FAQ - Startup Business 002

Startup Law 101 Series - Advantages and disadvantages of setting up a startup business in Delaware.

The Issue for Founders

Founders of startup businesses need to decide whether to incorporate in Delaware or in the state in which they will be conducting business. In spite of the commonly held lawyer view to the contrary, I believe founders should think long and hard before choosing Delaware since it often is not the best choice for a typical early-stage startup company.

Many Startup Business Lawyers Routinely Recommend Delaware

During the high-tech bubble in the late 1990s and early 2000s, the idea of a quick path to an initial public offering became so entrenched that startups began skipping the step of incorporating in their own states and moved directly to a Delaware incorporation to speed up the process of going public. The bubble burst but this practice did not.

So what do we have? The impetus that drove lawyers to use Delaware routinely for startups was to shorten the path to IPO. After Sarbanes-Oxley and certain public accounting rules changes, very few startups any longer go the IPO route. Yet the Delaware filing pattern persists.

Let us consider the advantages of a Delaware incorporation versus the disadvantages to see if it makes sense for startups to file routinely in Delaware as many lawyers urge them to do.

Why VCs Favor Delaware

Delaware law affords substantial advantages and is an ideal state of domicile for public companies and late-stage startups that are about to go public. Delaware has a well-developed and reasonably consistent body of corporate law with which most business lawyers are familiar. It offers various advantages that help shield an entrenched management - such as the ability to dispense with cumulative voting for directors and the ability to stagger the election of directors. Owing to these advantages, Delaware is favored by venture capital investors who typically do control their portfolio companies and who prefer to make that control as complete as possible. Public company managements like Delaware for this reason as well.

Delaware law also typically gives preferred stock investors with voting control of a corporation the unilateral power to merge that entity into another, or otherwise have it get acquired, without need for approval of the founders or other early-stage participants who typically own most of the common stock. This type of transaction can "wipe out" the value of the common stock because it can be structured so that only those who hold a liquidation preference (i.e., the preferred stockholders) get any economic value out of it while the remaining shareholders may get little or nothing. In Delaware, unlike other states such as California, those who stand to get nothing out of such deals often have no voice in stopping them. Thus, there is good reason why preferred stock investors (i.e., VCs) will tend to favor Delaware corporations. It gives them enormous leverage over the remaining shareholders in the event the VCs decide to "take out" the company.

Here is a real-world illustration of how this can work. A few years back, when the tech bubble burst, our firm was working side by side with lawyers from a prestigious Silicon Valley startup venture firm on some joint client matters. During a lengthy phase, we could never get hold of the senior associate from the big firm who was working with us - he was doing an endless stream of "mergers" for weeks on end. Why, as everything around us was coming crashing down, would there be a rash of mergers? Not because these were success cases. They were not. What was happening was a systematic shedding of portfolio companies by the VC firms with quickie mergers as the vehicle. The dreams of many founders fell fast and fell hard in those short weeks.

Thus, the startup world as dominated by VCs had evolved. Before the high-tech bubble, the typical approach was for startups to incorporate in their home states and only reincorporate in Delaware when they reached a mature stage at which the advantages of Delaware law made a substantive difference to them - that is, on the eve of IPO. In the post-bubble era, the VC preference is universally for Delaware, even from inception.

Founder Concerns About VC Expectations

So where does this leave founders who need to decide where to incorporate their startup?

Founders need to understand how all this works and then make the decision that is best for them without regard to what they believe VCs will think.

Sometimes founders want to incorporate in Delaware precisely because they believe that the venture capitalists who will be funding the company later will insist on it. A few venture capitalists do, but most do not, and many startups will never seek venture capital funding in any event.

