Why You Probably Shouldn’t Form a Delaware Corporation

Start-up clients often ask me whether they should from a Delaware corporation. My answer is usually that unless the company can point to some specific compelling reason for forming in Delaware, a Delaware corporation is unlikely to be the best vehicle for achieving the company’s goals. Setting aside for another blog post the question of whether an LLC would be a better option, it often makes sense for a corporation to form under the laws of the state in which it will be principally located or transact the majority of its business. Let’s unpack the reasons for this conclusion:

First, in the interest of fairness, let’s start with a partial list of why it might make sense for a corporation to form under Delaware law. If the company will be principally based or legally transact business in Delaware, it likely makes sense to form a Delaware corporation. Under both scenarios, the company will already be subject to Delaware law and filing requirements, so choosing an entity form as familiar to investors and transactional partners as the Delaware corporation might be a good idea. The vast majority of start-ups, however, do not have significant legal ties to Delaware.

The next best reason for forming a Delaware corporation is that the company is either a serious contender for imminent private equity investment or will be going public through the help of an investment bank. It is absolutely the case that certain large investors expect their investment targets to be organized as Delaware corporations. Because of Delaware’s historical reputation as a business friendly destination, many of the country’s largest and most iconic corporations were formed there. As a result, certain large investors (and their lawyers/accountants) have become very familiar with Delaware corporate law, which the Delaware courts have extensively interpreted. This is the likely source of the persistent myth that every start-up must be a Delaware corporation. Before a given start-up jumps on the bandwagon, however, it should realistically consider how likely it is to actually receive funding from the types of investors that demand Delaware corporate form. The statistics are sobering – most start-ups are capitalized with the help of friends and family long before they ever reach the point of being competitive for private equity attention. If the corporation forms under a different state’s laws and later beats the odds to become attractive for significant outside investment, it may be able to convert to Delaware corporate form or engage in other strategic reorganizations to avoid the problem. Until that happens, there are several reasons why forming as a Delaware corporation is likely to be a bad idea.

To begin, when it comes to state regulation and related risks of non-compliance, less is more. Why would any start-up trying to find its footing in the market voluntarily subject itself to the laws and regulations of an additional state if there’s no real benefit to be had from doing so? If the company won’t have a presence in Delaware or transact business there, the company will likely already be subject to the laws of the other jurisdiction(s) with respect to which it has substantial ties. Forming as a Delaware corporation will often serve only to add another set of annual fees, filing deadlines to remember, potential tax complications, the costs of maintaining a Delaware registered agent, and another jurisdiction in which the company can potentially be sued. The last point is particularly important to consider, although it’s a legally complicated issue and oversimplified for the purposes of this post. Although many large companies actually prefer to have access to the Delaware legal system because of process efficiencies and judicial familiarity with corporate law, the costs of having to defend a significant lawsuit in Delaware if the company is based elsewhere can be devastating to a small start-up.

Although some companies may see income tax benefits from choosing Delaware corporate form, that assessment is highly fact specific and depends on the nature and source of the company’s income as well as its access to significant professional accounting services. Additionally, forming as a Delaware corporation does not come without its own set of potential traps from a tax perspective. The Delaware Corporate Franchise Tax is based on a complicated set of alternative formulas which can easily lead to absurdly high tax assessments for an early growth-stage corporation that has not carefully considered the ratio of its authorized stock relative to the shares of stock it actually intends to issue in the short term.

Additionally, choosing to organize your start-up under the laws of a state other than Delaware is unlikely to affect the company’s ability to obtain financing from typical commercial lending sources. Most commercial lenders do not require borrowers to be organized under Delaware law and some even prefer borrowing entities to be formed under the laws of their own state for ease of access to information and overall familiarity. In general, status certifications and certified corporate documents required by lenders take longer and cost more to obtain from Delaware than many other states, which can end up delaying or increasing the cost of the Company’s financing.

Considering the relative benefits and drawbacks of forming a Delaware corporation, start-up clients should seriously consider whether Delaware corporate form makes sense for a given company. For certain start-ups, Delaware is a good choice while many others would be better served by forming under the laws of a different state to which the company has more significant ties. In any case, this is a significant decision in the life of a start-up and one that should only be taken after seriously considering the company’s short and long term goals.

Perkins Thompson regularly helps entrepreneurs and start-up companies navigate the complex legal issues that arise during a company’s formation and early growth stages. If you would like more information please email Ian Green or call him at 207-400-8176.