What state should I incorporate in?

March 3, 2009

I think there are three primary choices for the state of incorporation for most technology startup companies:  (i) Delaware, (ii) the state where the company has its headquarters (i.e. California), and (iii) the Cayman Islands.

Almost all of the companies that I represent that intend to receive venture financing are incorporated in Delaware.  I represent a few pre-VC financed California companies were already incorporated by the time that I met them.  I also represent a few Cayman companies that have headquarters outside the U.S.

Reasons to incorporate in Delaware

Regardless of where the operations of a business entity are located, Delaware is frequently chosen as the state of incorporation for the following reasons:

  • Investors insist on Delaware

Almost all investors, regardless of where they are located, are familiar with Delaware corporate law.  They may also be familiar with the corporate law of state where they are located.  Because of the various advantages that Delaware law provides, most venture capital investors insist on investing in a Delaware entity. 

If a company is incorporated in another state, such as California, and needs to reincorporate in Delaware in connection with a venture financing, the company will incur additional legal expenses in connection with the reincorporation.  If a company ultimately undertakes an initial public offering of its stock, the underwriters will usually require that the entity be incorporated in Delaware.  In order to complete a reincorporation, a California company typically creates a subsidiary in Delaware and merges into it, with the Delaware company surviving.  Compliance with securities laws may be problematic if there are lots of shareholders. All contracts of the company must be reviewed in order to ensure that the reincorporation doesn’t accidentally terminate an agreement.

One example of a material difference in corporate law between states is the stockholder vote necessary to sell a company.  California corporate law provides that a merger requires the approval of a majority of the outstanding shares of each class of the corporation. This means preferred stock as a class and common stock as a separate class.  In contrast, Delaware corporate law provides that a merger requires the approval of a majority of the outstanding stock entitled to vote.  The fact that holders of common need to approve a merger of a California corporation is one reason why venture funds prefer Delaware. Venture funds don’t want common holders to have the ability to block a merger.

  • Delaware has a predictable, fair and well-developed body of corporate law

Delaware has a specialized court (the Court of Chancery) that has original jurisdiction over corporate law matters.  Because of its unique expertise on corporate and business law matters, the Court of Chancery has produced a large body of decisions that has clarified and interpreted the Delaware corporate statutes. In addition, the Court of Chancery (and the Delaware Supreme Court which hears appeals from the Court of Chancery) is focused on the timely resolution of corporate law disputes.  An appeal from the Court of Chancery may often be heard and ruled upon by the Delaware Supreme Court in a matter of days.

  • Directors of Delaware corporations are afforded a high degree of protection

While the directors of Delaware corporations have a fiduciary duty to act in the best interest of the stockholders, Delaware courts will, as a general matter and absent fraud or self-dealing, defer to the good faith business judgments made by the directors.  In addition, Delaware corporate law allows for a corporation to indemnify its directors for losses that they may incur from being sued.  Attorneys are generally more comfortable advising directors on their fiduciary duties under Delaware law as opposed to the law of any other state.

  • Complying with procedural formalities is efficient in Delaware

Observing proper corporate formalities under Delaware law is efficient, which is critical to preserving the limited liability feature of corporations.  Delaware was one of the first states to allow voting by electronic proxy and attendance at stockholder meetings through the Internet.  Additional areas of flexibility include the ability of less than all stockholders to act by written consent and the allowance of electronic signatures.  Filings, such as an amendment to a company’s certificate of incorporation in connection with a venture financing, can be made electronically and are generally accepted upon submission within a day.

In addition, Delaware law is more flexible with respect to the number of directors.  When a California corporation has two shareholders, it must have two directors, and when it has three or more shareholders, it must have three directors.  Delaware corporations are only required to have one director.

Reasons not to incorporate in Delaware

There are some reasons why a company may not want to incorporate in Delaware, including the following:

  • Delaware franchise taxes

An entity that operates in a state other than Delaware will need to comply with tax and regulatory requirements in both Delaware and the state in which it operates (including qualifying to do business as a “foreign” corporation in that state and paying the relevant fees).  In particular, Delaware has an annual franchise tax that it levies on its corporations, although this amount is generally negligible for a start-up company with few assets and stockholders.  If a company is not going to raise venture financing and will not otherwise be forced to reincorporate to Delaware, then incorporating in the state where it conducts business will save the company from paying Delaware franchise taxes.  However, the cost and hassle of reincorporating to Delaware in the future may be greater than any tax savings in the early stages of the company.

