Where to Incorporate? Delaware or Washington

One of the first decisions founders typically need to make is where to incorporate their new company. It is an important question. It affects investor perceptions and the ease with which you are going to be able to conduct your business.

For startups headquartered in Washington, there are really only two choices: You can incorporate in Delaware or Washington. You might wonder which is better, or which to choose. I've laid out the best reasons to incorporate in either state below.

The best reasons to choose Delaware are:

  • No one will ever ask, "Why didn't you incorporate in Delaware."
  • A lot of the standard form documents that are available on the web and are widely accepted in startup circles (see, e.g., the Series Seed documents), are prepared for Delaware corporations.
  • If you happen upon an investor not familiar with Washington corporations, you won't be forced to reincorporate in Delaware.
  • If you move your company south, to Silicon Valley, being a Delaware company will make more sense than being a Washington corporation.
  • There are certain provisions of Delaware law that are more favorable to company management than Washington corporate law.
  • Delaware has a separate court system dedicated to corporate disputes.
  • Delaware corporate law is updated more often than Washington corporate law.
  • Again, if you move your company to another state, it will probably be easier to find a Delaware corporate lawyer in that state than a Washington corporate lawyer.

The best reasons to choose Washington are:

  • It is less expensive to form and maintain a Washington corporation (about $600 a year to start, and the costs of Delaware go up over time relative to the costs of being incorporated in Washington).
  • Washington corporate law is substantially similar to Delaware law, and in the event of any litigation Washington courts would likely look to Delaware court opinions as persuasive authority.
  • If you run into a complex question of corporate law and you are incorporated in Delaware, you may have to retain a law firm in Delaware to assist you. This will probably wind up being more expensive than continuing to work with your Washington corporate lawyer.
  • Microsoft is a Washington corporation, and it never held it back.

On balance, if you don't want to have to answer the question--Why didn't you incorporate in Delaware?--and you don't mind spending a little extra money, Delaware is the way to go. If you are frugal, and you don't mind answering the question, Washington is fine.

The Benefits of Convertible Equity

You might not yet have heard of convertible equity. It is somewhat new.

What is it?

It is a form of equity in a company similar to a convertible note, but:

  • It is expressly not debt (and won't appear on the company's balance sheet as debt);
  • It doesn't bear interest; 
  • It doesn't have a maturity date.

It is like a convertible note in that:

  • It converts into equity later; e.g. upon the occurrence of a subsequent financing; and
  • It can have a valuation cap and a conversion discount, just like convertible debt.

Why is convertible equity interesting? Because founders frequently think of convertible debt holders as equity investors. But convertible debt holders can have it both ways. They can be equity holders when the company consummates a qualified financing. But when the company doesn't reach that milestone they can remain debt holders and potentially demand repayment of their debt. 

There are a number of different example convertible equity instruments online:

Choice of Law in your Terms of Service

I am going to follow Joe's lead here and share a question that I got from a client this week.  The client's question was about their Terms of Service.  More specifically, whether the governing law specified should be their local jurisdiction or the state in which their company was incorporated. In this case, my client was incorporated in Delaware, but the founders and the business itself was based in Washington State.   

Interestingly, companies don't have to incorporate in the state where they are headquartered.  Delaware, for instance, is an extremely popular option for companies all over the country.  In the case of Delaware, there are some advantages that can make it work incorporating outside of your home state.  

  • Delaware has very management/company favorable laws related to corporate governance.  
  • They also have courts that have heard lots of disputes related to corporate issues, which means they have a rich body of case law to draw on.
  • A Delaware corporation is also a known quantity to investors outside of the state of Washington.

The founder in this case was wondering whether we should specify Delaware governing law, since their company was incorporated in Delaware and their corporation is governed by Delaware law with respect to corporate issues. 

Here, the answer was no.  Washington governing law and venue was the better choice.  The benefits that make Delaware an attractive state for incorporation don't really apply in the typical contract scenario, and the inconvenience of defending or bringing a claim in Delaware makes the decision even easier.  In the case of a Terms of Service, Washington law was a great fit.  We have plenty of case law in the state related to the enforcement of contracts, and Washington has a huge software industry, which makes it a great place to deal with software/Internet related issues.  The biggest benefit, however, is the convenience of being able to defend or bring a lawsuit close to home.  Hopefully my client's Terms of Service won't ever be the subject to a dispute, but if they ever need to enforce their terms against someone, it would be an unnecessary burden for the trial to take place outside of Washington.  Particularly if company personnel need to attend depositions or appear in court.  

