Where Should You Incorporate?!

It is best to form an entity in either the state where your company mainly does business or one with a well-developed body of corporate law. Many companies tend to pick Delaware for its favorable and well-developed corporate law. Having an entity in Delaware can increase management power and provide majority shareholder with more flexibility when dealing with minority shareholders. Delaware also may provide administrative advantages such as faster document processing, which can be crucial when time is of the essence. Even more, Delaware possesses a specialized and very experience court that is dedicated to quickly resolving corporate law disputes.

The differences between state law can also be seen in the type of consideration available to purchase stock, how enforceable voting agreements are, and the ability for shareholders to (1) act by written consent; (2) exercise preemptive rights to maintain their pro rata ownership percentage in the event of a financing; (3) to call a special shareholders’ meeting; (4) elect directors for multiple-year terms (allowing for staggered elections, helping prevent hostile takeovers and provide institutional continuity); and (5) demand appraisal rights upon certain events. Where you choose to domicile your business also affects indemnification of directors and officers as well as the ability of directors to adopt certain poison pills and other antitakeover defenses.

There are disadvantages to incorporating in Delaware though as well. Incorporating out of state tends to result in higher fees and other costs because of the need to comply with certain filing and regulatory requirements in both states.

California law contains many notable restrictions. For instance, California requires that at least three directors unless there are fewer than three shareholders A California corporation may only buy back shares or pay dividends only to the extent that it meets certain asset coverage or retained earnings tests. Thus, companies that have negative retained earnings are prohibited from paying dividends, repurchasing shares, or making other distributions to shareholders. Running afoul of these provisions will result in a heavy penalty and directors are personally liable for any violations of this law. Moreover, privately held California corporations must give shareholders the right to vote cumulatively, possibly giving shareholder the opportunity to elect one or more directors. Under cumulative voting, each shareholder may cast a total number of votes equal to the number of shares owned multiplied by the number of to be elected directors; the shareholder can allocate those votes to such nominees as he or she feels. Directors must be elected yearly as well.

One substantial difference between California and Delaware law is the right of California corporation common shareholders to vote as a separate class in the event of a merger of the corporation. This right can provide California common shareholders important leverage and this right does not exist for the shareholders of a Delaware corporation. In Delaware, a majority of all classes of stock—voting together—must approve a merger. That said, holders of preferred shares typically negotiate the right to vote as a separate class in substantial matters such as merger.

A corporation typically is subject to the corporate governance laws of the state it is incorporated. But California applies its pro-shareholder corporate governance laws to corporations that are incorporated elsewhere but have strong ties to the state (i.e., quasi-foreign corporations). Specifically, a privately held corporation is subject California corporate governance laws, no matter where said corporation is incorporated, if more than 50% of its shares are owned by California residents and more than 50% of its business is done in California. Thus, if a business owner will reside in California as well as have most of its business done in the state, it is likely sensible to incorporate in California and then wait to reincorporate in Delaware or another jurisdiction at an appropriate time.