breach of duty of care by asserting the “business judgment rule”. This rule protects officers and directors from liability if their decisions were reasonably informed and did not involve self dealing. Further, Delaware has strong indemnification statutes allowing the company to indemnify officers and directors held liable in derivative actions. This reality thwarts the effectiveness of derivative action, as having the company pay a debt to itself does not increase company value.
Of course, shareholder derivative actions are very rare in startup ventures. It is not until a company becomes public that they become very concerned with management protections. The same is true for hostile takeovers.
The lack of consumer protections statutes in Delaware does make it friendlier than California. Cumulative voting provides shareholders with far more strength in Delaware. Also, prohibiting staggered board takes away an important protection for directors.
California requires that a majority of shareholders for every class of stock must approval a corporate merger, acquisition, or IPO. Delaware law allows classes of shareholders to vote together.
Entities issuing securities (stock or debt instruments) must comply with state and federal securities laws. Most startups perfect an exemption from the onerous registration requirements under federal law. Notably, there is a specific exemption from federal registration for issuances taking place entirely within a company’s state borders.
If a company is organized in Delaware but operating in California, this type of exemption would not be available.
Filing Fees and Franchise Taxes
The primary consideration of whether to organize in California or Delaware comes down to franchise taxes.
Delaware Franchise Taxes – In Delaware, a startup company will likely have to pay a minimum franchise tax of $175 – 400. This just the minimum for filing in Delaware. The actual franchise tax will be based on either the par value of the company shares or the number of shares authorized. An early-stage tech startup will likely not have a very high par value for stock. The $400 amount applies up to one million dollar capital stock value. The other method is based upon the number of authorized corporate shares. If the company authorizes less than 5,000 shares, the tax is $175. 5,000 – 10,0000 shares cost $250. Each additional 10,000 shares is $85. It is common for a startup to issue lots of shares for purposes of distributing to founders and compensating employees. Also, once a tech startup receives funding from an outside investor, it is very common for the total par value of all company stock to exceed $1M.
California Franchise Taxes – California charges a minimum franchise tax of $800. Companies organized in other states but carrying on business in California must pay this franchise tax.
Organizing in Delaware and carrying on business in California would subject the company to double franchise taxes.
Reaching a Decision Based Upon All Considerations
Evaluating these considerations together will help make the decision of where to incorporate. As discussed, Delaware has more friendly management protections which may become relevant to the startup later in its existence. VC investors who assume a role on the startup board may be more comfortable with the protections afforded under Delaware law. Regarding franchise taxes, filing in Delaware will subject the startup to franchise taxes in Delaware and California.
In summary, if the startup needs to attract venture capital investors, incorporating in Delaware is likely a good idea. Until that time, there are numerous expenses to save and advantages (such as intrastate securities offerings) to simply incorporating in California.
LawTrades Knows Corporate Formation
If you are making the decision of where to incorporate, take the time to discuss your company’s specific characteristics with a legal professional who has knowledge in such matters. The legal professionals at LawTrades are experts in the field of business incorporation. They fully understand the issues faced by startups. They can help you make the decision that makes the most sense for your business.