  • Non-U.S. businesses

Some companies may be initially incorporated in the U.S., but may determine that establishing an off-shore parent entity is beneficial for investment or tax reasons.  For example, some non-U.S. venture funds are prohibited from investing in U.S. companies.

Companies incorporated in tax-favorable jurisdictions like the Cayman Islands, the British Virgin Islands and Bermuda are not subject to taxation in their jurisdiction of incorporation, although depending on the nature of their operations, they may be taxed on their earnings in higher tax jurisdictions.  Thus, a Cayman company may avoid paying U.S. corporate taxes on a portion of its worldwide income. 

However, there are serious tax issues associated with establishing an off-shore parent company when there is an existing U.S. entity or if intellectual property originates in the U.S.  Thus, if there is some reason that a company may need to establish an off-shore parent company in the future, then legal and tax advisors should be consulted prior to incorporation.

The Cayman Islands has become the preferred jurisdiction for many Chinese companies.  Only companies established in the Cayman Islands, Bermuda, China and Hong Kong are pre-approved for listing on the Hong Kong Stock Exchange.  In addition, Cayman corporate law has enough flexibility to permit U.S. style preferred stock financing arrangements and most venture capital investors that regularly invest in companies with headquarters in China are familiar with Cayman law and the documents used in these financings.

Comments

  • http://www.laduidefenseteam.com Joe

    Starting your own business is such a complicated process. How does it affect your business to have it physically operated in one state, but incorporated in another?

  • http://www.usviedc.com Island Ed

    Yocum,

    I read with interest your comments and you are correct for the reasons you described. However, I respectfully suggest there may be one more jurisdiction that can be added to this list.

    The US Virgin Islands using the US Virgin Islands Economic Development Commission program:

    Why the US Virgin Islands?

    The US Virgin Islands Economic Development Commission (USVI EDC) program provides qualified businesses and individuals with exceptional and comprehensive benefits and incentives that allow them to take control of their income taxes and significantly improve their profits.

    The USVI EDC program falls under the US Department of the Interior, and is authorized jointly by the United States tax laws (IRC 934 & IRC 937) and the United States Virgin Islands tax laws. It is a legitimate program whose purpose is to draw business to the US Virgin Islands, help the Virgin Islands economy diversify, and is designed to produce significant, positive economic benefits to the Territory of the US Virgin Islands and its residents.

    As with many Economic Development programs, various tax incentives are used to attract, retain, and expand businesses for their community. The US Virgin Island EDC program offers various tax incentives, which include:

    • 90% Exemption on Local Income Taxes (Federal equivalent)
    • 90% Exemption on Dividends
    • 100% Exemption on Gross Receipts Taxes
    • 100% Exemption Property Taxes
    • 100% Exemption on Excise Taxes
    • 1% Custom Duties

    Like most insular territories of the US, the USVI operates under a “mirror tax” system with the US, which means that for many taxpayers, the tax forms and calculations are the same as what would be expected elsewhere in the US. The key difference: taxes owed are remitted or allocated to the territorial Bureau of Internal Revenue (BIR) instead of the IRS. While remitting taxes to the BIR, the USVI remains a US jurisdiction subject to US laws; including corporate, intellectual property and investment laws. It also has support from Philadelphia’s Third Circuit Court of Appeals has federal and appellate jurisdiction.

    Of special interest to you is that in 2006, the United States Internal Revenue Service delivered an early holiday present to the US Virgin Islands, its Economic Development Program and particularly to technology companies. IRS Notice 76-2006 issued in late August specifically cited the USVI EDC program for utilization by technology companies. Key clarifications pertinent to Knowledge Based Businesses were published in final regulations for IRC 937(b) in April, 2008, which speak specifically to certain e-commerce and IT-related business models. These notices, along with a Tier-1 data-center facility housing the world’s largest amount of unused internet/telecommunications bandwidth, the Virgin Islands offers technology companies an unparalleled opportunity to execute their business model in the most tax advantaged way.

