One of the commonly asked questions that entrepreneurs
ask their attorneys when forming a company is where to incorporate it. Most
frequently, companies choose between incorporating in their home state and
registering in Delaware.
Delaware is chosen by many companies because of its well-developed corporate
law that is typically viewed as pro-management and that gives the majority
shareholders the flexibility in dealing with the minority shareholders. It is
easy to file documents and obtain certificates from the Delaware Division of
Corporations. Also, Delaware has a separate Court of Chancery, dating back to
1792, which is a business law court where judges are appointed on merit, not
elected. This Court has no juries, and decisions are issued in a form of
written opinions. Delaware business case law is abundant and there is much
precedent for corporations to refer to when considering what actions they can
and cannot take. Delaware business law (statutes and precedents) has come to be
considered as the "national corporation law" since all lawyers are well
familiar with it, having studied it in law school, and the most well-known
business-related decisions have come out of Delaware courts.
Large companies with complex structures or those companies that plan to seek
venture capital financing or go public typically consider Delaware as the state
of incorporation. In fact, it is almost expected that a company going public be
a Delaware corporation. In the 1990s, for example, the share of Delaware
companies' IPOs registered on the New York Stock Exchange increased to 73-77%.
After all, Delaware's corporate laws are the most flexible, its Chancery Court
is the oldest in the country, and the abundance of business law precedent is
clear. However, costs of incorporation and ongoing tax obligations in Delaware
may be substantial.
Typically, companies are entitled to apply the laws of their state of
incorporation to their internal affairs and corporate governance. However, it
is not entirely the case if the company is deemed to be a quasi-foreign
corporation in California. A private corporation becomes subject to the
California Corporations Code Section 2115 (to the exclusion of the law of the
state of incorporation) if more than 50% of its outstanding voting stock is
owned by California residents and more than 50% of its business is conducted in
California (measured by property, payroll and sales).
So, a Delaware private corporation with business in California may find itself
subject to pro-shareholder corporate governance laws of the state of
California. Section 2115 of the California Corporations Code requires foreign
companies to apply various provisions of California laws to such fundamental
areas of their internal affairs as annual election of directors (cumulative
voting is required, not optional), directors standard of care, removal of
directors without cause, indemnification of officers and directors,
distributions to shareholders, supermajority vote requirements, limitations on
sale of assets, cumulative voting provisions, reorganizations, dissenters'
rights, rights of inspection and class voting for mergers.
A particular area of concern is the provision applicable to class voting on
mergers. The California law requires that the holders of each class of capital
stock of a corporation approve the merger, whereas the Delaware law only
requires the approval of holders of the majority of the outstanding stock. This
class vote requirement gives a small group of shareholders holding a majority
of one class of stock the opportunity to block the merger, even if the merger
is favored by the majority of shareholders of the company.
In VantagePoint Venture Partners 1996 v. Examen Inc., 871 A.2d 1108 (2005) [an enhanced version of this opinion is available to lexis.com subscribers], the
Delaware Supreme Court considered this point and found that California could
not constitutionally impose its corporate governance laws on a Delaware
corporation that was governed by the Delaware General Corporation Law.
The California courts have also recently come to the same conclusion, although
indirectly. In May 2012, the Second District Court of Appeal in California
mentioned, in dicta, that matters of internal governance should be governed by
the laws of the corporation's state of incorporation.
However, Section 2115 still governs as written. It is a matter of the local
legislature to repeal or amend the long-arm statute. Recently, proposals have
been made and considered to repeal Section 2115, but they have not been successful.
So, what are startups to do in the meantime? Businesses that are based in
California or that would qualify as quasi-foreign corporations pursuant to
Section 2115 may be better off choosing to incorporate in California (since
Section 2115 would still subject them to the California Corporations Code), and
then re-incorporate in Delaware when they are ready to go public. Remember:
Section 2115 only applies to private companies, not those with stock listed on
a national stock exchange or quoted on Nasdaq.
This article is not a legal advice, and was written for general
informational purposes only.
Read more commentary from Arina Shulga on the
legal aspects of operating new and growing businesses at Business Law Post.
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