QUESTION:
One of our founders asked, “Why do venture capitalists prefer Delaware corporations? Can’t I simply register my company in California or Nevada? Why is Delaware so important?
ANSWER:
I found a great article which addresses this exact question. It says, “Delaware has a well-developed and reasonably consistent body of corporate law with which most business lawyers are familiar. It offers various advantages that help shield an entrenched management – such as the ability to dispense with cumulative voting for directors and the ability to stagger the election of directors.”
It goes on to say, “Delaware law 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.”
You can read the full article at http://www.grellas.com/faq_business_startup_002.html
Keep in mind that this is only one opinion, and many lawyers and VC may not agree with this. We welcome other opinions on the subject. It’s worth discussing since it’s something almost every founder wants to know more about.
However, what is ignored is that you can generally be sued in one of two places- 1) the state of incorporation or 2) the state where the principal place of business is located. By incorporating in a state outside of the state where your principal place of business is located, you are basically giving anyone who wants to sue you the chance to cherry-pick the most advantageous forum.
VC’s act similar to the stock market and those prefer DE; plus it is the standard de facto so people prefer it not necessarily for the law but for the ease of use.
founders can incorporate easily online with Silicon Valley grade documents, where they can customize their vesting and receive tailored documents for VC backed companies at http://www.founderspack.com
There's a myth that Delaware law is popular because it favors management over shareholders (or, as mentioned above, preferred shareholders over common). That's simply not true. There are four basic reasons sophisticated shareholders (e.g. VCs, but also founders) and experienced managers prefer Delaware law:
First, it's predictable. California is a big state, but it still doesn't close to the volume of litigation on corporate law issues that Delaware does. No state comes close. A lot of litigation means that you can find definite answers in the Delaware case law to questions that are simply undecided in other states. Delaware also has a Chancery Court that is largely dedicated to corporate litigation, does not conduct jury trials and is staffed with judges chosen in a relatively non-political process for their expertise in corporate law, not their political contributions. Appeals from the Chancery Court go directly to the Delaware Supreme Court whose members, though less specialized, spend a large percentage of their time on corporate questions.
Second, it's efficient. Delaware relies on the incorporation business for a large percentage of its state budget. Accordingly, the secretary of state's office is well staffed and customer oriented. I'm currently trying to close a deal that requires “good standing” certificates from multiple states. With some of them (e.g. Louisiana), we had to start the process months ago. Others (Texas) said they could produce in 3-5 days, but still haven't, ten days later. There's never any worry about Delaware. In fact, the other side in the deal just produced a stale Delaware certificate and we're supposed to close today. There's a good chance we'll still close because Delaware can produce in real time. What's true of the secretary of state's office is also true of the courts: They're expert and efficient. If the circumstances warrant it, you can get from complaint to supreme court decision in a few months.
Third, it's neutral. Delaware law means that no one is going to get a hometown advantage over other parties. A few years ago a rival tried to make a hostile bid for the Taubman shopping center REIT, taking advantage of a loophole in Michigan's harsh anti-takeover law (something, incidentally, you won't find in Delaware because it isn't interested in “protecting” local companies). The Taubmans were able to get the Michigan legislature to “fix” the law before the bid could proceed. That kind of monkey business would never happen in Delaware. Delaware's legislature understands that the value of its incorporation franchise is far more important than the interests of any individual or company, no matter how big, local and generous with political donations. Changes to the corporations code are made cautiously at the suggestion of a panel of non-political experts. Judges are non-political.
Finally, and most importantly, Delaware law is flexible. There are almost no mandatory rules telling you how to set up your governance structure. That's good for sophisticated parties who want to negotiate a deal and know that it will be enforced. Of course, it means that you should know what you're doing if you're negotiating the complex set of governance arrangements typical of a venture capital financing. Delaware law contains few mandatory provisions designed to protect clueless stockholders. It's designed for well-advised stockholders who want the freedom to write their own ticket. In the final analysis, however, the Delaware courts deal harshly with people (e.g. controlling stockholders) who truly abuse their power to rip off minority shareholders (as opposed to exercising the rights for which they negotiated in the first place). The comment above says that ““Delaware law gives preferred stock investors with voting control of a corporation the unilateral power to merge” etc. But it also gives the stockholders the right (through the certificate of incorporation or stockholders' agreements) to modify that if they think it's unfair and can convince the investors.
FYI, Nevada law is not preferable on any of the matters discussed above. It's basically Delaware law without any of the advantages (good courts, developed law, etc.). Nevada law is mostly favored by people who have fallen for bogus schemes to avoid tax (you can't legitimately save taxes by organizing in Nevada unless your business is, in fact, located in Nevada) or are planning to rip someone off.