The Age-Old Question – Should I Incorporate in Delaware or California?

There are a lot of great open source resources available which address the pros and cons of incorporating in Delaware vs. California.  By way of example, the Delaware Department of State Division of Corporations published an article titled “Why Corporations Choose Delawarehttps://corp.delaware.gov/whycorporations_web.pdf.  As a general rule, most seasoned corporate attorneys will recommend incorporation in Delaware over California for three reasons:  (i) most angel investors, venture capitalists and investment banks are familiar with Delaware law and prefer to invest in Delaware entities; (ii) Delaware corporate law is well developed, and provides an element of legal certainty; and (iii) Delaware law provides flexibility with respect to corporate administration.  Let’s briefly analyze these elements.

Investors

The following should put things into perspective.  Based on information published by the 2016 National Venture Capital Association (http://nvca.org), of the 100 highest market capitalization U.S. VC-backed companies, 84 are incorporated in Delaware and two are incorporated in California (Apple and Cisco Systems).  The remaining 14 companies are incorporated as follows: One in Florida (SBA Communications Corp); one in Maryland (Under Armour); three in Massachusetts (EMC Corp, Genzyme Corp, Vertex Pharmaceuticals); one in Michigan (Stryker Corp); two in New York (Bed Bath & Beyond, Regeneron Pharmaceuticals); one in Texas (Whole Foods Markets); four in Washington State (Costco Wholesale, Immunex, Microsoft and Starbucks); and one in Wisconsin (Fiserv).

Delaware Law is Well Developed

The Delaware Court of Chancery (http://courts.delaware.gov/chancery/) has decades of first-hand experience and has promulgated a vast amount of precedent in the area of corporate law.  Delaware is known to be business friendly, offering broad latitude in management decision-making, strong anti-takeover protections, and well developed corporate defenses.

Delaware Law Provides Flexibility with Respect to Corporate Administration

The Delaware General Corporation Law provides for significant structural flexibility and management of a company’s business affairs.  By way of example, a Delaware corporation may have any number of stockholders, and only one director may comprise the board of directors.  California law, on other hand, has a tiered approach, and provides in relevant part that the board of directors must be comprised of no less than three directors, except that the board of directors (a) may have only one director if there is no more than one shareholder, and (b) must have at least two directors if there are two or fewer shareholders (see §212(a) of the California Corporations Code).  Many early stage companies are not prepared to have a three-person board of directors, and this alone could represent a significant impediment to incorporating as a California corporation.

The Takeaway

The above is not to say investors won’t invest in a non-Delaware entity (plenty do), but it does demonstrate the prevalence of Delaware corporations in successful VC-funded entities.  At the end of the day, if you plan to seek traditional outside investors for your start-up company, you may be better served by incorporating in Delaware from the start.  Incorporating in Delaware upfront can save the need to reincorporate down the road (which means more legal fees), and may make the entity slightly more attractive to an outside investor, as the investor may have a comfort level with Delaware law that it does not have with other states.  However, if you do not plan to seek outside investors, you may very well decide to incorporate in California, and forgo the additional expense and reporting requirements of incorporating in Delaware.

The additional cost to a California-based company to incorporate in Delaware (vs. California) is, on a relative basis, negligible.  Assuming the California-based company meets certain thresholds of “doing business” in California (see https://www.ftb.ca.gov/businesses/Section_23101.shtml), it will be required to Qualify to do Business in the State of California as a foreign corporation.  The current cost of qualification is $100, plus $25 per year to file an Annual Statement of Information.  The corporation will also need to maintain an agent for service of process within the State of California (at a cost of approximately $50-$100 per year).  With respect to annual franchise taxes, a Delaware company that is Qualified to do Business in the State of California will need to pay franchise taxes in both Delaware (approximately $350 per year, see https://corp.delaware.gov/taxcalc.shtml) and California (approximately $800 per year) – remember that all California corporations are required to pay the $800 annual franchise tax, so this amount is not an extra cost.  Lastly, the Delaware corporation will be required to comply with both Delaware and California corporate law reporting requirements, which adds a negligible amount in legal fees every year.

All of that said, please don’t assume Delaware law reigns supreme.  In fact, there was a relatively recent Wall Street Journal article that challenged the predominance of Delaware law (see “Dole and Other Companies Sour on Delaware as Corporate Haven” written by Liz Hoffman dated August 2, 2015 available at http://www.wsj.com/articles/dole-and-other-companies-sour-on-delaware-as-corporate-haven-1438569507), as well as a recent study published in the North Carolina Law Review titled “The Delaware Delusion” written by Robert Anderson IV of Pepperdine University School of Law and Jeffrey Manns of George Washington University School of Law (available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2500465).

Furthermore, for some California companies who are incorporated in Delaware, the California long-arm statute, §2115 of the California Corporations Code (available at http://www.leginfo.ca.gov/cgi-bin/displaycode?section=corp&group=02001-03000&file=2100-2117.1), may in any event require application of California law to the Delaware corporation with respect to several key provisions, to include directors’ fiduciary duties/standards of care, indemnification provisions, cumulative voting, voting in merger transactions, dissenters’ rights and the like.  However, the ultimate enforceability of the §2115 long-arm statute is a question of significant debate – more on that topic at another date.

Disclaimer: This article discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Helen E. Quinn expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.

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