Incorporating a Business: Where, When and How
Incorporating a business is not synonymous with “incorporating a business in Delaware,” yet many businesses do incorporate in Delaware. In fact, according to Delaware’s official website, it consistently ranks among the top five states for entity formations (Florida, California, New York and Texas being the other four). The state also leads in out-of-state incorporations, that is, when a business that is located outside of the state incorporates within the state. So the obvious question is, why is a state that accounts for 0.29 percent of the country’s population considered a name brand when it comes to corporate formation?
Before addressing that question and whether it makes sense for your business to incorporate in Delaware, below is a brief discussion on what incorporation is and why you should do it if you are thinking about starting a business.
What does incorporating a business mean?
In layman’s terms, incorporating a business means that the corporation housing the business is now considered separate and distinct from its owners. The principal benefit of incorporation is that an owner or owners of the business will generally not be personally liable for the debts and obligations of the business. It also means that the entity itself is considered a legal person under the law, so it can, among other things, bring suit or be sued, enter into contracts and will also be responsible for paying taxes.
What is the process of incorporation?
The process of incorporating a business and forming a corporation is relatively straightforward in most jurisdictions. It usually involves a three step process: (i) checking with the applicable Secretary of State’s website for available names, (ii) filing a Certificate of Incorporation (also called an Articles of Incorporation depending on your jurisdiction) and (iii) paying applicable filing fees.
Does incorporating in Delaware make sense for your business?
Where to incorporate your business depends on a few factors, such as the stage you are in, what you seek to achieve with your business, the jurisdiction you principally conduct your business in and if you are thinking about raising outside capital. Below are the most common reasons for choosing Delaware as your state of incorporation:
- Predictability in jurisprudence: Delaware has robust jurisprudence on corporate law matters. Delaware’s well established jurisprudence allows corporations and the related constituencies of the corporation (i.e. shareholders, directors and officers) to understand their respective roles and obligations. It also allows the officers to structure transactions in a manner that is consistent with precedent to reduce the likelihood of the transaction being challenged in court, or if challenged, to obtain a favorable ruling. This is in part why a majority of Fortune 500 companies are Delaware corporations. Even if you are not a Fortune 500 company, predictability in jurisprudence has a lot of value. Take, for example, a startup that is seeking to raise capital from a venture capital firm. Along with an investment, it is typical for the venture capital firm to ask for a board seat, and being a director of a corporation comes with certain responsibilities and expectations. Since Delaware has robust jurisprudence on what a director’s responsibilities are, and how to satisfy his or her fiduciary responsibilities in particular situations, this gives a VC that has a board member on a portfolio company a good amount of comfort. This is particularly the case when a venture capital firm has multiple board designations across its portfolio companies.
- Ease for outside investment: Delaware corporations allow for the creation of various classes of shares that have unique preferences and rights. If you are seeking capital from a VC, they will likely ask for preferred stock that gives them certain voting, consent and liquidation rights that are distinct from the common shareholders. While it takes some legwork to agree on the terms of the preferred stock, once agreed, the process of amending a certification of incorporation or drafting a certificate of designation is simple. In fact, once the VC is ready to fund, the amended certificate of incorporation can be filed and evidence received on the same day.
- Less corporate formalities: Unlike some states, Delaware doesn’t require corporations to disclose the identity of its owners as part of the filing process. This allows owners to maintain their privacy and avoid public scrutiny. Moreover, while a Delaware corporation must have a board of directors, the board itself can be comprised of one director and the director need not be a stockholder of the corporation.
- Initial filing fees and efficiency: Unlike some states, Delaware has pretty low filing costs. It only costs $89.00 to file the certificate of incorporation with the state, and if you are in a rush, you can pay an extra $100 to get evidence of the filing the same day.
Forming a corporation in Delaware may not be right for all businesses. Below are additional considerations to take into account when deciding whether Delaware makes sense for you.
- Registered agent: If you are a Delaware entity, you must designate a registered agent within the state, which is responsible for receiving court documentation. Unless you are located in Delaware or know someone in Delaware who is willing to act as the corporation’s registered agent, you will have to engage and pay a service provider.
- Franchise taxes: The state collects franchise taxes, irrespective of whether the corporation does business within or outside of the state. Taxes can range from as little as $175.00 to $180,000. If you are a small business and the capital structure is simple, the tax will generally be the minimum or close to the minimum. This is a key reason why it is good to get an attorney involved when setting up the entity’s capital structure initially to avoid paying unnecessary or excessive franchise taxes.
- Foreign qualifications requirements: If you are a Delaware corporation transacting business in another state, you may have to file a certificate of authority (i.e. foreign qualification) in that other state. This additional paperwork generally involves a filing fee. The consequences of not doing so may involve, among other things, losing access to the applicable state court.
Forming a corporation can be a relatively simple process, but determining where to form can be a little more complicated. If you are a small business and only conduct business in your home state, then it may not make sense to form a corporation in Delaware. On the other hand, if you have aspirations of building a business with the help of outside institutional capital, it probably makes sense to form a Delaware corporation and avoid the unnecessary paperwork of reincorporating in Delaware later on. It is always advisable to get an attorney involved in the formation process to help you think through the issues and select a jurisdiction that fits the goals of your business.
Disclaimer: This article is not a substitute for professional legal advice. This article does not create an attorney-client relationship, nor is it a solicitation to offer legal advice. Seek the advice of a licensed attorney in the appropriate jurisdiction before taking any action that may affect your rights.