| The Issue for Founders | | | | VC preference is universally for Delaware, even from |
| Founders of startup businesses need to decide | | | | inception. |
| whether to incorporate in Delaware or in the state in | | | | Founder Concerns About VC Expectations |
| which they will be conducting business. In spite of the | | | | So where does this leave founders who need to |
| commonly held lawyer view to the contrary, I believe | | | | decide where to incorporate their startup? |
| founders should think long and hard before choosing | | | | Founders need to understand how all this works and |
| Delaware since it often is not the best choice for a | | | | then make the decision that is best for them without |
| typical early-stage startup company. | | | | regard to what they believe VCs will think. |
| Many Startup Business Lawyers Routinely | | | | Sometimes founders want to incorporate in Delaware |
| Recommend Delaware | | | | precisely because they believe that the venture |
| During the high-tech bubble in the late 1990s and early | | | | capitalists who will be funding the company later will |
| 2000s, the idea of a quick path to an initial public | | | | insist on it. A few venture capitalists do, but most do |
| offering became so entrenched that startups began | | | | not, and many startups will never seek venture capital |
| skipping the step of incorporating in their own states | | | | funding in any event. |
| and moved directly to a Delaware incorporation to | | | | In over two decades of representing tech startups, at |
| speed up the process of going public. The bubble burst | | | | no point have I seen a VC firm refuse to fund a quality |
| but this practice did not. | | | | startup in which it was otherwise interested simply |
| So what do we have? The impetus that drove | | | | because it was not incorporated in Delaware. In other |
| lawyers to use Delaware routinely for startups was to | | | | words, during the early funding stages of a startup, |
| shorten the path to IPO. After Sarbanes-Oxley and | | | | most VCs are no more consciously focused on the |
| certain public accounting rules changes, very few | | | | downstream factors of what happens during a |
| startups any longer go the IPO route. Yet the | | | | merger than are the founders. They may be told by |
| Delaware filing pattern persists. | | | | their lawyers of the key factors but they then need to |
| Let us consider the advantages of a Delaware | | | | decide whether to invest in a company that is |
| incorporation versus the disadvantages to see if it | | | | incorporated somewhere besides Delaware. In all the |
| makes sense for startups to file routinely in Delaware | | | | cases I have seen, they have chosen to invest without |
| as many lawyers urge them to do. | | | | regard to the Delaware factor and, indeed, have |
| Why VCs Favor Delaware | | | | further chosen to keep the company incorporated in its |
| Delaware law affords substantial advantages and is | | | | home state thereafter unless and until it reached a |
| an ideal state of domicile for public companies and | | | | stage where it would want to go IPO. Based on this |
| late-stage startups that are about to go public. | | | | experience, I would say that the fear factor among |
| Delaware has a well-developed and reasonably | | | | founders about VC expectations on this point is almost |
| consistent body of corporate law with which most | | | | universally either misplaced or at least much |
| business lawyers are familiar. It offers various | | | | overstated. |
| advantages that help shield an entrenched | | | | Factors Affecting a Founder's Decision Whether to |
| management -- such as the ability to dispense with | | | | Choose Delaware |
| cumulative voting for directors and the ability to | | | | For the typical California-based early-stage startup, |
| stagger the election of directors. Owing to these | | | | Delaware normally does not offer any practical |
| advantages, Delaware is favored by venture capital | | | | advantages over a California incorporation (to pick as |
| investors who typically do control their portfolio | | | | an example the local jurisdiction of Silicon Valley). |
| companies and who prefer to make that control as | | | | Perhaps the only near-term advantages are (1) that |
| complete as possible. Public company managements | | | | Delaware allows for a single-member board of |
| like Delaware for this reason as well. | | | | directors, regardless of the number of shareholders in |
| Delaware law also typically gives preferred stock | | | | the company, where a state like California requires |
| investors with voting control of a corporation the | | | | that the number of directors match the number of |
| unilateral power to merge that entity into another, or | | | | shareholders up to three, and (2) quicker and more |
| otherwise have it get acquired, without need for | | | | reliable filing of documents in connection with funding |
| approval of the founders or other early-stage | | | | events. |
| participants who typically own most of the common | | | | The first of these can facilitate easier corporate |
| stock. This type of transaction can "wipe out" the | | | | governance in an early-stage startup, especially a |
| value of the common stock because it can be | | | | startup controlled by one predominant founder. |
| structured so that only those who hold a liquidation | | | | The second can avoid sometimes embarrassing |
| preference (i.e., the preferred stockholders) get any | | | | delays when fundings are set to close. |
| economic value out of it while the remaining | | | | Apart from these areas, however, a Delaware |
| shareholders may get little or nothing. In Delaware, | | | | domicile normally just adds administrative burdens for |
| unlike other states such as California, those who stand | | | | an early-stage startup based in a state like California. |
| to get nothing out of such deals often have no voice in | | | | These burdens include the difference in the way |
| stopping them. Thus, there is good reason why | | | | franchise taxes are handled and the need to qualify as |
| preferred stock investors (i.e., VCs) will tend to favor | | | | a foreign corporation in the local state. There are also |
| Delaware corporations. It gives them enormous | | | | downstream risks to founders in connection with losing |
| leverage over the remaining shareholders in the event | | | | the value of their interests in mergers without having a |
| the VCs decide to "take out" the company. | | | | voice in the process (discussed above). In general, then, |
| Here is a real-world illustration of how this can work. A | | | | a Delaware domicile imposes more administrative |
| few years back, when the tech bubble burst, I was | | | | hassle upon an early-stage company than would a |
| working side by side with lawyers from a prestigious | | | | local domicile and may create substantive risks down |
| Silicon Valley startup venture firm on some joint client | | | | the road for the founding team. The burdens can be |
| matters. During a lengthy phase, I could never get hold | | | | dealt with, but the question is whether they are worth |
| of the senior associate from the big firm who was | | | | the meager advantages, if any, afforded by a |
| working with me -- he was doing an endless stream | | | | Delaware domicile in the early stage. |
| of "mergers" for weeks on end. Why, as everything | | | | The major advantage to incorporating in your local |
| around us was coming crashing down, would there be | | | | state is simplicity. In an early-stage startup, keeping |
| a rash of mergers? Not because these were success | | | | matters simple is important. It saves expenses and |
| cases. They were not. What was happening was a | | | | does not divert company resources toward issues |
| systematic shedding of portfolio companies by the VC | | | | that can be avoided. |
| firms with quickie mergers as the vehicle. The dreams | | | | Use Caution in Choosing Delaware |
| of many founders fell fast and fell hard in those short | | | | The point is not to avoid Delaware but rather to |
| weeks. | | | | consider the issues in light of your company's goals |
| Thus, the startup world as dominated by VCs had | | | | and not simply choose Delaware reflexively. At that |
| evolved. Before the high-tech bubble, the typical | | | | point, check with a good lawyer and make your best |
| approach was for startups to incorporate in their home | | | | call, whether it be Delaware or not. Just remember: if |
| states and only reincorporate in Delaware when they | | | | you choose to go simple and stay at home, and this |
| reached a mature stage at which the advantages of | | | | proves in retrospect not to be your best choice, you |
| Delaware law made a substantive difference to them | | | | can always reincorporate in Delaware later. |
| -- that is, on the eve of IPO. In the post-bubble era, the | | | | |