Forming in Delaware or California?
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Should You Incorporate in Delaware or California?
The majority of startups begin business as a sole proprietorship, general partnership, or limited liability company. The business generally changes entity forms when it needs the more formalized ownership and control structure characteristic of a corporation. Specifically, the separation between officer, director, and shareholder provides a level of formality that can be beneficial to the company as it grows.
When a company seeks investors, it will generally reorganize the business as a corporate entity. The reason is because, in exchange for their capital, investors require preferred stock in the company. This stock provides all sorts of preferential treatment and rights to the investors. While these same writes can be established in a limited liability company (LLC), the process for doing so is very complex and requires extensive contracts. Also, the LLC may not be able to take advantage of some of the tax benefits available to early-stage, startup businesses.
The question becomes, “Where should I incorporate my startup company?” The two most common states of incorporation for technology company are California and Delaware. Companies choose California, as that is often the state of primary operations. Companies choose Delaware out of tradition and pursuant to investor preference.
Delaware versus California
The majority of startup ventures in the United States organize or reorganize in Delaware when they are seeking equity investment from venture capital firms. This trend, however, is changing rapidly as more and more investors accept incorporation in California. Below are the primary considerations when choosing the state of incorporation.
• Tradition - Most investors believe that Delaware is the only suitable location for business incorporation. This is true even when they do not know the reasoning behind their belief.
• Document Drafting - Investors do not want to reinvent the wheel when entering into a funding transaction with a tech startup. These investors generally use a standard set of investment documents that they modify to meet the needs of the particular investment. Most of the existing documents publicly available are drafted in accordance with Delaware law. While it would not be overly cumbersome to find and become familiar with California documents, investors may seek the easier (more traveled) road.
• Management-Friendly State Laws - Investors in a company generally prefer Delaware law. The investors will exercise extensive control over the company by electing board seats or personally sitting on the company’s board. In this regard, Delaware corporate law is known to be very management friendly. That is, Delaware has a very strong “business judgment rule”. This rule protects management (directors and officers) from liability in derivative actions by shareholders. For more information on derivative shareholder actions and the business judgment rule, visit the LawTrades blog.
• Shareholder Protections - While the law in Delaware is generally management-friendly, it is often considered oppressive to shareholders. California has numerous shareholder protection laws, such as mandatory cumulative voting and limitations on staggered voting for board seats. Both of these make it difficult for an investor to unilaterally exercise control over the company. For more information on shareholder voting rights, visit the LawTrades blog.
• Business Court - Investors are wary of being subject to litigation in California. The juries are notorious for delivering outrageous verdicts. 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.
• Franchise Taxes - The primary consideration of whether to organize in California or Delaware comes down to franchise taxes. Delaware has an established an predictable method of calculating franchise taxes based upon shares authorized. Here are the differences:
⁃ Delaware - In Delaware, all corporations must pay a minimum franchise tax of $175, plus a $50 report fee (total $225). The annual franchise fee is calculated either based upon the par value of the company’s total shares or number of shares authorized for distribution. The company must choose the applicable method.
⁃ Par Value - This method charges .035% tax on the total market capitalization of the company. The market capitalization is either the “state par value” or the “assumed par value” of the company’s shares (whichever is greater). The stated par value is the par value ascribed in the articles of incorporation. The assumed par value is the company’s gross assets divided by the total number of outstanding shares. This grows assets calculation is used as the market capitalization.
⁃ Number of Authorized Shares - If the company authorizes less than 5,000 shares, the tax is $175. If it authorizes 5,000 - 10,0000 shares, the tax is $250. Each additional 10,000 shares is $85 more. The maximum level of taxation is $200,000 per year.
⁃ California - California charges a minimum franchise tax of $800. Companies organized in other states but carrying on business in California must pay this franchise tax. As such, a technology company operating in California and organized in Delaware would pay both fees.