    Federal law permits insular territories of the US, including the USVI, to operate under modified tax scenarios as long as key “residency” and “income sourcing” requirements are met. Care must be taken to meet the income sourcing and residency requirements. There are a variety of ways an individual or company can qualify for the EDC benefits.

    I hope you will agree, the US Virgin Islands offers some very interesting possibilities for technology companies.

    Regards,

    Edgar
    http://www.usviedc.com

  • Pingback: Pros and Cons of Incorporating in Delaware | Insights into Startups and Entrepreneurship - nPost Blog

  • http://www.startupcompanylawyer.com Yokum

    @Ed – I think USVI as an incorporation jurisdiction will not be feasible until investors and their counsel are comfortable/familiar with USVI. Assuming that a USVI entity is treated as a domestic U.S. entity for tax purposes, I would guarantee that any venture capitalist would reincorporate a USVI-incorporated company to Delaware.

  • http://www.usviedc.com Island Ed

    Yocum,

    Thank you for your prompt reply.

    My apologies as I was not clear. It is incorrect to assume a USVI corporation is treated as a domestic entity for US tax purposes. That assumption may have caused you to miss the point I was hoping to make, which is the Virgin Islands EDC program allows companies to receive a 90% tax savings on their income, including a 90% savings on the 35% repatriation tax which offshore entities could cause for US investors.

    From a purely corporate law standpoint, you are correct when you stated, “Regardless of where the operations of a business entity are located, Delaware is frequently chosen as the state of incorporation”, for the benefit of their corporate friendly laws.

    With that comment in mind, the best of both worlds is available! A Delaware entity can be a USVI EDC beneficiary as long as its principal place of business is within the territorial boundaries of the USVI. This opens up possibilities for US businesses, including technology companies, to position and structure themselves in the most tax advantaged way to benefit themselves and their shareholders, while keeping the benefits of the Delaware corporate law.

    I encourage any investor and their counsel to investigate this program and become “comfortable/familiar with it”, then you may readily agree, the US Virgin Islands offers some very interesting possibilities.

    Regards,

    Edgar
    http://www.usviedc.com

  • http://www.startupcompanylawyer.com Yokum

    @Ed – my assumption on USVI treated as a U.S. entity for tax purposes relates to whether a reincorporation would be taxable to shareholders, not the particular tax benefits to the corporation of being a USVI entity. For example, I suspect that all venture capitalists would also force a reincorporation from Nevada to Delaware, as that transaction can be structured as tax-free to the shareholders. Reincorporating from certain non-U.S. jurisdictions to a U.S. state is a taxable transaction to some shareholders, which makes it a non-starter.

  • tiffany

    Could you please elaborate on the pros/cons around incorporating in “(ii) the state where the company has its headquarters (i.e. California)”? Btw, great blog!

  • http://www.startupcompanylawyer.com Yokum

    @Tiffany – If the company's headquarters are in CA, the company will need to pay franchise taxes in CA even if it is incorporated in DE. Thus, if a company wants to save a little bit of money, it could incorporate in the state that it would otherwise have to pay franchise taxes in.

  • http://www.usviedc.com Island Ed

    Yocum,

    You are right, it would be a taxable event to reincorporate a USVI corporation in Delaware and vice versa. However, there is no tax consequence to utilizing a Delaware corporation as an EDC company. In order to qualify for EDC benefits, the Delaware entity would simply need to have its principal place of business within the Territory of the USVI.

    So, maybe incorporating in the USVI is not the best location for companies who plan and intend to use venture capital investors who require a Delaware corporation, but domiciling it in the USVI could be a great move for increasing shareholder value.

    Now, you have to agree the US Virgin Islands offer some interesting possibilities for start up technology companies, especially if someone as knowledgeable and competent as yourself advise them how to go about structuring themselves in their initial start up phase as a “Tax Advantaged technology company”.

