Best State to Incorporate: Delaware or California?

If you have just built a startup based in California, your next question may be ‘Where should I incorporate my company?’ The logical conclusion may be to incorporate in the state that your company is geographically located. One might also think that California would be a great choice, since it is booming with startup companies. However, you would be surprised to find out that Delaware has always been the preferred (and often, required) state of incorporation by venture capitalists for a litany of reasons.

Delaware has been the unanimous preferred state of incorporation by investors. The Delaware General Corporation Law (DGCL), which governs disputes brought against businesses, is pro-business, modern, and flexible. The favorable treatment that businesses have garnered in Delaware has established its reputation. Delaware courts and judges have historically offered the best protection for board members against shareholder lawsuits and limited protection against hostile takeovers. California, on the other hand, has more protection for minority shareholders and more unpredictable court decisions. These laws make Delaware much more favorable to larger companies and bigger investors. For companies seeking venture financing, incorporating in Delaware is recommended, as most venture capitalists will only choose to invest in a Delaware C Corporation.

In addition, Delaware courts are well-established in business law. Delaware's Chancery Court, one of the leading business law courts, hears only Delaware business entity cases, and their judges specialize in business law. Delaware's Secretary of State's office is efficient and easy to navigate. Throughout the years, Delaware has developed a more robust canon of case law regarding corporate issues, and therefore, more predictable legal outcomes. Documents for transactions are more readily available and familiar to investors and their counsel. Likewise, VC partners are more familiar with director liability under Delaware law.

On the contrary, there are issues in California's Revised Uniform LLC Act (RULLCA), which governs all business disputes. The statute allows California courts to void contracts under the “manifestly unreasonable” standard. This gives them the power to define “manifestly unreasonable” as broadly as they wish. Sometimes, anything that causes a dispute or inequity among members will fall under the standard and void the contract. Meanwhile, the Delaware LLC Act has no such exception and must respect your Operating Agreement under all circumstances.

When making a corporate change like a merger, acquisition, or IPO, California requires a majority share of each class of stock to give their consent, whereas Delaware corporate law allows all classes to vote together. The latter option is preferable for investors; this voting system prevents exit options to be blocked by a single class (common stock held by founders and employees). Therefore, Delaware is generally the best state for managers of public companies, so if your company is considering an IPO in the future, you may consider incorporating in Delaware.

Finally, Delaware has historically been known as a tax haven. Delaware has no sales tax and no intangible personal property tax, also known as the “Delaware loophole”, saving large corporations lots of money on tax reductions. No Delaware income tax has to be paid or filed, and a business license is not required if the LLC does not do business in Delaware. You will still need to pay taxes where you transact business.

While there are great benefits to incorporating in Delaware, you should not simply incorporate in Delaware no matter the situation. You should consider these reasons for large corporations, but they mean very little until your company is ready for an IPO or later rounds of equity financing. If your company does not plan to seek venture financing in the near future, California may prove to be the superior option for your start up right now due to its relative convenience.

For a California business, incorporating in Delaware can be costly. The Delaware corporation must pay to file in Delaware and to run the corporation in California, increasing costs in extra filing fees and administrative duties. They must pay California State Franchise Tax Board taxes and Delaware taxes. To do business in California, the corporation must also file its Articles of Incorporation to the Secretary of State, a statement of qualification in California, and pay the minimum franchise tax. The Delaware corporation must also maintain a registered agent in Delaware annually.

Also, a California corporation incorporating in California gives them access to an intrastate exemption to federal securities laws. These laws can make certain finance transactions and equity compensation a bit easier and cheaper to carry out. However, a Delaware corporation would not benefit from the intrastate exemptions.

Of course, if a California corporation later decides to seek venture financing, it can reincorporate in Delaware through conversion, asset transfer, or by creating a Delaware corporation and merging the California corporation into it.

In conclusion, Delaware has proven to be the preferred state for incorporation for a host of reasons—its laws are pro-business and beneficial for top executives. But if your business has a small number of owners and does not plan on going public soon, choosing to incorporate in California is a very viable option.

As your business grows, you may want to consider implementing a more formal business structure. When it is time to take that next step, talk to an experienced Silicon Valley business lawyer. At SAC Attorneys LLP, we have extensive experience helping both start-ups and established businesses grow and thrive, and we can provide the advice and strategic planning that will lay a solid foundation for the future growth of your business. Contact us today at (408) 547-4288 to arrange a no obligation consultation.

Read more about why you should convert your business to a LLC.