Delaware, or Incorporate in Arizona, Texas or California?

A founder in Scottsdale, Austin or San Francisco is about to form a company and hopes to raise outside money within a year or two. Someone has said "just do Delaware," and someone else has said a home-state company is simpler. Both comments leave out what the choice actually changes.

This post is for founders choosing where to form a corporation before a priced round or a first SAFE. It explains what forming in Delaware does and does not change for a company that operates in Arizona, California or Texas, and the questions to settle before filing. It is general information, not a recommendation for any company, and it does not address tax. If you have not yet decided between an LLC and a corporation, start with our post on choosing between an LLC and a corporation.

The short answer

Forming in Delaware generally makes Delaware corporate law the starting point for the company’s internal affairs, such as directors’ duties and stockholder rights, subject to issues such as California’s section 2115 discussed below. It does not move the business. A Delaware corporation whose activities in Arizona, California or Texas require foreign qualification or registration must also complete that state’s process, adding another state’s requirements to its Delaware obligations. Many institutional investors are used to Delaware documents, which is a practical reason founders choose it. Whether that reason outweighs the added filings depends on your plans, your investors and where your people are.

What "incorporating in Delaware" means

Delaware's General Corporation Law lets anyone form a Delaware corporation "without regard to such person's or entity's residence, domicile or state of incorporation."¹ Founders do not need to live in Delaware or maintain an operating office there, but the corporation must maintain a Delaware registered office at its registered agent’s address.¹

The practical effect comes from the rule that the law of the state of formation governs a company's internal affairs. Texas puts this rule in its statute: the law of the jurisdiction where a foreign entity's certificate of formation was filed "governs the formation and internal affairs of the entity," and internal affairs include the rights, powers and duties of its governing persons, officers and owners, and matters relating to ownership interests.² So a Delaware corporation operating in Texas still looks to Delaware law for questions such as how directors approve a financing or what stockholders may vote on.

Internal affairs are not everything. Incorporating in Delaware does not, by itself, displace employment, contract, consumer-protection or licensing rules that otherwise apply to the business; the applicable rules depend on the issue, the relevant jurisdictions and, where permitted, contractual choice-of-law provisions. Our post on running a business across Arizona, California and Texas covers those operating rules.

Registering in your home state

A Delaware corporation that runs its business from Arizona, California or Texas generally has to register there as well:

• California. A foreign corporation "shall not transact intrastate business without having first obtained from the Secretary of State a certificate of qualification."³
• Arizona. A foreign corporation "shall not transact business in this state until it is granted authority to transact business in this state" by the Arizona Corporation Commission. The statute lists activities that do not, by themselves, count as transacting business, such as holding board or shareholder meetings, maintaining bank accounts, and transacting business in interstate commerce, and it says the list is not exhaustive.⁴ Arizona has a parallel registration rule for foreign LLCs.⁵
• Texas. A foreign corporation, foreign LLC or other listed foreign entity, or one that affords limited liability to its owners, "must register" to transact business in Texas and must maintain that registration while transacting business there.⁶

Failing to register carries consequences. In Texas, for example, an unregistered foreign filing entity may not maintain a lawsuit in a Texas court on a claim arising from business transacted in Texas until it registers, although the failure does not affect the validity of its contracts or prevent it from defending a lawsuit.⁶ Our post on registering an out-of-state business in Arizona, California and Texas walks through the registration step.

Both the state of formation and the home state can impose filing fees, annual reports and taxes. This post does not compare those amounts or address tax treatment. Tax questions go to the firm's of-counsel tax attorney.

California can reach some Delaware corporations

California's statute reaches some foreign corporations' internal affairs. Under California Corporations Code section 2115, a foreign corporation can become subject to specified California corporate-law provisions instead of the law of its incorporation state if, subject to the statute’s exceptions and calculation rules, two tests are met: the average of its California property, payroll and sales factors exceeds 50 percent during its latest full income year, and more than half of its outstanding voting securities are held of record by persons with California addresses appearing on the corporation’s books at the statutory measurement date.⁷