    Regards,

    Edgar
    http://www.usviedc.com

  • Les

    If you are registered in VA as an LLC can you incorporate in DE? Or would you have to dissolve the VA LLC and incorporate in DE. I do not have a “store front” and have been told that since I sell in different states I can “incorporate” in any state. Is this true?

  • http://www.startupcompanylawyer.com Yokum

    @Les – Plenty of companies that don't have a presence in DE are incorporated in DE. A reincorporation to DE could be effected by a merger.

  • John

    Delaware has one significant disadvantage if your company operates in a field with complex, overlapping patents (e.g., biotech): the courts in Delaware strongly favor patent holders. If your company is sued for patent infringement in Delaware your chances are considerably worse that they would be in most other jurisdictions. This may seem unlikely, but even the most scrupulous company can end up on the receiving end of a strategically-motivated infringement action.

  • http://www.startupcompanylawyer.com Yokum

    @John – That assumes that you get sued in DE. Many plantiffs chose fast courts, such as the Eastern District of Texas.

  • Sonja Haggert

    How can I form an LLC in Delaware if I do not live there? I would not think a PO Box would be acceptable. I am planning to start a consulting company.

  • http://www.startupcompanylawyer.com Yokum

    @Sonja – Plenty of companies with no physical presence in DE are incorporated there. You simply need an agent for service of process in DE, which may cost somewhere between $100 and $250/year.

  • ladylaw

    Very interesting post. I was wondering about the difficulty in migrating to the Cayman Islands. To do so, the Cayman Islands Companies Law requires that the state the company is incorporated in does not prohibit such a transfer. It seems many California companies transfer to the Cayman Islands, but I wasn't sure what law enables them to do so. Any thoughts?

  • http://www.startupcompanylawyer.com Yokum

    U.S. companies typically don't migrate off shore because it triggers U.S. anti-inversion laws, which may result in adverse tax consequences. There are various mechanisms (share exchange, merger, etc.) to put an off-shore parent company (Cayman) or otherwise on top of an existing California company). There isn't a law per se that enables it.

  • http://www.lilbil.com Will Chow

    You mention that a DE corp operating in CA must file in CA as a foreign corp to raise VC. Is this also necessary to raise angel or F&F funds?

  • http://www.startupcompanylawyer.com Yokum

    @Will – Qualifying to do business in CA is independent of angel financing. A company operating in CA must qualify to do business in CA.

  • http://www.lilbil.com Will Chow

    You mention that a DE corp operating in CA must file in CA as a foreign corp to raise VC. Is this also necessary to raise angel or F&F funds?

  • http://www.startupcompanylawyer.com Yokum

    @Will – Qualifying to do business in CA is independent of angel financing. A company operating in CA must qualify to do business in CA.

  • danstuart

    Great article. Quick follow-up: if I incorporate a foreign company in Delaware and take online payments into this company but then remit them overseas, does this then negate the tax benefits of Delaware? Cayman Islands would seem to be preferred in this case, but only if similar merchant account facilities were available. Correct?

  • http://www.startupcompanylawyer.com Yokum

    @Dan – you should consult with a tax advisor. If you are incorporated in DE, the company will be exposed to US taxes. If a company intends to derive most of its revenue from non-US sources, then considering an offshore jurisdiction may make sense.

  • danstuart

    Thank you.

    Trying to setup an online business outside the US but that which can use modern, secure payment gateways, yet remain free from US tax is next to impossible. You can setup offshore, but the payment/merchant account options are poor. You can register in the US, but then you are paying tax. The trade-offs seem simple but are complex.

    If anyone has experience/success here please let me know.

  • Coop

    Hello, I'm currently DBA a Texas sole proprietor. I am going to change the structure before 12/31 of this year. My goals are:

    #1 – reduced tax liability

    #2 – personal asset and liability separation

    If I am sued personally, I do not want it to affect my business and vice versa. The legal process scares me much less than the ramifications of the PR of being sued. Sometimes accounting error lead to public filings I'd like that to be reflected in the appropriate entity if that ever takes place. Then, if a client enquire's about such a filing, they'll know the nature is business/personal before they ask.

