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Whats the Deal With Delaware

What’s the Deal with Delaware?

I’ve represented several startups recently where the same circumstance has presented itself.  Since I’m a Texas attorney, it must be assumed that the founders of these startups either live in or are operating their business out of Texas.  By the time they’ve come to me, they have already formed their company (whether a corporation or LLC) in Delaware.

“Why’d you form your company in Delaware” I inquire.

“Uhm, because we were told that was the best place”, they respond.

“Yes, but why is it the best place for your company?” I ask.

Silence.

Then, they (being startups on a shoe string budget) get freaked out when I tell them that since they are operating their business out of Texas, they have to register to do business in the state, which costs $750.00 just in filing fees.  The bigger surprise comes when they receive a notice from the State of Delaware saying that they owe hundreds of thousands of dollars in franchise taxes – but that’s another topic for another blog post.

Yes, sometimes it may be better for some companies to incorporate in Delaware – it depends on the growth strategy for the company.

Delaware became a go-to place for companies to incorporate because they have an entirely separate court system called the Court of Chancery for corporate disputes, composed of judges with a great deal of knowledge in such disputes.  The court is without a jury, and in the event of a dispute, the parties don’t have to wait months behind non-corporate suits on the docket, to be heard.  As a result of all of this, there is a tremendous amount of precedent, which can be good or bad, depending on what side of the argument you fall on.

While Texas does not have a Court of Chancery, it is a corporate friendly place from a franchise tax perspective – no franchise taxes are owed unless the company generates over $1,000.000.00, which, let’s face it, is not the case for most startups.  This has led to more companies being formed in the state, and thus, more precedent being developed in the court system.  Plus, the Texas Secretary of State’s Office is all online and it is so easy to file or to incorporate.  Delaware, on the other hand, is for the most part, not online.  You have to either hire someone to physically file for you, or you must mail in or fax in documents, which may take weeks, or even months to get processed (unless you pay extra for expedited service).

The filing fee in Texas is more expensive than in Delaware, but that’s all you pay, unless your company is killing it, in which case the franchise tax kicks in (talk to your accountant about the tax rate).  Delaware has a yearly payable franchise tax, which for most startups runs about $400 per year.  Plus, if your company does not have an office in Delaware, you will be paying a registered agent in the state a yearly fee of on average $100.00 per year.

So, why would you incorporate in Delaware?

Well, VC’s and PE’s feel comfortable investing in companies incorporated in a neutral state with established precedent.  They like the fact that they don’t have to mess with local courts in different states, some of which may not be shareholder / investor friendly.  It’s easier to simply say, “if you want my money, then you must be incorporated in Delaware”.

But, unless you are seeking money from these sources, it does not make much sense to incorporate in a state other than where you intend to operate your business.  It just makes everything much more complicated and ultimately more expensive.

So, let’s say you’ve already formed your company in Delaware, what happens if  you don’t register to do business in Texas?  Well, there are consequences of failing to register when you are in fact operating in Texas.  These include:

  • Inability to maintain an action, suit, or proceeding in a Texas court until registration;
  • Injunction from transacting business in Texas;
  • Civil penalty equal to all fees and taxes that would have been imposed if the entity had registered when first required; and
  • Late filing fees owed to the secretary of state by an entity registering more than 90 days after first transacting business in Texas.

(see http://www.sos.state.tx.us/corp/foreign_outofstate.shtml)

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