Where Should I Incorporate My Startup Business

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, I was working side by side with lawyers from a prestigious Silicon Valley startup venture firm on some joint client matters. During a lengthy phase, I could never get hold of the senior associate from the big firm who was working with me — 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.