A surprisingly common error amongst first time founders is not incorporating correctly.
While COVID lockdowns and technological advances have forced more VCs to become more comfortable investing in teams outside of Silicon Valley, don’t assume that means that VCs are comfortable investing in businesses legally headquartered outside of Delaware state.
Even if you’re a team sitting in Madrid, please, please, please, consider incorporating in Delaware, USA.
Why do VCs care so much about your legal headquarters?
Well, for starters, Delaware Court of Chancery is the oldest business court in America. This means that there is a large bank of prior judgements that can be referenced when legal questions arise, making legal outcomes predictable and often pre-empting the need for litigation.
The Delaware Court of Chancery is the oldest business court in America
Additionally, should litigation occur, the Court uses judges instead of juries, which speeds up legal proceedings considerably and lowers legal costs. And because the Delaware Court of Chancery is a separate court designated to decide ONLY corporate cases, the judges have extensive expertise interpreting and applying corporate law.
Because so many large corporations are incorporated in the state, Delaware case law is also the most up-to-date and corporation-friendly. Delaware receives several hundred million dollars per year (approximately 15-20 percent of the state’s budget) from corporate franchise taxes, so the Delaware legislature has a special incentive to pay close attention to developments in business law, which means there are frequent amendments to keep the state’s regulations and statutes up to date.
More than 65% of all Fortune 500 companies and more than half of all U.S. publicly-traded companies are incorporated in Delaware.
More than 65% of all Fortune 500 companies and more than half of all U.S. publicly-traded companies are incorporated in the state of Delaware. Approximately 80% of U.S.-based initial public offerings (IPOs) choose the state as their corporate home. Basically, if you’re planning to IPO, you’re probably going to end up as a Delaware corporation - so why not just start that way?
If you’re planning to IPO, you’re probably going to end up as a Delaware corporation - so why not just start that way?
A second major benefit is the efficiency (relatively speaking) of Delaware courts. Delaware offers expedited applications and quick turn-around times for many corporate filings - key during critical times like the closing of a fundraising round.
Delaware offers expedited applications and quick turn-around times for many corporate filings - key during critical times like the closing of a fundraising round.
In addition, while annual franchise taxes payable by corporations can vary significantly, in many cases, Delaware’s tax rate can be lower than that of other states, and Delaware has favourable treatment for non-Delaware income and non-Delaware resident shareholders.
On a related note, neither the shareholders nor the executives of a Delaware corporation need to live in Delaware, meaning you can incorporate in Delaware and not have to move your team or your investors. And Delaware has strong privacy protections for directors and officers of corporations - it is NOT among the many states which require corporations to publicly identify directors and officers in state filings that are publicly available on state websites.
An additional benefit is related to the highly complex nature of VC funds, which involve multiple legal entities for each fund (plus one - or a few - for the fund management). And each fund has dozens (sometimes, hundreds) of investors, called Limited Partners (LPs). For the largest funds, where investors include non-profit endowments and foreign pension plans, tax considerations are a key part of the investment structure, and heavily negotiated side letters and operational controls to ensure the LPs do not receive “bad income”. Delaware corporations are a known structure, spinning off reasonably predictable types (if not amounts) of income, that can be processed and legally transferred in known ways, without breaching legal fund documents and operational processes.
Keep in mind that using a different geography for your incorporation results in lawyers (on all sides - your company’s, the VC’s, and the LP’s) needing to spend time learning the law of that state, resulting in greater costs.
VCs, and their lawyers, are familiar with the Delaware corporation legal structure, and have firm grasp of the risks and benefits of the structure. Showing up with a different legal structure is going to raise the perceived risk of the investment for the VC, and derail your pitch away from more important topics like your vision and your product.
In fact, if a company is formed elsewhere, a VC may refuse to invest unless you convert to a Delaware corporation, which can result in delays and increased costs. While almost all unicorns are incorporated in Delaware, virtually none are actually located in the state.
Much as discussed in my prior post on preferred vendors, this is not a time to be cute. When looking at legal company formation, pick a good, experienced lawyer, and consider incorporating in Delaware as your first option.