Delaware Incorporation

Purposes of Incorporation

Incorporating a business creates a new legal entity that shields the owners from business liabilities and debts. Incidentally, the corporate form also protects the company from the owner’s liabilities and debts. Incorporation also allows for easy transferability of ownership, the ability to establish credit and raise capital, and flexibility with the number of business owners. When a company is incorporated, the company also survives the lives of the company owners, unlike with a sole proprietorship and sometimes a partnership. Each of these benefits creates the need for entrepreneurs to decide whether and where to incorporate their businesses.

Articles of Incorporation

Articles of incorporation are what business owners file with a state government to create a corporation. Depending on the state, these articles are also known as corporate charters, articles of association, or certificates of incorporation. This article discusses why companies most commonly file their articles of incorporation in Delaware.

Delaware & IPOs

Interestingly, about 75% of all new initial public offerings in the U.S. are done by companies incorporated in Delaware, yet very few of these companies are actually headquartered in Delaware. Delaware has consistently been the most popular place of incorporation among the states in the United States as evidenced by the 68% of Fortune 500 companies currently incorporated in Delaware. For reference, the accompanying chart shows the total number of incorporations in Delaware in 2020.

Despite Delaware being only 1,955 square miles—and the second smallest state in the United States—it has more registered corporations than any other state. So, what makes Delaware so attractive to business owners?

Delaware’s statutes, specialized courts, and familiarity among attorneys are just some of the reasons for why businesses incorporate in Delaware. A common misconception about Delaware is that the state gives deference to management over shareholders, but this is untrue. Delaware laws are favorable for both businesses and investors alike, as described in the remainder of this article.

Statutes

First, the General Assembly in Delaware is highly responsive, which results in a finely tuned statutory framework. The state works with attorneys to update statutes often and create new ones that offer continual favorability to businesses. This, in part, is why Delaware has maintained its advantageous position as the preferred place of incorporation for many years.

Delaware’s General Corporation Law is known as one of the most sophisticated corporation statutes in the United States. This, along with other statutes, such as those governing alternative entities, allows for more flexibility in the corporate structure and the organization of its board members. For example, shareholders, directors, and officers can be residents of states other than Delaware. Additionally, Delaware allows for one person to serve as both the director, shareholder, and officer of a corporation while other states may require a minimum of three people to hold those positions. Delaware’s statutes are designed to foster efficiencies and preferences to business owners compared to other states’ statutes.

Another benefit to Delaware’s statutes includes the fact that corporations do not need to disclose officer or director names on the formation documents. This allows businesses to have some privacy and protection as the new business entity is formed. 

Another statute in Delaware, the Limited Liability Company Act, is one of the most business-friendly legal environments in the United States. This statute protects the interests of the business owners and incentivizes more entrepreneurs to start businesses as well.

Other states, including Wyoming and Nevada, are popular places of incorporation. Surprisingly, Wyoming was actually the first state in the United States to permit individuals to form corporations and limited liability companies. Wyoming and Nevada (among other states) both are also attractive because of their lack of state corporate taxes.

Court of Chancery

Second, the Court of Chancery is a unique court in Delaware that hears issues relating to corporate law, commercial litigation, and other contracting disputes. One thing that makes this court unique is that it uses judges instead of juries. Essentially, the business involved in litigation will have a judge with a breadth of corporate law experience who will hear the disputes rather than the case being evaluated by a jury of citizens who may know nothing about business entities or structures. The Court of Chancery also has its appeals sent directly to the Supreme Court of Delaware. So, instead of having to go through a trial, appellate court, and then the Supreme Court, the Court of Chancery appeals are immediately sent to the Delaware Supreme Court.  

Familiarity & Efficiency

Third, the majority of corporate attorneys are familiar with Delaware corporation law. In law school and in practice (due to the sheer number of companies incorporated in Delaware), attorneys often learn the laws governing Delaware. This may reduce the costs of litigation due to the familiarity of the laws that corporate attorneys already know.

The familiarity of Delaware law allows for attorneys on both sides of a dispute to have equal ground with respect to knowledge of the relevant corporate law. Oftentimes, Delaware is seen as a neutral site where companies can resolve disputes without fear of partial biases.

Because Delaware receives significant revenues from business incorporations, it is well staffed and fast at what it does. Both the Secretary of State and courts are expert and efficient in their tasks; some cases can progress from complaint to the Supreme Court in only a few months. In other states, this rapid handling of cases is impossible.

Investors Preferences

Fourth, investors and venture capital firms tend to favor incorporation in Delaware because of the costs and efficiencies. Large investment banks also tend to prefer incorporations in Delaware. Although it is possible to convert an LLC or corporation from another state to become a Delaware incorporated entity, the process is simpler to start out in Delaware rather than change to Delaware later. It is more difficult to convert to Delaware, rather than incorporating in Delaware in the first place, because the business must consult tax professionals or attorneys to determine whether any taxes or fees are owed in the current state of incorporation. Additionally, the business would need to sever its ties with the current state and perform the necessary steps with Delaware. This is another reason why VC, investment banks, and other investors prefer the original incorporation to be in Delaware.

