Updated: Mar 20
One question we often get from new business owners in California is whether they should incorporate[i] their business in Delaware instead of California (the home state of the business). This choice depends on several factors. In this blog, we explore some of those factors. Among other things, the decision depends on the scale of the business, whether the corporation intends to seek outside financing and whether the corporation will have ties in multiple states.
California and Delaware both impose income taxes and franchise taxes on regular “C” corporations. While Delaware’s state corporate and franchise tax rates are slightly less than California, a corporation transacting business in California cannot avoid California corporate income taxes and franchise taxes by merely incorporating in Delaware. This is because such a corporation must qualify to do business in California and thereby it will be subject to the same corporate tax rate and franchise taxes that would be imposed on it had it been a California corporation. Further, a Delaware corporation transacting business in California, must comply with the registration and filing obligations of both states including maintaining a registered agent in Delaware.
Both Delaware and California corporate laws protect board and management actions taken in good faith and in the best interest of the corporation (the so called “Business Judgment Rule”). And the corporate laws of both states allow the corporation to indemnify legal expenses and judgments (subject to certain exceptions). However, California applies a stricter standard in determining whether directors have met their duty of care in performing actions on behalf of the corporation—their actions are scrutinized under the “ordinary negligence” standard, whereas in Delaware the standard applied generally is that of “gross negligence.” Delaware also allows corporate charters and bylaws to waive or otherwise limit certain fiduciary duties of management that cannot be waived in California.
Also, California provides shareholders more rights in certain aspects. For example, in Delaware shareholders are only permitted to call special meetings if authorized by the company’s certificate of incorporation or bylaws. In California though, not only may a special meeting of shareholders be called by the holders of 10% or more of the voting stock of the corporation, but this right may not be waived by the shareholders in the corporation’s articles of incorporation or bylaws. However, even though Delaware law is slightly more favorable for CEOs and managers over shareholders, practically, this becomes beneficial only when a corporation has many shareholders and, therefore, there exists a greater risk of derivative actions (i.e., lawsuits) by shareholders (on behalf of the corporation) against management.
A corporation intending to seek venture financing may prefer to be incorporated in Delaware. Generally, venture capitalists (“VCs”) prefer Delaware corporations over other entity types and corporations formed in other jurisdictions. Among the reasons for VCs’ preference are (i) a well-developed body of corporate law and vast amount of precedent in the area of corporate law; (ii) greater predictability of outcome of legal issues because of Delaware’s well-developed body of corporate laws; (iii) the Delaware Court of Chancery, which is a leading business court in the country and has judges who are experts in business law matters; and (iv) VCs’ overall familiarity with Delaware laws which helps in better business planning.
Delaware law provides for greater structural flexibility than California. For example, a Delaware corporation may have several shareholders, but can have only one director. California law, on other hand, requires at least three directors when there are three or more shareholders. California is also more protective of minority shareholders rights than Delaware. California requires a majority vote of each class of outstanding stock to approve mergers, acquisitions, etc., whereas in Delaware a majority vote of all classes taken together suffices. Also, a shareholder voting at an election of directors has a statutory right to cumulate votes in California whereas this right must be provided by the certificate of incorporation in Delaware.
For a business primarily based in California with few shareholders and which does not intend to seek outside investment, being incorporated in California may make the most sense. Also, it is not impossible to change the jurisdiction to Delaware later if the trajectory of the business changes and Delaware becomes more desirable.
[i] Note in this blog we have analyzed the choice of jurisdiction between California and Delaware for a C-Corporation, and not the choice of business form – for more on choosing the appropriate business form review our blogpost LLC versus C-Corp