DELAWARE: is it the right choice?

Transcription

1 DELAWARE: is it the right choice? by Stefano Linares, Esq. of Linares Associates PLLC introduction Every time an entrepreneur considers the opportunity to open a subsidiary abroad he will, necessarily, have to deal with two important decisions. First of all, he will have to decide what would be the best structure for an early stage company, based on the economic and financial goals identified in the business plan. He will also have to establish where it would be more convenient to incorporate his start-up company. The latter decision may turn out to be a particularly difficult one any time the country in which the entrepreneur intends to do business will be the United States of America. Considering that each State of the Confederation has its own corporate and tax laws and regulations, it is extremely important for each entrepreneur doing business in the United States to familiarize with such laws and opt for the most suitable to his company s needs. It is usually the corporate structure conjugating cost and production most effectively that gets all of the entrepreneur s initial attention. Most of the time the entrepreneur s choice falls to the State where the business activity will take place. However, especially in the United States, a company may find itself in a position where it is necessary or convenient to expand its business activity outside the borders of its incorporation State. It is, therefore, essential for each entrepreneur interested in doing business in the United States to devote time and consideration to identify the State where it is more convenient to legally reside. DELAWARE: what are the pros? This might explain why more and more foreign investors opt for establishing their companies in the State of Delaware. A decision very well supported and promoted by an increasing number of lawyers and accountants and which is becoming extremely popular in recent years not only in the United States but also in Europe. The following are a number of questions that we are going to try to answer in the course of the present article. Does it really make sense for a start-up company, doing business in the U.S. A., to incorporate in Delaware? Why is Delaware the State with the highest number of registered companies in the Country? 1

2 Why so many foreign investors choose Delaware rather than New York, Florida or California? Logging on to the State of Delaware s official website, in the division of corporations section, you can download the Why Corporations Choose Delaware brochure, available in English, Chinese and Portuguese, in which you will find a list of all the pros for incorporating in the State. In particular, after pointing out that more than 900,000 business entities have their legal home in Delaware including more than 50% of all U.S. publicly-traded companies and 63% of the Fortune 500, the brochure proceeds analyzing, in details, the main factors making Delaware such a desirable place for investors worldwide. i) Flexible Laws. Delaware s General Corporation Law is the most advanced and flexible business formation statute in the United States. It is designed to provide maximum flexibility in the structuring of business entities and the allocation of rights and duties among founders and shareholders. The statute itself is an enabling statute intended to permit corporations and their shareholders the maximum flexibility in ordering their affairs. As such, it does not to purport to be a code of conduct. Indeed, it is written with a bias against regulation. When compared to some corporation laws where the drafters have attempted to regulate every nuance of corporate behavior or deal with every conceivable eventuality, the Delaware statute has a spare almost open quality. Every effort is made to simply drafting and avoid complexity. On the other hand, the statute has many provisions dealing with practical problems which might otherwise impair business planning. For example, the Delaware General Corporation Law led the way in permitting stockholders to limit the liability of directors by appropriate language in the corporate charter. This provision was in direct response to problems related to the high cost of liability insurance for directors and officers that threatened to deprive businesses of able leaders. In the same vein, the statute also includes provisions authorizing corporations to indemnify directors, officers and employees. On a more mundane level, the General Corporation Law includes a number of provisions designed to make the internal workings of corporations run smoothly. For example, committees of the board of directors may have alternate members so that the committees still function even though one member is absent or disqualified. ii) No Wildcard Juries. Delaware has a separate court system, the Court of Chancery, which was established by virtue of the State's Constitution of 1792, to exclusively adjudicate corporate litigation. So, if you do end up going to court to settle a dispute, Delaware s Court of Chancery uses judges instead of juries, as the case might be in most of the states of the Confederation. Delaware's Court of Chancery is one of the most important corporate law courts in the country, second only to the Supreme Court of the United States, in its impact on corporate law. Delaware's corporate laws are regularly reviewed, revised and simplified by the Delaware State Bar Association and the Delaware Legislature. Delaware Court of Chancery is more than often called upon to provide opinions on complex business transactions where the financial and economic interests of thousands of shareholders are at stake. No need to stress out the importance of having well-trained expert deciding a company s legal fate rather than people whose legal experience consists of The People s Court and Law and Order re-runs. 2

3 Not to mention that the selection process for judges in a number of states remains a political process rather than a merit-based process; not exactly the ideal context for guaranteeing an efficient and reliable judicial system. iii) Precedence Equals Less Litigation. Since professional judges are used, decisions are issued as written opinions that any company can rely on. Thus, most Delaware corporations do not end up litigating disputes because their professional advisers examine these published opinions and construct deals to avoid lawsuits. iv) Low Incorporation Costs. Delaware charges $89 to incorporate. A little bit cheaper than California ($100), New York ($125), and a lot cheaper than Texas ($300). Note, however, that even if you incorporate in a foreign state like Delaware, your startup company may still be subject to registration as a "foreign entity" and compliance with the laws of states you transact business in, as explained below. v) Privacy. In a world where personal privacy is constantly eroding, Delaware does not require director or officer names to be listed in the formation documents. Thus, Delaware provides a reasonably high level of anonymity. There are only two circumstances under which identities are revealed to public access: legal proceedings by the State or law enforcement actions due to illegal activities. Where it all began Notwithstanding the accuracy of the previous statements and its favorable corporate laws, I strongly believe that foreign entrepreneurs should think long and hard before choosing Delaware since it often is not the best choice for a typical early-stage startup company, especially for those not interested in going public. Delaware owes its great popularity to the New Economy movement, which is commonly believed to have started in the late 1990s in the United States of America. During the high-tech bubble in the late 1990s and early 2000s, the idea of a quick path to an initial public offering became so entrenched that startups began skipping the step of incorporating in their own states and moved directly to a Delaware incorporation to speed up the process of going public. After the dot-com bubble burst and the subsequent enactment on July 30, 2002, by the U.S. Government of a new federal law, known as Sarbanes-Oxley Act, with the purpose of setting new standards for all U.S. public companies boards, management and public accounting firms and the creation of a new, quasi-public agency, the Public Company Accounting Oversight Board, charged with overseeing, regulating, inspecting and disciplining accounting firms in their roles as auditors of public companies, very few startups any longer went the IPO route. Yet the Delaware filing pattern persisted: a pattern still extremely popular nowadays, which, however, does not reflect the original goals Delaware corporation laws drafters had in mind when they enacted the Delaware s General Corporation Law. In particular, the goal was to create the perfect tax and corporate environment in order to attract the most prestigious and high-profile public companies interested in accessing the U.S. capital market. With this regard, there are a number of provisions of the Delaware General Corporation Law explaining why Delaware is favored by venture capital investors as well as public company managements. It offers various advantages that help shield entrenched management, such as the ability to dispense with cumulative voting for directors and the ability to stagger the election of directors. Delaware law also 3

