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.

Legal Structures for Impact Entrepreneurs

Below is a webinar featuring BCL Founder Francesco Barbera and serial entrepreneur Michael Anderson discussing legal structures available to mission-driven and social impact entrepreneurs.

Hosted by Conscious Capital San Diego, the discussion focuses on the legal and business factors that come into play when deciding on the right corporate structure for impact-drive ventures.  It includes consideration of traditional corporate forms such as corporations and LLCs, benefit and social purpose corporations, and hybrid structures with for- and non-profit components.

Preparing Your Business For Strategic Acquisition

Key Legal Strategies For Maximizing The Likelihood and Value Of A Future Business Sale

This article lists key legal strategies and practices for business owners considering a company sale as a potential short- or long-term exit strategy.  These practices are intended to minimize red flags that may derail or adversely impact a company sale.   Whether or not a sale is achieved, these practices will create a strong legal foundation for sustainable business growth.

• Incorporate Properly.   When handled properly, incorporation of the business protects owners from uncertainty and potential disputes about basic matters such as ownership of the business, company management and decision-making, the transferability of stock, and buy-sell arrangements in the event of intractable shareholder disputes.  Effective incorporation also helps ensure that assets and other contributions of the company's founders are effectively vested in the company.  Finally, incorporation may help owners realize more favorable tax treatment in an eventual company sale.
• Exercise Caution When Raising Capital.  Outside investment introduces substantial risk and complexity into a business.  Matters such as the economic and governance rights of the investors need to be carefully considered.  Failure to comply with securities laws creates substantial legal risks that raise red flags for potential buyers.   Companies raising capital, whether from friends and family or professional investors, should ensure the offering is handled properly and in compliance with applicable federal and state securities laws.     
• Perfect Title In Key Assets.  Buyers want to know they are getting good title to a seller's business assets.  Companies should take care to clear up uncertainty in chain-of-title and liens or other encumbrances on company assets, including real properties, proprietary software or other intellectual property, and other tangible assets.  The presence of such factors erodes confidence. 
• Protect Your Intellectual Property.   If a company's value is tied to its intellectual property, owners should take steps early on to establish sound IP portfolio practices.  Valuable IP may include a recognizable brand or trademark, patentable inventions, copyrighted content, or proprietary formulas, business methods or customer or supplier lists.   In each of these cases, a company should establish clear ownership to (or rights in) all core IP assets and maintain the value of those assets through appropriate monitoring and enforcement activities.
• Establish Reliable Finance, Accounting and Reporting Systems.  Apart from their value to business decision-making, reliable metrics facilitate the due diligence process and often enhance the sale price of the business.  Verification of financial data is a principal buyer concern, and reliable metrics help greatly with that.
• Establish Standard Agreements That Protect Your Company.   Recurring contracts in a business, such as standard customer agreements, represent an opportunity to enhance value and minimize risk.  Provisions addressing express or implied warranties, term and termination, changes to the agreement, damage limitations or dispute resolution processes, all can minimize liability exposure and impact a company's risk profile and bottom line.  
• Use Well-Drafted Employment and Consultant Agreements.  Proper employment and consulting agreements used organization-wide help protect the company’s intellectual property and business secrets, secure the company’s clients against improper solicitation, and create valuable certainty around the scope and duration of employment and consulting arrangements.  
• Maintain Good Employment and HR Practices.  Given the prevalence of wage and hour and other class actions in today’s business climate, it is important that growing businesses introduce sound employment policies and practices to ensure compliance with basic legal requirements.  
• Maintain Adequate Insurance Coverage.  A clear track record of appropriate coverage against risk is good business and reassuring to buyers. 
• Keep Up With Compliance and Regulatory Matters.  Maintain corporate books and records and required business licenses and permits.  Keep up with regulatory and compliance issues.  Don't let the small stuff accumulate through neglect.  
• Long-Term Contracts.  Long-term business arrangements should be drafted with a possible company sale in mind.  Such agreements will ideally give owners flexibility to pursue a sale without triggering additional legal or consent requirements or other adverse consequences.

This list is by no means exclusive but it represents a basic set of sound legal practices that, if implemented consistently, will help owners build sustainable organizations well-positioned for strategic exit.

Barbera Corporate Law advises family-owned and lower middle market business on these matters.  We also help new companies launch themselves on proper legal footing.  If you have questions, please contact us.