    I am a small business owner and only employ myself and my wife works for me part-time. I am not going to have a large number of employees or will I be looking to ever become a very large business. If I become wildly successful, I might have 5 employees, but likely they will still remain contractors.

    I have heard that Wyoming is a great place, but, everything that I'm finding lately points me to simply just C-corp in Nevada. Although double-taxation is a possibility, it is unlikely as I could opt for $0 retained earnings and therefore not have dividends that year (only income tax). Texas does have a franchise tax but there aren't any state income taxes.

    Would it benefit me to have a c-corp from Nevada/Wyomic (any advice on either) holding the general partner role in an LLC (from TX/NV/WY??) and me personally holding the limited partner role? Then income would flow to me persaonllay from the LLC unless we retained the earnings and then it would be taxed at the corporate rate?

    Any advice would be greatly appreciated.

  • Lawinc

    Incorporating business online is a possible choice, and certainly an option you should consider. There are lots of online incorporation services to choose from, and their services are pretty competitively priced.

  • PHInventor

    I have bootstrapped development of a consumer health care product with around $150K of my own money. I own all the IP in my own name. I plan to launch in 2011 but I have not yet formed a company (or companies). I believe the ultimate market potential for the product is $30-$100M / year. I would be happy to keep all the equity myself if I can fund growth through sales alone, but will certainly sell equity to angel investors if that's what's needed to make the company thrive.

    I live in NY. My manufacturing is spread across the US but I may decide to start by using my NY property as a base of operations (e.g., early warehouse/shipping). In my initial chat with an experienced business formation attorney I was advised to create a NY-based LLC because it would save me some DE fees, including filing as a foreign company in NY, etc. Avoiding the DE fees makes no sense to me because if my project succeeds, I'd assume the DE fees would be trivial next to the benefit I will see from already having formed in Delaware and not having to deal with that issue when I am in a rapid-growth phase, seeking funding, etc. If my project fails, the DE fees would be trivial next to the losses I have already incurred from patent filings and other costs. Am I missing something here? Given the scenario, is there a compelling reason to form in NY rather than DE?

  • Jyonglee2002

    Does anyone know if you have a medical practice and have a PLLC and I want to venture out, open other business like a restuarants to add to a diverse portfolio of businesses… would it be better to incorporate to keep all the business under one umbrella or create a separate LLC?

  • Nate R

    Hi YokumGreat post. I have a few questions regarding my venture. Sorry about the lengthy response.I’m in the process of forming an LLC for a venture that I started. I brought-in a co-founder (personal friend) who serves as my technical arm. We have a customer and need to form the company asap.Questions:1. Should I form the LLC with a 100% stake first and then sign a MoU with the co-founder awarding him a stake with a vesting schedule? Or, should I include him as the member of the LLC at the time of formation? Are there pros/cons for either approach?2. If I was to apply a vesting schedule for a stake, how does it work when the LLC is being formed? I’m planning to use legal zoom or Nolo to save on costs. Since both these options don't allow for vesting, should I include those provisions within the Operating agreement or a separate MoU with the co-founder?3. If one was to form the LLC with 100% stake, is it of any advantage to have your spouse be a stakeholder too irrespective of whether he/she is a contributing member of the company? For example, I start the LLC with the following:T=0:
    member 1 (co-founder 1): 89%
    member 2 (co-founder 1?s spouse): 11%T1=T+1 month:
    member 1 (co-founder 1): 51%
    member 2 (co-founder 1?s spouse who is not contributing): 8%
    member 3 (co-founder 2): 41%Assume at T2 we receive interest from a VC, and assuming we change the company from an LLC to a C-Corp., and the company is valued at $100K.T2=T+1 year
    member 1 (co-founder 1): 51% – value $51K
    member 2 (co-founder 1?s spouse who is not contributing): 8% – value $8K
    member 3 (co-founder 2): 41% – value $41KWill the value of member2?s stake (per share) be perceived any lesser than the other members because of the fact that the member was not an active contributor within the company?Usually, the VCs put a multiplication factor to buy-out the shares from the respective shareholders. Assuming the factor is 3x (average for a product company), will member2?s factor be any lesser because he/she is a passive stakeholder?Any input is appreciated.ThanksNate