Why Do So Many Startups Incorporate In Delaware - And Should I?

Most emerging growth and publicly-traded companies in the United States are organized as Delaware corporations. While Delaware isn’t the best choice for all business incorporations, there are a number of very good reasons to incorporate a high growth startup in Delaware. Below are a few of the key benefits:

• Efficiency. In the United States, each of the 50 states has its own set of corporate laws. For businesses with national reach, it is impracticable for stakeholders and their legal or other advisors to learn the laws a new state. Delaware has become a kind of de factor “national” corporate law jurisdiction to solve this problem. Investors and other stakeholders and their advisors tend to be well-versed in Delaware corporate law, and widely-used legal forms and precedent are based on Delaware law. All of this facilitates negotiation, increases efficiency, and reduces cost.

• Flexibility. Delaware’s general orientation in corporate law is to respect the decisions of the principals forming the company. California, by contrast, takes a more paternalistic approach, imposing requirements by statute that Delaware leaves up to the parties themselves. For example, a Delaware corporation with 3 or more shareholders can have a single director on its board, whereas the same corporation formed in California must have at least 3 directors. California mandates class-based shareholder votes in certain circumstances, whereas Delaware generally allows the parties to determine when such votes are required. Delaware’s more deferential approach provides founders and other stakeholders with more protection and flexibility to negotiate terms that make sense for the business.

• Deference. All states require corporate directors and officers to manage companies consistent with the fiduciary duties of care and loyalty. But Delaware’s interpretation of these fiduciary standards is generally more deferential to management, reducing legal risks.

• Predictability. As businesses grow in complexity, clarity in the legal rules governing their operation become essential. Delaware has a well-developed body of corporate law providing corporate directors and officers unparalleled guidance in understanding and discharging their obligations and navigating complex governance matters, like takeover defensive measures, acquisitions, executive compensation, proxy issues, interested party transactions, shareholder voting matters, and so forth. Delaware law is also widely studied and written about by academics and practitioners, providing even more guidance and clarity.

• Administration. The Delaware Secretary of State, which handles the administration of corporate filings, is responsive, flexible and highly skilled. It’s possible to have a business filing returned from the Delaware Secretary of State within an hour, to give a trivial example that turns out to be really helpful amidst critical business transactions. (California’s Secretary of State, by contrast, is bureaucratic and unresponsive.) Further, Delaware has dedicated courts charged with the administration of its corporate laws, providing a reliable adjudicatory body with deep expertise in corporate matters to preside over business disputes.

• Taxation. In the U.S., business taxes are mostly based on a company’s physical location, not its state of incorporation, so contrary to a popular misconception, incorporation in Delaware will not, for example, help California-based business avoid California state income taxes. But Delaware does take a hands-off approach to state-level taxation that is helpful to businesses incorporating there.

Is Delaware Right For My Startup?

Naturally, the decision in the case of any particular business should be based on individual considerations in consultation with your legal and tax advisors.

That said, Delaware is a good choice if you are building a growth company that will seek funding from an institutional or geographically-broad base of investors, have a larger number of shareholders with varying interests, and/or involve operations and stakeholders in many jurisdictions.

If that is not the planned trajectory of the business, or if it’s not yet clear, incorporating in your home state may be the right choice, at least for the time being. If necessary, it is possible to convert your company into a Delaware entity at a later time, though doing so can becomes more arduous once a company has grown in complexity.

LLC or Corporation? Choosing the Right Entity for Your Startup

One of the first questions to address during the startup process is whether to incorporate as a limited liability company (LLC) or corporation. Both entities provide the benefit of liability protection and the ability to issue equity to investors and service providers.

But these entity type have different strengths and weaknesses depending on the specifics of your business.

Below are the key factors when choosing between these two corporate forms:

• Taxation. LLCs are taxed as pass-through entities, which means they are not taxed at the entity level. This enables the distribution of profits to owners on a tax-free basis. Of course, owners still have to report the profits on their personal tax return but the LLC itself does not pay tax on those profits. Likewise, this enables the pass-through of losses, which, especially in the early stages of a business, can be advantageous to founders who are bootstrapping or raising capital through debt and have other income to offset. Some of these advantages can be secured through a corporation electing to be taxed as an “s corporation.” But maintaining that election comes with restrictive requirements - such as limits on the classes of stock and shareholders - that aren’t suitable for growth-oriented companies. Corporations, on the other hand, enable the carry-forward of losses and the issuance of qualified small business stock, which have significant tax advantages. In short, analysis of the tax implications can involve a wide range of considerations particular to your business plans and objectives.

• Capital Raising. Many institutional investors are prohibited from investing in pass-through vehicles like LLCs or have strong preferences against them. For this reason, companies planning to seek institutional growth capital often incorporate as or convert into corporations.

• Equity Compensation. Both LLCs and corporations can issue equity to service providers but corporations can generally do so more efficiently. While LLCs can issue options, they cannot issue incentive stock options, which are tax favored options for employees. Because LLCs are generally taxed as partnerships, when they issue equity interests to team members, they must issue K-1s to recipients and maintaining capital accounts for them. The tax complexities can multiply quickly.

• Flexibility. While corporations are highly efficient, LLCs are highly flexible. The governance and ownership structure of an LLC is largely determined by the contract among its owners, giving the parties latitude to accommodate different business needs and scenarios.

• Legal Predictability. Corporations are the most well-established legal form for the conduct of business. Corporate governance matters and the legal principles that apply to them are well developed, providing important predictability and guidance in the conduct of a business.

For emerging growth companies with the clear intention to raise institutional capital and scale with large teams, formation of a c-corporation is almost always the most efficient and effective legal entity for the job.

For others, the choice of entity can be a more complex and nuanced decision. We always advise making the choice of entity decision in consultation with legal and tax advisors based on the specific plans for your business.