4 typically gives preferred stock investors with voting control of a corporation the unilateral power to merge that entity into another, or otherwise have it get acquired, without need for approval of the founders or other early-stage participants who typically own most of the common stock. This type of transaction can "wipe out" the value of the common stock because it can be structured so that only those who hold a liquidation preference (i.e., the preferred stockholders) get any economic value out of it while the remaining shareholders may get little or nothing. In Delaware, unlike other states such as California, those who stand to get nothing out of such deals often have no voice in stopping them. Thus, there is good reason why preferred stock investors (i.e. venture capitalists) will tend to favor Delaware corporations. It gives them enormous leverage over the remaining shareholders in the event the venture capitalists decide to "take out" the company. As anticipated above, European companies wishing to do business in the U.S. market will find Delaware an interesting jurisdiction for basing operations. The U.S. capital market is large, liquid and flexible. Many American investors are eager to diversify their portfolios by holding European securities and this demand can provide European companies with funds at a reasonable cost. In addition, raising capital in the U.S. offers European companies a way to diversify currency risk by issuing dollar-denominated securities. In the light of the above, Delaware appears to be an ideal state of domicile for public companies and late-stage start-ups that are about to go public. For all other types of companies, however, Delaware does not offer any specific practical advantage over any other jurisdiction. It is actually fair to say that a Delaware domicile normally adds administrative burdens for an early stage start-up company based in another State. These burdens include the need to qualify as a foreign corporation in the local state and the difference in the way franchise taxes are handled. Each single company interested in doing business in the United States is required to pay a local annual fee in each State in which it plans to operate. Thus, if a company willing to do business, for instance, in California, decides to incorporate in Delaware it will have to pay a fee in California for each year in which it does business in California. An extra cost which would be avoided by incorporating in California rather than in Delaware. The way states apply and handle franchise taxes is also something to consider very carefully by foreign companies entering the US market. Franchise tax is a tax charged by some U.S. states to corporations with a nexus (such as a filing obligation) with those states. The common feature of a state's franchise tax is that it is not based on income. Rather, the typical franchise tax calculation centers around the "net worth" of the taxpayer. Typically, the number of shares they issue or, in some cases, the amount of their assets is used to make this determination. The purpose of the tax is to raise revenue for the state. The state of Delaware does not offer any significant advantage when it comes to franchise tax, while other states, such as Nevada, have none at all or a smaller one. In Delaware all corporations with or more no par value authorized shares will pay a minimum franchise tax of $350 and a maximum of $ , depending on the method used by the company to calculate the amount due. For more detailed information on Delaware franchise tax, you can refer to the Delaware Code by using the following link: 4

5 Each company incorporating in Delaware will, therefore, incur in such extra cost no matter where it will end up doing business. However, as indicated previously, such costs and expenses can be saved simply by incorporating in the company s home state, namely, the state where it actually does business. It is true, however, that a few other U.S. states have as favorable tax laws as Delaware. Well-established Delaware law, for example, includes Section 1902(b)(8) of Delaware's corporation tax code, which provides that a Delaware corporation that limits its activities to the maintenance and management of intangible assets is exempt from Delaware state income tax. This exemption covers dividend income, interest on notes receivable, capital gains, trademark payments, rents, and royalties. CONCLUSIONS Delaware is very well known as the incorporation capital of the United States. One of the reasons being the excellent body of corporate case laws spanning 110 years regarding such matters as management/shareholders issues and mergers and acquisitions. Delaware laws, however, tend to be pro-management when it comes to minority shareholder disputes. Huge public companies have literally hundreds of such disputes pending in the courts on any given day. So Delaware s case law offers such public companies managers many insights into what they can and cannot do, and what the likely consequences may be. In the light of the above, Delaware appears to be the ideal state where to incorporate public companies and/or companies whose main goal is to go public in the very near future. To earlystage start-ups, however, Delaware does not offer the same practical advantages. In an earlystage start-up, keeping matters simple is important. The point is, therefore, not to avoid Delaware but rather to consider the issues in light of your company's goals and not choose Delaware reflexively. At that point, check with a good lawyer and make your best call, whether it be Delaware or not. Just remember: if you choose to go simple and stay at home, and this proves in retrospect not to be your best choice, you can always reincorporate in Delaware later. RIPRODUZIONE RISERVATA 5