Silicon Valley startups keep focused on incorporating in Delaware. Various advisers apparently claim that Delaware is the favored state for investors or that the corporate law protects majority shareholders over minority ones. Now, I question whether any of this is true. As COO, Corporate Counsel, and interim-President, I endeavor to minimize costs for the startup company, especially when it comes to legal administrative fees. I have yet to understand why any young, startup company would bother to incorporate in Delaware when the company’s principal office is not in Delaware.
Let’s look at the costs. When the startup has its principal office outside of Delaware, it has to pay an annual franchise tax fee to Delaware and for a Representative Agent to represent the company as virtual presence while registered in Delaware. Assuming that this startup’s major office is in California, the startup needs to register its presence in the State of California just to open a corporate bank account. That represents another annual franchise tax that increases to no less than $800 after the first year. (I actually questioned a Californian startup why he needed to incorporate in Delaware. Then he found out that he could not get a corporate bank account, unless he registered with California as well. Of course, the company would be indebted for registration fees for California as well.) Also one forgets that to close permanently the company, one must file a dissolution document – an additional cost — for both States where the company is registered. Not paying the annual franchise tax fee does not absolve the annual fees, and will accrue penalties otherwise. One CFO I worked with had to be explained why the holding company kept receiving franchise tax bills from 49 states for a multistate project that was abandoned. You must dissolve the company’s registration in every state. And, if we stick with California, one should be aware that the State imposes unitary tax regime for corporate income tax. That means that the taxing authority evaluate worldwide income in determining taxes due to the State of California. Having incorporated in Delaware is no help at all to avoid franchise fees and taxes for the other state, in this case, California.
In terms of the argument that Delaware is attractive to investors, statistically, not all companies are registered in Delaware – actually less than half. All other companies are registered in other States. Wall Street investment banks favor Delaware since the corporate laws have substantial jurisprudence and, as a consequence, favors the majority shareholders. Maintaining a corporate governance litigation in Delaware is a financial burden for smaller companies, so well funded litigants prefer Delaware. Still, there are many class shareholder actions filed by minority shareholders in Delaware anyway. So that argument does not hold water.
In terms of investors favoring Delaware, I have blogged previously that private investors don’t really care where a company is incorporated. I personally have witnessed that well qualified investors have invested in companies incorporated in other states.
There are some distinctive qualities to Delaware jurisdiction. First, it has a tribunal, the Chancery Court, that exclusively handles corporate governance litigation. A law classmate working at a major NYC law firm only appeared at that court, and I guarantee you that the legal fees to appear in that court would be excessive. And, if the startup already has a dispute with shareholders at such an early stage, that situation does not bode well for the future of the company. Nothing is more discordant than a startup’s early investors already fighting among themselves. Second, Delaware calculates the annual franchise taxes by a formula combining the quantity of authorized shares and overall revenues. There is minimum floor, less than $100 and the maximum is $250,000 total. It seems that attorneys forget that. In one SoCal company, I noted that the number of authorized shares was over 300 million. I asked the founder, how many shareholders did he really have — answer, 2, he and his wife. Revenues for the last year, zero. Still the company’s Delaware franchise tax had been kicked up by the ridiculous number of authorized shares. I have worked with less than 100 outstanding shares with multiple investors, as what determines control is the percentage owned against the outstanding shares, not authorized. This SoCal company could have done the same. California looks at revenues to determine its taxes, not the number of authorized shares. Third, there were attempts to include a clause in Delaware’s corporate law to allow a succeeding claimant in court to recover its legal fees from the losing party. Such approach is used to discourage contingency law suits, and there are many minority class action lawsuits against publicly traded companies that attract contingency lawyers. It was knocked down. Another feature peculiar to Delaware is not corporate, but contractual – choosing corporate governance litigation venue and enforcement of term sheet that promises to invest but the investor backs down. The latter seems peculiar in that if the company is forced to enforce the term sheet, then the relationship between that investor and the company is built on friction, not amity. And if the venue is Delaware and the company is located on the West Coast, then that increases the costs for a startup company.
Now, for international comparative analysis, minority shareholders from a Hungarian corporation have more rights than the American equivalent. Minority Hungarian shareholders can control major actions of a company such as relocation or other major actions. I have used this country as an example to demonstrate that not all corporate governance rules are the same internationally. However, the 50 States do follow a standard format of corporate governance with minor differences. But not one state would state that minority shareholders will have the same impact as in Hungary, as anyone owning more than 50% of the equity can control the corporation — whether in Delaware or California. And this example proves one thing — not to assume that a foreign corporate governance structure is identical to U.S.
Now, as I have stated in earlier blogs, incorporated outside of Delaware is not fatal. One can change the incorporation state in less than a week. But to incorporate in Delaware and operate outside of that State represent additional costs and more administrative headaches, especially for a startup. It doesn’t make sense.