Obviously, circumstances differ, and in some cases it make sense to choose governing law outside of your home state (for instance, if the law in your home state is particularly unfavorable).  But generally speaking, it is better to keep disputes close to home.  

Section 83(b) Elections

I received a panicked call from a founder the other day. The call went like this. (Disclaimer: I didn't incorporate this company; they were a new client to me.)

Founder: We didn't file 83(b) elections. Are we in trouble?

Me: Were your founder shares subject to vesting?

Founder: What do you mean by vesting?

Me: Were the shares subject to a repurchase right in favor of the company at the lesser of the purchase price for the shares or fair market value, which repurchase right lapsed over a service based vesting period?

Founder: No. The company doesn't have any rights to repurchase our shares.

Me: Well, if there is no vesting then no 83(b) election is due, but you should send me your corporate documents so that I can confirm.

Postscript: I've run into this a lot. A vague sense of unease about the failure to file something. And horrible consequences that might follow.

Not filing an 83(b) election within 30 days of receiving shares subject to vesting is a horrible mistake. What happens then is when the shares vest the service provider has income equal to the difference between the then FMV of the shares and what they paid for them. If the value of the company's stock has gone up the taxes can be significant. More than the service provider can pay. And if the service provider is an employee the company is supposed to withhold income and employment taxes. This is why in due diligence investors typically want a representation and warranty that all 83(b) elections have been timely filed. 

The 30 day deadline is short. Make sure not to miss it if you are required to file an 83(b) election. I also recommend you file the election certified mail, return receipt requested, and send a copy and self addressed stamped envelope and ask the IRS to confirm receipt and return the confirm copy to you.

I've written an example letter you can send to the IRS with your 83(b) election and posted it on Scribd. You can find it here: http://www.scribd.com/doc/59825408/EXAMPLE-83-b-Letter-to-IRS-Individual#scribd  

LLC as S Corp or C Corp?

Sometimes people get too enthralled with LLCs. Sometimes the flexibility seems really exciting and appealing.

To give you an example of the flexibility:

Did you know, for example, that you can form an LLC and make an S election? That's a great thing isn't it? Isn't that easier than forming a corporation under state law and going through the hassle of additional corporate documentation?

Simplicity Can Turn Out a To Be More Complex

There is a belief, especially amongst CPAs it seems, that state law corporations are substantially more difficult from a paperwork perspective than LLCs. This is generally not true. In fact, except for single member LLCs, corporate documents are easier to put together than LLC documents.

Here is the trouble: you form an LLC because you want to keep things simple. If you are going to be the sole owner for as long as you can imagine, you have probably made the right call. Single member LLCs are easier than one shareholder corporations. 

But if you want to grant stock options to employees, or if you think you might want to seek angel capital a few months from now, don't start out as a state law LLC.

First, a few things about LLCs

LLCs are state law entities. But for federal income tax purposes they can be any number of things:

  • They can be a "disregarded entity," meaning they are considered to be a sole proprietorship if owned by one individual, or a division of a corporation if wholly owned by that corporation. 
  • They can be a partnership of owned by several people.  
  • They can be a C corporation, if the LLC checked the box to be taxed as a corporation.  
  • They can be an S corporation, if they checked the box to be taxed as a C corporation and elected to be an S corporation.  

You might like all this flexibility. True, in some cases it is nice. But if you are an early stage company that wants to raise angel or venture capital, grant stock options, and follow the traditional growth company route, just say no to LLCs.  

When Are LLCs A Good Idea?

LLCs are a good idea in the following situations:

  • You will have a set group of owners from the start, and you don't plan to regularly grant the equivalent of stock options to new hires or raise angel or venture capital. 
  • You are forming the entity to build a business that will be a cash cow for its owners.
  • You are forming the entity to invest in real estate or venture capital style investments.
  • It will be wholly owned by you.

State Law Corporations Are Great

Forming a state law corporation is not that much more difficult than forming an LLC. And the benefits of starting in the corporate form, even if you want to be an S corp initially, are substantial. They are:

  • You can easily convert an S corp to a C corp before or incident to an angel financing. Converting an LLC to a corporation before or incident to an angel financing typically requires more work.
  • State law corporations that are taxed as S corps can grant stock options. It is very difficult to grant the equivalent of stock options in LLCs, especially LLCs that have checked the box to be taxed as S or C corporations.

But perhaps the biggest reason I am not a fan of forming an LLC and then checking the box to be an S or a C corporation is the unfamiliarity of that form of doing business. especially if you potentially want to raise angel capital. Doing business through a form that is unique or unusual means spending more time and money on legal matters, not less. Typically entrepreneurs want to minimize legal expense. And certainly investors do not want to confront an unusual legal structure that is difficult or hard to understand.

