In the Start-Up Entrepreneur Series, I will be taking a deeper look into some of the most common questions early stage founders face in putting together and operating their new businesses. For more information, check out www.hoeglaw.com or drop Rick a line at firstname.lastname@example.org.
One of the most common questions I receive from folks looking to start their first business (or who were not previously included in organizational discussions) is “Where should I form my Company?”.
Like most legal questions, the answer can be complicated (and must always be tailored to the specific facts and circumstances at hand), but there are a few “rules of thumb” that should be considered at the start.
Institutional Investors Absolutely Do Prefer Delaware Corporations
Though in some ways an accident of history, it is an undoubted fact that the bulk of major U.S. corporations are incorporated in the State of Delaware. Why do institutional investors prefer a Delaware corporation? For the most part it’s simple consistency. Both the corporate form under Delaware law and the Delaware courts’ reactions to corporate disputes are well understood (or thought to be well understood by the folks investing, in any event).
Thus, a Delaware corporation is more attractive to outside investment than a Michigan corporation, all other things being equal. It’s also important to note that incorporating in Delaware (or any other state of the union) does not require any actual geographic connection to the state, so it is an option for manufacturers in Alaska, software programmers in Miami, and everyone in between.
If You Don’t Need Institutional Investment (Immediately) Then You Don’t “Need” Delaware
If you are not seeking institutional investment (venture capital, private equity, bank debt, etc.), and you won’t need such investment in the short-term, then you are “free” to consider forming your company wherever you would like.
When clients tell me they know exactly what funds they will need and where they will get them (their own accounts, Rich Uncle Joe, etc.), the Delaware question is not as important. Since Delaware incorporation is not without its costs (franchise taxes, resident agent fees, extra filings in the state where the company is physically located), my advice to these clients often results in our forming a Michigan limited liability company (LLC), or a corporation in whatever jurisdiction they are actually going to be operating in. Such a move saves at least a small amount of administrative hassle and legal expense, expense which can be all the difference in seeing a brand new start-up succeed.
If you Don’t Know What Investment You’ll Need (or are Wrong), Conversion is An Option
In the very old days of about 10 years ago, changing the “domicile” (or state of formation) of a company was a somewhat arduous process. Generally, a fully new entity needed to be formed in the state you wanted to “move” into, and then merger documentation needed to be drafted and filed where the new company effectively “bought” the old.
Nowadays, almost every jurisdiction has adopted “conversion” statutes which allow for a corporation organized in another state (a “foreign” corporation in the parlance) to become a corporation organized in the state with the statute (a “domestic” corporation). So if it turns out that Rich Uncle Joe isn’t actually so rich and your new company needs to attract that hot venture capital money, changing your Michigan corporation (or LLC) to a Delaware corporation is not nearly the hassle (or cost) that it once was.
In other words, don’t let paralysis by analysis rule the day. While your state of formation is important, even a wrong step at the beginning is not the end of the world for you or your endeavor. If you don’t know whether you’ll need outside investment, or if you’re wrong about what you do end up needing, you can almost always “convert” your entity, even on the same day that that institutional money needs to come in.