In over two decades of representing tech startups, at no point have I seen a VC firm refuse to fund a quality startup in which it was otherwise interested simply because it was not incorporated in Delaware. In other words, during the early funding stages of a startup, most VCs are no more consciously focused on the downstream factors of what happens during a merger than are the founders. They may be told by their lawyers of the key factors but they then need to decide whether to invest in a company that is incorporated somewhere besides Delaware. In all the cases I have seen, they have chosen to invest without regard to the Delaware factor and, indeed, have further chosen to keep the company incorporated in its home state thereafter unless and until it reached a stage where it would want to go IPO. Based on this experience, I would say that the fear factor among founders about VC expectations on this point is almost universally misplaced or at least much overstated.

Factors Affecting a Founder's Decision Whether to Choose Delaware

For the typical California-based early-stage startup, Delaware normally does not offer any practical advantages over a California incorporation (to pick as an example the local jurisdiction of Silicon Valley). Perhaps the only near-term advantages are (1) that Delaware allows for a single-member board of directors, regardless of the number of shareholders in the company, where a state like California requires that the number of directors match the number of shareholders up to three, and (2) quicker and more reliable filing of documents in connection with funding events.

The first of these can facilitate easier corporate governance in an early-stage startup, especially a startup controlled by one predominant founder.

The second can avoid sometimes embarrassing delays when fundings are set to close.

Apart from these areas, however, a Delaware domicile normally just adds administrative burdens for an early-stage startup based in a state like California. These burdens include the difference in the way franchise taxes are handled and the need to qualify as a foreign corporation in the local state. There are also downstream risks to founders in connection with losing the value of their interests in mergers without having a voice in the process (discussed above). In general, then, a Delaware domicile imposes more administrative hassle upon an early-stage company than would a local domicile and may create substantive risks down the road for the founding team. The burdens can be dealt with, but the question is whether they are worth the meager advantages, if any, afforded by a Delaware domicile in the early stage.

The major advantage to incorporating in your local state is simplicity. In an early-stage startup, keeping matters simple is important. It saves expenses and does not divert company resources toward issues that can be avoided.

Use Caution in Choosing Delaware

The point is not to avoid Delaware but rather to consider the issues in light of your company's goals and not choose Delaware reflexively. At that point, check with a good lawyer and make your best call, whether it be Delaware or not. Just remember: if you choose to go simple and stay at home, and this proves in retrospect not to be your best choice, you can always reincorporate in Delaware later.

G.G.

(Follow George Grellas on Twitter for new articles)

Back to Startup Law 101 Series of tutorials for founders and entrepreneurs.

Question or comment about this topic? Was it helpful? Can it be clarified? Email George Grellas at gg@grellas.com

 

Business

Core Areas

High Tech

Key Technologies

p: 408-255-6310 f: 408-255-6350 e: info@grellas.com

California Business Lawyers and Business Start Up Attorneys Disclaimer: The business law and business start up or other legal information presented at this site should not be construed as formal legal advice, or the formation of a lawyer or attorney client relationship. Any results portrayed here were dependent on the facts of that case, and results will differ if based on different facts. Please contact a California business lawyer or San Jose business start up attorney at our Silicon Valley law firm located in Cupertino, California. This web site is not intended to solicit clients on behalf of any attorney or lawyer for matters outside of the State of California.

Copyright © 1998-2011 Grellas Shah LLP - California Business Lawyers and Startup Business Lawyers serving clients throughout Northern California, Silicon Valley and the San Francisco Bay Area / South Bay Area, including San Jose, Campbell, Santa Clara, Cupertino, Los Gatos, Saratoga, Mountain View, Sunnyvale, Los Altos, Hayward, Fremont, Milpitas, Palo Alto, Menlo Park, San Mateo, San Carlos, Redwood City, Burlingame, San Francisco, Oakland, Alameda, Santa Cruz, Monterey, Watsonville, Scotts Valley, Gilroy, Morgan Hill, Capitola, Aptos, and Soquel, Santa Clara County, Santa Cruz County, San Mateo County, San Francisco County, Alameda County, Contra Costa County, Solano County, Marin County, Napa County, and Monterey County, CA - and clients worldwide who seek to do business in California.

Sitemap