Follow The Typical Path

My advice: follow the typical path, if you want to grant stock options and potentially raise angel or venture capital. Don't do business through a unique or unusual legal structure. It is more pain than it is worth.

Forming a Washington Corporation

If you are forming a Washington corporation, here are the steps you are going to want to take:

  1. First, prepare Articles of Incorporation to file with the Washington Secretary of State. If your corporation is going to have multiple shareholders, or if you want to raise angel or venture capital or grant stock options, you will want to make sure your Articles of Incorporation contain certain specific provisions. These provisions may not be present in forms of Articles you find on the Internet. Thus, it is advisable you work with counsel to make sure your Articles are angel and venture capital ready.
  2. Once your Articles are ready for filing, file them with the Washington Secretary of State.
  3. When you get your Articles back from the Secretary of State, they will be stamped with your UBI number. You will want to use this number when you fill out your Master Business Application.
  4. Your initial directors will either be named in the Articles of Incorporation or, if they aren't, the incorporator will need to execute a consent naming the initial directors.
  5. The initial directors will then need to have an “Organizational Meeting” or execute an “Organizational Consent in Lieu of a Meeting." In this document the initial directors will adopt the Company's Bylaws, appoint its initial officers, and authorize the issuance of the initial shares.
  6. You will then need to obtain a taxpayer identification number from the IRS.
  7. If the corporation is eligible and intends to elect to be taxed as an S corporation, do not forget to file the S corporation election timely and have spouses sign it as well if required. If any of the initial shareholders live in community property states, then spousal consents will typically be required even if the shares are held in the name of the shareholder spouse only. An S corporation election without required spousal signatures is not valid.
  8. You will want to apply for your state and city business licenses.
  9. The initial shareholders will then subscribe for their shares, execute stock subscription agreements, and pay for their shares. The stock subscription agreements should contain appropriate vesting and buy back rights.
  10. The initial shareholders will want to make sure that they timely file their 83(b) elections, if required.
  11. You will want to make sure that all service providers to the company execute IP assignment agreements in which they assign IP arising out of services to the company to the company.
  12. You will need to open a bank account in the name of the company and deposit to it the checks written to it by the initial shareholders. At all times you will want to make sure that the corporation has a separate financial life than that of its directors or officers or shareholders.
  13. Do not forget to file the initial annual report that is returned with the file stamped Articles of Incorporation.

It is a good idea to work with counsel throughout this process.

Washington State Equity Crowdfunding

I was recently asked whether I was aware of any companies having completed a Washington State equity crowdfunding offering.

I do not believe any companies have yet gotten through the process with the Washington State Department of Financial Institutions and completed an offering. But I am aware of several companies that are working on completing the Crowdfunding Form to submit it to the DFI.

If you are not aware, before you can proceed with a Washington State equity crowdfunding offering you first have to complete and submit the Washington Crowdfunding form with the DFI. The DFI then has to approve your form before you can proceed. The form is designed for companies to be able to complete it without the help of an attorney, but you should work with an attorney throughout your offering. You also need to have financial statements prepared in accordance with GAAP. You may need to work with accountant to prepare GAAP compliant financial statements.

The DFI has written a nice summary of the equity crowdfunding law here: http://www.dfi.wa.gov/small-business/crowdfunding

I was also asked where you can find the Washington Crowdfunding Form, and the DFI regulations.

You can find the forms here:

Crowdfunding Forms

You can find the regulations here:  http://apps.leg.wa.gov/wac/default.aspx?cite=460-99C

 

 

New Site - New Firm

We are marking the start of 2015 with the launch of a new website/blog and are announcing that we are going to be working to build a startup and emerging companies practicing together starting February 1st at the Seattle law firm of Carney Badley.  For more about the Carney Firm, you can find information at www.carneylaw.com.  

We are looking forward to building something great at the Carney Firm.  A new option for startups and emerging tech companies for legal services.  We are bringing our experience in corporate securities, financing, technology transactions and intellectual property to handle business-side needs, and the Carney Firm has an amazing team of litigators to handle disputes and help our clients enforce contracts and IP rights.  

We will be blogging here from time to time, and are working on a podcast discussing startup and legal issues.  Stay tuned for more details.

In the mean time, if you are interested in hearing more about our new platform, please feel free to reach out to either of us directly.

Best regards,

Joe Wallin and Mike Schneider