When setting up a company, you must not only choose the right type of entity, but the right state of formation. The term “incorporate” means you are forming a corporation, but a corporation may not necessarily be the best choice for your business (we will address this issue in next week’s post). You may also have heard that Delaware is the premium jurisdiction for your startup. That may be the best choice in some instances, but not always. There are a number of factors to consider when setting up your company, such as how business-friendly the state is, or whether the state is widely recognized as a hub for your venture’s specific industry. Other considerations include proximity to your business, legal jurisprudence favorable to you, and of course, tax implications.
It is no secret that there are some states, such as New York and California, but most notably Delaware, that are widely lauded as the premium state to start your business. We address below some of the factors driving these initial startup decisions.
Flexibility in Organizational Structure
Depending upon your needs, the flexibility of the state’s corporate statute might be a decisive factor in choosing your preferred jurisdiction. Some states offer greater flexibility in how a corporate entity may be structured, for example, by allowing one person to serve as a director, shareholder or officer of a corporation, as opposed to imposing a one person per role rule. Other advantages might relate to greater privacy in formational documents, by not requiring you to disclose the identity of officers or directors. These might be key factors for your entity, and thus, should be carefully examined.
Another factor is the expense of setting up your new company in the state. Organizational costs may range from $1025 to only $70, depending on the state and type of entity. There may also be expediting fees that you may want to pay in order to accelerate the process, with some jurisdictions offering the option to set up a company within the hour. Other states even offer the option of filing a form to reserve your company name while you get all of your ducks in a row. These costs will not have a definitive impact down the line as they are only paid once, but they often reflect the future costs that will be charged by the state in terms of annual fees and reports that need to be maintained.
Most states charge an annual fee to maintain an LLC or corporation. This fee is often paid when the company files an annual report containing basic information such as the location of the company’s headquarters, or information about current board members or officers, and how many shares have been issued. Failure to file an annual report may result in penalties, such as an administrative dissolution of the company – timely filings are thus important in maintaining the integrity of your business.
Some states, such as Delaware, for example, also impose an annual franchise tax. It is important to consider how such franchise taxes are calculated by the state as some are fixed fees, whereas others are calculated based upon authorized and issued stock. This may be an important consideration in choosing the appropriate state for you, and may drive how your company is initially structured in terms of stock ownership.
Finally, close attention should be paid to how business friendly the state is in terms of filings. Consider efficiency and how costly it can be to need someone to prepare such filings based on their complexity, as well as whether or not it has to be mailed or can be done electronically.
Another important factor is the state’s ability to tackle commercial disputes and the predictability of such outcomes, particularly with respect to governance matters. It is more advantageous to select a state with an established and highly respected court system that favors your interests as an entrepreneur, rather than sludge through years of expensive litigation with no clear precedent to guide the dispute’s outcome.
What about Investment?
If you are thinking about raising capital – chances are – investors will expect your entity to be a Delaware entity. Factors investors may take into serious consideration are the stability and predictability of the judicial system, and the absence of corporate taxes. Other important considerations are the ease of restructuring your entity, the convenience and speed of such changes, and the associated costs. While these are noteworthy factors, it is also important to consider the drawbacks of incorporating in Delaware, as further discussed below.
What’s the Deal with Delaware?
We mention Delaware because it is the leading domicile for U.S. and international corporations; more than 1,000,000 business entities have made Delaware their legal home. Even more impressive is the fact that more than 66% of the Fortune 500s have chosen Delaware as their legal home.
Delaware also has the well-established and highly respected Court of Chancery that specializes in corporate issues. The Court of Chancery has issued numerous rulings on corporate matters, thus providing new businesses with a greater degree of certainty as to how potential corporate governance disputes may be resolved.
Another advantage of setting up your company in Delaware is the open line of communication with the office of the Secretary of State: representatives are available to answer corporate questions via email, phone and even online chat. As of this year, almost all filings and payments can be done online. As for costs, the process of setting up a corporation can be expedited to be completed in the same day for only $100 (set up costs for a corporation are $90, and for a limited liability company, $90).
Should all companies be set up in Delaware?
No. If your business is not located in Delaware, there are some disadvantages that you should take into consideration. For example, Delaware requires you to name a registered agent with an actual street address in Delaware. Registering your business in Delaware does not give you a pass in your home state, you must still register your entity as a “foreign” entity in your home state. This means complying with franchise tax and annual reporting requirements in both Delaware, as well as your home state. These are costs and inconveniences that may not be worth it to a business located outside of Delaware, particularly where there is no need or anticipated plan for a capital raise.
Whatever scenario you end up choosing, you should work with a good lawyer and certified public accountant (CPA) to determine what is the best solution for you.