Thursday, February 28, 2013

Where to Incorporate: Should a California-based startup incorporate in Delaware?

One of the commonly asked questions that entrepreneurs ask their attorneys when forming a company is where to incorporate it. Most frequently, companies choose between incorporating in their home state and registering in Delaware.

Delaware is chosen by many companies because of its well-developed corporate law that is typically viewed as pro-management and that gives the majority shareholders the flexibility in dealing with the minority shareholders. It is easy to file documents and obtain certificates from the Delaware Division of Corporations. Also, Delaware has a separate Court of Chancery, dating back to 1792, which is a business law court where judges are appointed on merit, not elected. This Court has no juries, and decisions are issued in a form of written opinions. Delaware business case law is abundant and there is much precedent for corporations to refer to when considering what actions they can and cannot take. Delaware business law (statutes and precedents) has come to be considered as the “national corporation law” since all lawyers are well familiar with it, having studied it in law school, and the most well-known business-related decisions have come out of Delaware courts.

Large companies with complex structures or those companies that plan to seek venture capital financing or go public typically consider Delaware as the state of incorporation. In fact, it is almost expected that a company going public be a Delaware corporation. In the 1990s, for example, the share of Delaware companies’ IPOs registered on the New York Stock Exchange increased to 73-77%. After all, Delaware’s corporate laws are the most flexible, its Chancery Court is the oldest in the country, and the abundance of business law precedent is clear. However, costs of incorporation and ongoing tax obligations in Delaware may be substantial.

Typically, companies are entitled to apply the laws of their state of incorporation to their internal affairs and corporate governance. However, it is not entirely the case if the company is deemed to be a quasi-foreign corporation in California. A private corporation becomes subject to the California Corporations Code Section 2115 (to the exclusion of the law of the state of incorporation) if more than 50% of its outstanding voting stock is owned by California residents and more than 50% of its business is conducted in California (measured by property, payroll and sales).

So, a Delaware private corporation with business in California may find itself subject to pro-shareholder corporate governance laws of the state of California. Section 2115 of the California Corporations Code requires foreign companies to apply various provisions of California laws to such fundamental areas of their internal affairs as annual election of directors (cumulative voting is required, not optional), directors standard of care, removal of directors without cause, indemnification of officers and directors, distributions to shareholders, supermajority vote requirements, limitations on sale of assets, cumulative voting provisions, reorganizations, dissenters’ rights, rights of inspection and class voting for mergers.

A particular area of concern is the provision applicable to class voting on mergers. The California law requires that the holders of each class of capital stock of a corporation approve the merger, whereas the Delaware law only requires the approval of holders of the majority of the outstanding stock. This class vote requirement gives a small group of shareholders holding a majority of one class of stock the opportunity to block the merger, even if the merger is favored by the majority of shareholders of the company.

In VantagePoint Venture Partners 1996 v. Examen Inc., 871 A.2d 1108 (2005), the Delaware Supreme Court considered this point and found that California could not constitutionally impose its corporate governance laws on a Delaware corporation that was governed by the Delaware General Corporation Law.

The California courts have also recently come to the same conclusion, although indirectly. In May 2012, the Second District Court of Appeal in California mentioned, in dicta, that matters of internal governance should be governed by the laws of the corporation’s state of incorporation.

However, Section 2115 still governs as written. It is a matter of the local legislature to repeal or amend the long-arm statute. Recently, proposals have been made and considered to repeal Section 2115, but they have not been successful.

So, what are startups to do in the meantime? Businesses that are based in California or that would qualify as quasi-foreign corporations pursuant to Section 2115 may be better off choosing to incorporate in California (since Section 2115 would still subject them to the California Corporations Code), and then re-incorporate in Delaware when they are ready to go public. Remember: Section 2115 only applies to private companies, not those with stock listed on a national stock exchange or quoted on Nasdaq.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.  Ms. Shulga is licensed in the State of New York.  

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