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.