When an entrepreneur decides to create a business, he or she will invariably takes the first step to incorporate. The question I get most frequently is in which state he/she should incorporate. Now most people will choose where they reside and where they intend to do the most business. However, in many startup meetings, you hear from attorneys that their preference for the state of incorporation is Delaware. I disagree. Most often than not, many cannot explain why. I personally feel that one should incorporate in whatever state makes economic and strategic sense.
My first comment is that there are 50 states and each has its own corporate laws, each associated with rules and regulations that relate to the management of the corporation and the individual filing fees and franchise taxes and any other fees. Even though the Model Business Corporation Act should have established a homogenous system, all the states have enacted variations on the same model.
States differ on how to apply the recurring franchise fees depending on the authorized shares. And some states treat foreign (outside of the state) revenues as part of franchise fees or taxes for the annual recurring fees. The process to initiate a derivative suit vary state by state. For example, in Delaware, once you have reached a certain plateau of shares, the company is required to pay a fractional franchise fee for each additional authorized share.
One notable example was a Californian tech startup whose corporate attorney filed the company in Delaware with the authorization of 300 million shares. The founder was not aware that after several thousand shares, he would have to pay additional recurring franchise taxes for the balance of 300 million shares – a cost of several hundred dollars a year to reflect the millions of authorized shares. Interestingly, the company had only 3 shareholders and no revenues. It only operated in California. I opined that it was a total waste of cherished capital to have so many authorized shares. In contrast, in some states like California one can authorize that many shares without paying incremental franchise taxes.
Some states have other pitfalls. California, for example, applies “unitary” tax which means that any business operations outside of California is added to the total revenues for tax considerations. In some circles, that tax policy would not be business friendly. Delaware does not apply the unitary tax philosophy.
Delaware is popular among major corporate lawfirms throughout the U.S. Note that Delaware is the home of over 50% of publicly traded companies, 60% of Fortune 500 corporations. Its corporate laws were enacted to attract foreign companies to be incorporated in that state and it corporate laws govern even if all business operations occur outside of Delaware. The leading top ten law schools favor teaching Delaware corporate law since many of these law students will work on Wall Street. And it is minority share friendly – owners of 33.4% or more of outstanding shares can control the company. And it has created a judicial system – Chancery – with exclusive jurisdiction to hear corporate legal matters. But if you have 3 shareholders (each shareholder being a family member) in California with no visible operations or revenues, was it necessary to incorporate in Delaware? I think not.
On the other hand, Wall Street favors companies incorporated in Delaware since the Delaware law is “corporate” friendly. However there is no barrier to shut down a non-Delaware corporation and moving the entity to Delaware, which I had executed. Prior to an IPO, I had closed a Colorado corporation and transferred it to Delaware.
My gripe is that, unless outside investors require such a move or those special corporate characteristics immediately, there is no critical need to incorporate in Delaware. Every dollar for every startup is dear. To expend unnecessary, critical capital in anticipation of an IPO does not make sense when the crystal ball is cloudy and unclear. I therefore recommend to look at jurisdictions which favor the entrepreneur economically and logistically.
Whenever I explore the incorporation process for a startup, I do look beyond Delaware. Most often than not, I prefer the state in which the company is operating. And if that state has problematic corporate and tax laws, then I will file in others that are nearby and have very minimal filing and annual recurring fees.
I will unquestionably look at the corporate laws to see how the statute is shareholder or corporate friendly. Interestingly, the corporate laws for New York and California lean for the shareholders, in contrast to Delaware. And I still believe that even that consideration is not necessary whenever the startup has so few shareholders.
Now I have been forced to select to file outside of the state where the entity operates. Recently, I needed to create a Limited Liability Partnership for business partners who only reside and work in California. I noted that in California only allows such filings for attorneys, accountants, or architects – and the instant partners did not fall into any of those categories. Delaware, Nevada, and Wyoming had no such limitations. Given that partnership laws are fairly simple and homogenous in each state, then it became a simple process to find the least expensive state for filing.
Before incorporating, one should ask the following questions – in which state are the business operations? Will the company have very few shareholders or will there be many in the short run? Will substantial portion of your revenues be generated outside of the state? What kind of entity are you creating? Will the majority of the shareholders come from outside of the United States? Is an IPO coming around the corner? Will outside investors require Delaware? And even if you believe that you had made a mistake, none of that is fatal – one can close that company and move it to another state.