The provisions listed include, among others, annual election of directors, removal of directors, the directors' standard of care, limits on distributions, cumulative voting, dissenters' rights and inspection rights.⁷ The section does not apply to a corporation with outstanding securities listed on one of the exchanges it names, or if all of its voting shares, other than directors’ qualifying shares, are owned directly or indirectly by one or more corporations not subject to the section.⁷

A founder-held startup based in California may meet both tests, but its location and the number of California stockholders are not enough by themselves; the statutory business-factor calculation, voting-security holdings, exceptions and timing rules must be checked.⁷ The statute remains on California’s books, but its application to foreign corporations’ internal affairs has produced conflicting judicial approaches. In VantagePoint v. Examen, the Delaware Supreme Court held that Delaware law, rather than California law invoked through section 2115, governed a Delaware corporation’s merger-voting rights.¹¹ That decision is a reason to obtain advice on both the statutory requirements and the governing-law issue, not to assume that section 2115 either always applies or can always be disregarded. That does not mean Delaware is the wrong choice, but it does mean the "Delaware law governs" assumption can be incomplete, and the cap table and payroll footprint matter.

Where disputes are heard

Delaware's Court of Chancery has jurisdiction "to hear and determine all matters and causes in equity."⁸ Delaware also permits a corporation’s certificate of incorporation or bylaws to require that some or all internal corporate claims be brought exclusively in Delaware courts, subject to applicable jurisdictional requirements. These claims include certain duty-based claims against current or former directors, officers or stockholders and claims for which Delaware’s corporate statute confers jurisdiction on the Court of Chancery.⁹ A forum-selection provision does not itself give a court jurisdiction over a claim.

Texas has created a Business Court with jurisdiction concurrent with district courts over specified business disputes. For the derivative, governance, internal-affairs and Business Organizations Code actions listed in section 25A.004(b), the amount in controversy generally must exceed a monetary threshold set in the statute, calculated under the statute’s inclusion and exclusion rules. That monetary requirement does not apply to those listed actions if a party is a publicly traded company. The statute also contains other jurisdictional requirements and exclusions, so the court is not automatically available for every startup governance dispute.¹⁰

Why investors often ask for Delaware

Delaware is a common default in venture-backed startup formation, and standardized financing documents are widely used in venture transactions.¹²¹³ Those practice norms do not establish that Delaware will make a particular financing faster or less expensive. An investor may have its own formation-state requirements, so confirm those requirements before filing or planning a round.

If you expect to raise on standard documents, ask your likely investors early. Our post on SAFEs and convertible notes covers the instruments themselves, and our post on founder vesting covers terms investors commonly ask founders to accept at the same time.

Questions to settle before you file

1. Do you plan to raise from institutional investors, and have any of them said whether they expect a Delaware corporation?
2. Where will the company's employees, contractors and property be in the first two years, and which home states will require foreign registration?
3. If you are in California, are you likely to meet both of the section 2115 tests, and does that change how you weigh Delaware?
4. Who will handle annual reports and filings in two states, and has the firm's of-counsel tax attorney reviewed the tax side of each choice?
5. Do you want the charter or bylaws to name a forum for internal disputes, and which forum?
6. Will the founders sign a founders' agreement and IP assignments at formation, whatever state you choose?

What this post does not cover

This post does not recommend a state for any company, compare filing fees or taxes, or analyze any tax consequence. It does not cover recent amendments to Texas corporate law, LLCs in detail, reincorporating an existing corporation, or securities law questions in a financing. If you already operate as an LLC and investors want a corporation, converting is a separate step; our post on choosing between an LLC and a corporation covers the comparison, and our posts on LLCs versus partnerships and how an LLC protects personal assets cover the LLC side. For the documents a new company needs on day one, see the contracts every startup needs and when a startup should hire a lawyer.

How we can help

Accord & Shield Legal handles entity formation, foreign registration and founder documents for companies in Arizona, California and Texas. To better understand the scope of your matter, you can schedule an initial consultation. The consultation is evaluation-only; no legal advice is provided. Representation begins only after an engagement agreement is signed and any required retainer is received. Please do not send confidential or sensitive documents before we confirm that we can assist.

This article is general information, not legal advice. Reading it does not create an attorney-client relationship. Which state of formation fits a company depends on its facts, investors and tax position; consult an attorney about your situation.