Note: The DE-related info in this post is really applicable to startups based in any state, but I’m speaking mostly to Texas entrepreneurs, particularly in Austin, in writing this. Because of the depth of startup activity in California, which might translate to more sophisticated case and statutory law, forming a non-DE startup there might make more sense than it would in Texas.
The default incorporation state in forming a company is always the state in which the company operates, but there are several reasons why an Austin/Texas startup might consider DE instead:
- Well-Established, Sophisticated Statutory and Case Law – Because DE is the legal home of, by far, the largest number of large corporations in the country, you’ll find the least amount of ambiguity in DE as far as corporate governance practices, contractual interpretation, etc. are concerned. And DE Chancery judges are by far the most knowledgeable in complex business matters of any judges in the country. Virtually every corporate lawyer in the country who operates a serious practice will be familiar with DE law, so if you call him/her up with a random question about whether a certain transaction is kosher, or how a particular provision would be enforced in court, you’re 10x more likely to get a quick answer if you’re a DE corporation. For a Texas entity, the answer will often be “I’m not sure,” which leads to “Let me research that for you,” and that research won’t be pro-bono.
- Sophisticated Investors will expect Delaware – Because of the above, institutional venture capital firms that manage large funds will (very) often refuse to invest in a Texas startup that isn’t a Delaware corporation. Angel investors are more likely to be OK with Texas, but we’ve encountered a fair amount of professional angels who either insist on DE before making their investments, or at least expect a conversion to a DE entity before the Company’s first venture capital equity round.
- Protective of Officers and Directors – Delaware courts have a history of deferring to the business judgment of the officers and directors of a Company, meaning that without evidence of gross self-dealing or negligence, they’re unlikely to use hindsight to second-guess business decisions. This makes finding reputable executives and directors easier, for obvious reasons.
- Response Time – Ever needed to close that bridge financing in the next 2 hours in order to make payroll? I’ve seen it plenty of times, but surely that would never be your company. Ever. Well, just in case, DE has an amazingly well-greased system for filing legal documents. For extra fees, you can get guaranteed 24-hour, 2-hour, and even 1-hour response times. Suriname should really consult with the Delaware Secretary of State to up its game.
- Converting Later is More Expensive – When you’re starting out fresh, there are no contracts to review, consents to get signed, etc. You just form the Company where you want to form it. But as time progresses, and you get shareholders, sign contracts, hire employees, etc., the amount of diligence involved in ensuring that you can convert to a DE entity grows exponentially. Pay now, or pay more later.
The Downsides to DE:
- Fees (Cost): This is really the only reason why a Texas startup that intends to eventually raise professional venture capital will consider not incorporating in DE. By forming a DE entity that operates in Texas, you’ll have to file a form to qualify to do business in Texas as a “foreign” (non-Texas) entity. This costs about $750. You’ll also need to maintain a “registered agent” in DE, which will run you about $125 a year. Finally, you’ll have to pay franchise taxes in both DE and TX, although the added cost until your startup becomes profitable is likely to only be a few hundred dollars a year.
So the decision to incorporate in TX or DE really boils down to two questions:
Do you ever intend to raise professional venture capital?
If not, then unless you just find Delaware’s sophisticated business-friendly environment really appealing, you’re probably well-served by sticking with a Texas entity. A lot, if not most, startups will fall into this category. Save your money and use it to build a great product.
If you do intend to raise professional venture capital, are you willing to incur the additional cost of forming a DE entity?
At formation, the up-front cost differential between a DE v. a Texas entity is likely to be about $1,000, with a few hundred extra a year for registered agent services and franchise taxes. As time progresses, the cost of converting to DE will increase in terms of legal diligence and logistics as you execute contracts, pick up shareholders, etc. While numbers obviously vary, you can probably expect about $5K-10K in fees in converting your TX entity to DE pre-Series A.
Most of our clients bite the bullet and pay the extra ~$1K to form in DE from the beginning. That’s because (1) we don’t really serve startups that don’t intend to raise professional capital, because they don’t need us, and (2) it sends a signal from the beginning that the Company intends to operate in the big leagues. Still, a handful take the approach that 5-10x in fees is fine down the road if, at least at that point, they’ve found investors or a good revenue stream to help pay the costs. I generally say that, if you’re really that worried about losing $1,000 in a startup that you seriously think will pursue venture capital, perhaps you should reconsider entrepreneurship altogether. But it’s ultimately a personal judgment call.