Case Law

Fifth, the United States uses a common law system. Through judicial opinions and case precedents, case law is determinative in establishing the current law. Given Delaware’s long history of case law, companies are better able to conform to Delaware state law than in other states. This suggests that the sheer number of business litigations that have resulted in Delaware can give businesses a good idea of what the outcome would be under similar circumstances. In a state with relatively less extensive case law history, it becomes harder for businesses to project what may occur in any given lawsuit. Thus, the body of existing case law is important for giving confidence and predictability to businesses incorporated in Delaware.  

IPO and Incorporation

The place of incorporation significantly impacts IPOs given the legal implications of differing state incorporation laws. Another reason most companies incorporate in Delaware is because of its allowable stock structures. Many attorneys agree that investors care more about the ability to share in profits with the company than the business model itself. Delaware is arguably the best state to offer the most versatile profit-sharing structures. Delaware offers blank check preferred stock, super-voting powers, stock warrants, stock options, and more to investors.

Under Delaware law, corporations may negotiate ownership with their investors. For example, the corporation may choose to issue preferred shares with a fixed dividend to guarantee the investors some kind of return. Additionally, the corporation may be unwilling to give up its voting rights, in which case the preferred stock will not have voting power. If, for example, the corporation needs the money immediately and believes the payoff will be substantial, the corporation may allow for the preferred shares to be convertible to common stock after an IPO. These sorts of negotiations are only allowed because of the laws governing Delaware, which are favorable to businesses. Without these kinds of provisions (especially the ones about protecting voting shares), the controlling owners could very easily lose their own voting power when the corporation gets funding prior to the IPO.

Long before seeking the initial public offering, corporations should be well versed in how they can best structure the stocks they issue. Even if an IPO is not in the immediate future, the ability to use Delaware’s favorable laws to create specialized stock structures early on will allow for a smoother IPO later and reduce fears of a corporate takeover.

Cons to Delaware Incorporation

First, as a small business doing business outside of Delaware, it may not be worth it to be incorporated in Delaware because of the costs. For example, for each state outside of Delaware where the company does business, it must pay “foreign qualification costs,” which allow it to do business in a state where it is not incorporated.

Second, a Delaware-incorporated company must have a registered agent located in Delaware to accept legal filings on behalf of the business. This could involve additional costs for the business.

Third, in addition to slightly higher filing fees in Delaware, Delaware does have more franchise taxes relative to other states. This franchise tax is based on a corporation’s share value and brings substantial revenue to the state. Consulting with a tax professional will prove important when weighing the costs of incorporating in Delaware compared to another state.

Fourth, if you do business outside of Delaware, the business will need to meet both states’ filing and licensing requirements. Just because the business is incorporated in Delaware does not mean all the other states in which they do business can simply be ignored for reporting and filing purposes.

Depending on the companies’ goals and projections, incorporating in Delaware may or may not be the right option for every company given these downsides.

The Public Benefit Corporation

In recent years, the world has seen a small shift to public benefit corporations (PBCs) in Delaware. A public benefit corporation is a different entity type that puts more emphasis on all stakeholders to the corporation rather than exclusively focusing on the shareholders. At the time of this article, there are only 15 public PBCs as well as thousands of privately owned PBCs.

These PBCs have an increased focus on Environmental, Social, and Corporate Governance (ESG) issues. Until 2013, Delaware law required the formal corporate focus to be that of promoting stockholder value. Boards of corporations were required to act in the best interests of the shareholders. However, since 2013, Delaware has allowed for PBCs, which alter this shareholder value maximation focus. “The ultimate end of a PBC is not the promotion of stockholder value, but rather advancing and balancing 1) stockholder value, 2) the best interests of those materially affected by the corporation's conduct, which captures a potentially wide universe of stakeholders, such as employees, customers, suppliers, and local communities, and 3) a public benefit purpose selected by the corporation” (Harvard).

As investors continue to shift their attention to ESG related issues in business, Delaware is at the forefront of providing flexibility to these entity types in PBCs.

Conclusion

The decision to incorporate is not one to be treated lightly. Clearly there are a lot of benefits to incorporating a business in Delaware. However, the cons could also outweigh the benefits for smaller companies. For companies with goals to go public, starting as an incorporated company in Delaware is a great first step along the path from private to public. Because of its long case history, the expertise of its Court of Chancery, and the widespread familiarity of its corporation law, Delaware will continue to be the leader in flexibility for corporations across the United States.

Resources Consulted

• https://whyy.org/articles/why-do-so-many-corporations-choose-to-incorporate-in-delaware/
• https://www.legalzoom.com/articles/incorporating-in-delaware-advantages-and-disadvantages
• https://www.legalzoom.com/articles/how-to-form-a-delaware-corporation
• https://corpfiles.delaware.gov/pdfs/whycorporations_english.pdf
• https://www.entrepreneur.com/article/287677
• https://www.delawareinc.com/general-corporation/ipo/#:~:text=There%20are%20several%20good%20reasons,may%20be%20the%20biggest%20one.&text=Most%20IPO%20experts%20agree%20that,functional%20toolbox%20of%20stock%20structures.
• https://www.wsgr.com/en/insights/converting-to-a-delaware-public-benefit-corporation-lessons-from-experience.html
• https://corpgov.law.harvard.edu/2022/02/18/converting-to-a-delaware-public-benefit-corporation-lessons-from-experience/