Delaware has been preeminent as the place for businesses to incorporate since the early 1900s. Close to a million business entities are domiciled in Delaware, including more than one-half of the corporations that make up the Fortune 500.
Why do corporations choose Delaware? There are several reasons. First, the Delaware General Corporation Law is one of the most comprehensive, advanced and flexible corporation statutes in the nation. Second, Delaware’s corporations court, the Court of Chancery, is highly respected because its judges are very knowledgeable and their decisions are well reasoned. The accumulated body of Delaware court decisions provides clarity and guidance in many of the situations that might arise in the realm of corporate governance or shareholder rights. Third, the state legislature is diligent about keeping Delaware’s corporation statute current. And fourth, the Secretary of State’s Office is not at all bureaucratic. Quite the contrary, it is efficient, helpful and courteous. As one small example, Delaware was among the first states to accept corporate filings by fax.
Delaware’s large body of corporation laws, including both statutes and court cases, allows a company to avoid lawsuits through better planning. The law is often much less clear in other states. Moreover, most corporate attorneys are familiar with Delaware corporation law in addition to the laws of the particular state where they are admitted to practice. A typical engagement letter from a law firm will say something like, “our practice is limited to the laws of [home state] and the Delaware General Corporation Law.”
For all these reasons, many venture capital firms are more willing to invest in Delaware corporations, and entrepreneurs want to make their new businesses attractive to venture capital firms from the outset.
What are the disadvantages of incorporating in Delaware? There are two. First, the Delaware annual filing fee and annual franchise tax is an added expense because most corporations (i.e., those located outside Delaware) must still register as a “foreign” corporation in the state where they are located and and pay annual fees to that state. And second, the annual franchise tax in Delaware can come as a shock if the corporation is formed without adequate planning.
The Delaware annual franchise tax is calculated as follows (this is somewhat over-simplified—the exact calculation can be found at http://corp.delaware.gov/frtaxcalc.shtml):
If the authorized shares have no par value, the franchise tax is $75 for up to 5,000 authorized shares; an additional $150 for the next 5,000 authorized shares; and an additional $75 for each additional 10,000 authorized shares above the first 10,000 authorized shares. The maximum annual franchise tax is $180,000.
If the authorized shares have a stated par value, the corporation must calculate the “assumed par value”, which is determined by dividing total gross assets of the corporation by the total number of issued shares. If this assumed par value is greater than the stated par value (which it almost always is), the assumed par value is multiplied by the number of authorized shares. The result is rounded up to the nearest million, then divided by a million, and then multiplied by $350. The minimum annual franchise tax is $350 and the maximum is $180,000.
Many entrepreneurs like to start their corporations with a huge number of authorized shares, hoping that they will need these shares for several rounds of future issuance: founders, new employees, family and friends, angels, venture capital investors and then the IPO. The problem is that a huge number of authorized shares, if not issued, can result in a very high annual franchise tax for a Delaware corporation, and the tax gets even higher as the gross assets of the corporation grow. The attached spreadsheet shows the annual franchise tax for a Delaware corporation with 30 million authorized shares (page 1), 10 million authorized shares (page 2) and 1 million authorized shares (page 3), at different levels of gross assets and issued shares.
The lesson here is that it can be very expensive for a Delaware corporation to authorize shares and not issue them. In most cases it would be better to start out with a small number of authorized shares and then later amend the certificate of incorporation to increase the number of authorized shares when a new issuance is planned.