What's the deal with Delaware?

Besides, my accountant says I should set up a California corporation.

May 24, 2024

Tl;dr: When you’re starting a company, you have a choice to make: will you be bootstrapping or raising VC funds? There’s no right or wrong answer there. However, if you intend to raise VC funds, you’re normally better off starting as a Delaware C-corp.

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My accountant said I should do a California corporation…

“Are you going to raise money from outside investors?”, I asked the two co-founders who had visited my office.

“Yes, that’s the plan,” replied one of them.

“Are you thinking smaller checks from friends and family? Angels? Or VC funds as well?”, I continued interviewing.

“VC funds for sure.”

“Sounds like you want to go the venture-backed route,” came my diagnosis. “In that case, go with a Delaware corporation.”

We spent the next 20 minutes or so chatting about the pros and cons of a Delaware corporation versus other options, and which made sense in which case. They thanked me for the guidance, and we agreed to touch base in a week when they were ready to roll.

* * *

“So, how are things going?” I asked over a follow-up call.

“So, we decided to go with a California corporation,” said the voice on the other end of the line.

“Let me guess: your accountant said it was better for tax.”

“How’d you know?”

🤦‍♂️ Here we go again…

Why Delaware?

There’s a common misconception that startups end up incorporating in Delaware for tax purposes. And so, when a CPA advises that it’s actually better for tax purposes to set up a corporation in their local state, the decision needle swerves the other way.

Time to bust that myth: Delaware isn’t a “tax haven” per se (although it is more secretive than other states when it comes to LLCs).

Here’s are the real reasons why Delaware continues to be the go-to jurisdiction for so-called “venture-backed startups.”

Certainty: The Delaware Court of Chancery

When you’ve been around as a commercial court for over two centuries (since 1792), you’ve likely seen it all when it comes to corporate law and disputes. What that means in a precedent-based (aka, common law) jurisdiction like the one we have in the states is: certainty. In business, certainty means less risk – and businesses appreciate less risk.

Sophistication: A well-developed legal code to boot

The case for certainty doesn’t stop with the Court of Chancery, but rather it starts with it. All these troves of caselaw eventually translate into a more sophisticated (that is, well-developed) corporate legal code and, by extension, a robust corporate bar (in the sense of qualified attorneys). With the power law at play, you can see why Delaware emerges as a clear winner, by far.

Flexibility: Delaware General Corporate Law

In a sense, corporate lawyers are architects, with charters and contracts being the trusses and concrete with which the foundation and stories of the corporate building is built. Compared to the corporation laws of other jurisdictions (such as California), Delaware General Corporate Law (or DGCL) gives lawyers flexibility to structure companies and deals as relevant, making it a favorable corpus of law.

Familiarity: Stakeholders regularly deal with Delaware

When virtually all your business relationships are with Delaware corporations (which is generally the case with VC funds), you become intricately familiar with the ins-and-outs of Delaware corporate law and custom. To invest in or otherwise engage with another corporate form – say, a German GmbH – means to educate oneself on the nuances of that other form, which is a factor of time and expense.

So, why does my accountant recommend I incorporate in my home state?

Generally, for tax purposes. You see, if you live in a state other than Delaware, then even if you incorporate in Delaware, you may have to “qualify as a foreign corporation” in your home state as well. Once that happens, you’ll end up having to pay tax to Delaware and your home state.

Qualify as a foreign corporation?

Yeah. In the U.S., companies are set up under the laws of a given state. There’s no such thing as a “U.S. corporation” (unless you’re one of the few types of businesses, such as banks, which are formed under federal laws instead of state laws).

As a result, each corporation has one state as its “primary residence”. All the other states view it as a “foreign corporation” (“foreign” meaning “from another state”, not “from another country”). When you “qualify” in another state, that means that other state “recognizes” you as a corporation for its own internal purposes. It’s kinda like “registering” in that state, but not really – you’re still only registered in your original state.

When do I have to qualify?

The key phrase here is “substantial nexus” – you’re required to “qualify” in another state when you have a substantial nexus with it.

There’s no bright line rule here, but rather depends on various factors. If you have one employee in a given state, you probably don’t have a substantial nexus there and don’t need to qualify in that state. But maybe your marketing team is based in that state, and you have an office there, and you bank at the local branch… and 20% of your revenue is generated from that state – those are factors that point to having a substantial nexus and, thus, having to qualify in that state.

In real world terms, what does that mean?

Several CPAs I’ve talked with opine that having a business address in a state is sufficient to establish a substantial nexus. Based on my experience, however, a freshly-minted corporation without significant traction can normally operate for a year or so without running into issues. Of course, this isn’t a risk-free approach but rather in line with the startup mindset of “let’s see if this thing takes off; we’re worry about other matters later”.

Must I start as a Delaware corporation?

The short answer is: no. However, if you intend to go the venture-backed route, you’re probably better off starting as a Delaware corporation. There’s an alternative route for getting there.

Converting to a Delaware corporation

An alternative route is starting as an LLC or a non-Delaware corporation and then converting into a Delaware corporation. The plan is to test things out first, and if things get going and you’re about to get funded, that’s when you convert into a Delaware corporation. That said, a few things to keep in mind here:

Converting can take time

Conversions don’t happen instantly. Normally, it requires creating a plan of conversion, which lays out the specifics of when and how the existing entity will convert into a Delaware corporation. One of the more sensitive nuances is specifically delineating how the ownership will convert – going from an LLC with multiple classes of units into a corporation can be particularly tricky. This plan of conversion will then have to receive the appropriate company consents.

Converting can be expensive

As a result of the above dynamics, conversions can cost a pretty penny. Not all corporate lawyers are qualified to handle conversions, so competent ones can be more expensive than usual. In fact, you’ll be juggling the laws of both jurisdictions in this process, which adds further complexity to the process. Additionally, the more you wait to convert, the more costly it’s going to be.

Converting may not be possible

Not all conversions are possible. Before you go with the alternative route mentioned here, make sure that both your home state and Delaware allow the respective conversion (for example, a California LLC converting into a Delaware corporation). As of writing this, this kind of conversion is indeed possible. Though remember, laws can change.

Conclusion: So then… why Delaware?

It comes at the risk of paying tax to more than one state, surely a downside not to be taken lightly. But this is one of those situations where the benefits far outweigh the downside. With an experienced corporate bench and bar, well-developed corporate code, and a solid reputation in the ecosystem, it’s not surprising to see Delaware continue to dominate as the go-to jurisdiction for venture-backed startups.

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