Silicon Valley ecosystem is obsessed with incorporating in Delaware and authorizing millions of shares for a startup company with one shareholder and one employee. When I suggested to an entrepreneur that he should incorporate for California only, he related to me that his local “lawyers” recommended that he incorporate in Delaware and authorize 2 million shares. The reason the attorneys gave? It would attract investors! Wow! I simply replied that investors look at business plans, cash flows, and the last thing investors think about is the state of incorporation and the shares.
My experience has been different, I guess. One New York startup company, for which I was the Chief Legal Officer, was incorporated in Colorado. That company had only several thousand authorized shares, which, when issued to various investors, had been distributed in fractional amounts. The notable investors included George Soros, Goldman Sachs, and a couple of well-known companies. Not once did I hear from the opposing counsel, which were attorneys from nationally well-known New York City corporate law firms, that the company should authorize millions of shares and change the state of incorporation in order to close the investment tranches. During negotiations, the investors only considered percentage ownership and the price per share. I would only work with the quantity of authorized shares provided by the Colorado’s initial certificate of incorporation.
Companies that concern themselves with the bottom line always look at ways to reduce unnecessary costs. In a well financially managed company, a former colleague of mine, a CFO of a publicly traded company, related that his company had authorized 40 million shares, even though less than 10 million were being traded. He reduced that authorization by half, in order to cut down the Delaware franchise tax – where any authorized shares beyond 5,000 are taxed in proportion to quantity. Financially prudent companies survive in the long run. Warren Buffet was quoted during the recent financial crisis that the companies’ survival depends on frugal financial management by this allegory – “you know who is wearing a bathing suit when the tide rolls out.”
Let’s revisit that the attorneys’ recommendation would attract investors. After I left that same New York company, my legal replacement decided to re-incorporate the company in Delaware and increase the quantity of authorized shares to millions. A year later, that company filed for bankruptcy. I gather that the change of State and the authorized shares change didn’t have any positive influential impact on the investors. Investors only review the financial condition of the company. So I am very willing to ask how in the world did those attorneys reached that conclusion, since there is no correlation between the State of incorporation and financially attractive profiles!