Startup Law 101 Series – Where Should I Incorporate My Startup Business?


The problem for the founders

The founders of start-up companies must decide whether to integrate in Delaware or in the state in which they will operate. Despite the generally held opinion of lawyers, I think the founders should think long and hard before choosing Delaware because it is often do not the best choice for a typical early start-up company.

Many start-up lawyers regularly recommend Delaware

During the tech bubble of the late 1990s and early 2000s, the idea of ​​a fast track to an initial public offering became so entrenched that startups started skipping the stage of incorporation into their own states and passed directly to an incorporation in Delaware. speed up the process of making public. The bubble burst but this practice did not do it.

So what do we have? The impetus that drove lawyers to use Delaware regularly for startups was to shorten the IPO process. After the changes made by Sarbanes-Oxley and some rules of public accounting, very few startups are now opting for the IPO path. Still, the Delaware filing model persists.

Let's take a look at the benefits of incorporating in Delaware versus its downsides, to see if it makes sense for startups to file filings in Delaware on a regular basis, as many lawyers have asked.

Why VCs favor Delaware

Delaware law offers substantial benefits and is an ideal state of residence for public companies and startups that are in the final phase that are about to become public . Delaware has a well-developed and reasonably consistent body of corporate law that most business lawyers are familiar with. It offers a variety of benefits that protect a well-established management – such as the ability to avoid the cumulative voting of directors and the possibility of staggering the election of directors. Because of these advantages, Delaware is favored by venture capitalists who generally control the companies in their portfolio and prefer to make this control as comprehensive as possible. Public companies like Delaware for this reason too.

The Delaware law also gives the preferred investors with voting control of a company the unilateral power to merge that entity with another, or to acquire it, without the founders or other junior participants owning most of the common shares. This type of transaction can "wipe out" the value of ordinary shares because it can be structured so that only those with a preference for liquidation (ie preferred shareholders) derive value from it. while the remaining shareholders do not get much. or nothing. In Delaware, unlike other states like California, those who do not get anything like this often do not have a voice. There are therefore good reasons for preferred investors in preferred shares (venture capital firms) to favor Delaware companies. This gives them a huge advantage over the remaining shareholders in case the venture capital firms decide to "dismantle" the company.

Here is a concrete illustration of how this can work. A few years ago, when the tech bubble burst, I worked alongside the lawyers of a prestigious start-up firm in Silicon Valley on behalf of joint clients. For a long time, I was never able to get the senior partner of the big company that worked with me – it was a constant stream of "mergers" for weeks. Why, as everything around us collapses, would there be a wave of mergers? do not because they were success stories. They were not. What was happening was a systematic erasure of portfolio companies by venture capital firms with the rapid merger as a vehicle. The dreams of many founders have fallen quickly and hard during these short weeks.

Thus, the world of startups dominated by venture capital companies had evolved. Before the high tech bubble, start-ups generally had to incorporate into their home country and only re-incorporate into Delaware when they reached a stage of maturity where the benefits of Delaware law brought them a substantial difference – that is, the day before. d & # 39; IPO. In the post-bubble era, the venture capital preference is universally valid for Delaware, even from the beginning.

Founder's Concerns About VC Expectations

So, where are the founders who must decide where to integrate their startup?

The founders must understand how it all works and then make the decision that suits them best, regardless of what they think, thinks the resumes.

Sometimes, the founders want to incorporate in Delaware precisely because they believe that venture capitalists who will fund the company later will insist. Some venture capitalists do it, but most do not, and many startups will never seek venture capital financing.

In addition to two decades of technology startups, I have never seen a venture capital firm refuse to fund a high-quality startup that otherwise interested it just because it was not incorporated in the industry. Delaware. In other words, at the start of financing a startup, most venture capital firms are no longer consciously focused on the downstream factors of what happens during the merger than are the founders. Their lawyers may explain the key factors, but then decide whether or not to invest in a company outside Delaware. In all cases that I saw, they chose to invest without regard to the Delaware factor and even chose to keep the company in his home country thereafter unless and until until she reaches a point where she wants to go into IPO. . Based on this experience, I would say that the fear factor among the founders regarding the venture capital expectations on this point is almost universally misplaced or at least overestimated.

Factors affecting the decision of a founder to choose to choose Delaware

In the case of start-up startups based in California, Delaware does not normally offer any practical advantages over incorporation in California (for example, the local jurisdiction of Silicon Valley). The only short-term benefits may be (1) that Delaware authorizes the establishment of a board of directors composed of only one member, regardless of the number of shareholders of the corporation. the company, when a state like California requires that the number of directors correspond to the number of shareholders three) and (2) a faster and more reliable ranking of documents related to events of funding.

The first of these can facilitate corporate governance during an early start-up phase, especially a startup controlled by a predominant founder.

The second can avoid sometimes embarrassing delays when financing has to be closed.

Outside of these areas, however, a home in Delaware normally only adds administrative burdens to a young start-up company based in a state like California. These charges include the difference between how franchise taxes are managed and the need to qualify as a foreign company in the local state. There are also risks downstream for founders related to the loss of value of their interests in mergers without having voice in the process (discussed above). In general, a home in Delaware therefore imposes more red tape on a start-up company than a local one and can create significant risks for the founding team. Charges can be handled, but the question is whether they are worth the meager benefits, if any, offered by a Delaware home at an early stage.

The main advantage of integration in your country is simplicity. In a start-up phase, it's important to keep things simple. This reduces spending and directs the company's resources to avoidable problems.

Use caution in choosing Delaware

This is not to avoid Delaware, but to consider the problems in light of the objectives of your company and not just choose Delaware by reflex. At this point, consult a good lawyer and make your best call, whether in Delaware or not. Just remember that if you choose to stay simple and stay at home, which ultimately turns out not to be your best choice, you will still be able to reincorporate later in Delaware.

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