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Does the state of incorporation matter?

07 Nov Does the state of incorporation matter?

The state in which a corporation is organized is an important consideration, but what really matters most are the impacts of the particular state corporate law that is going to govern the corporation. This is essential because state corporate statutes specify important default rules – default rules that will apply in governing the affairs of the corporation unless the organizational documents specify otherwise.

These default rules vary from state to state. In many situations, a particular default rule will be perfectly consistent with the business owner’s objectives and there will be no need to call attention to the rule in the organizational documents and trigger the possibility of other owners raising an objection. In such a situation, say nothing in the documents and letting the default rule automatically kick in may be the best course of action.

In other situations, a particular default rule will be inconsistent with an owner’s core objectives and then the organizational documents will need to be drawn to negate the effect of that default rule. The starting point of course is to choose the state of incorporation. A key to this decision is the old traditional doctrine known as the internal affairs doctrine. It is alive and well in nearly all states including Delaware. Simply state, this doctrine provides that the laws of the state of incorporation will govern any matter related to the internal affairs of the corporation.

Internal affairs generally include matters involving the relationship between the corporation and its officers, directors, and shareholders. Common examples of internal affairs subject to this doctrine include voting rights, the rights and liabilities of directors and officers, shareholder rights, shareholder distributions, indemnifications of officers and directors, mergers, and derivative litigation, litigation brought by shareholders on behalf of the corporation.

The internal affairs doctrine does not apply to matters unrelated to internal corporate relationships or procedures. Things such as taxes, antitrust, employment matters, environmental issues, securities laws, intellectual property matters, consumer protection, and most tort and contract claims are outside the scope of the internal affairs doctrine.

Two big states, California and New York, have statutes that apply their corporate law to resolve specific internal affairs of a corporation organized in another state, a pseudo-foreign corporation that conducts most of its activities in California or New York as the case may be and has most of its outstanding stock owned by residents of that state. These pseudo-foreign corporation statutes will likely govern the outcome of any litigation in California or New York courts. But it’s very unlikely that they will have any impact in a dispute that breaks out in another state.

In a significant 2005 decision, the Delaware Supreme Court refused to apply California’s pseudo-foreign corporation statute to a corporation that was organized in Delaware but had its closest ties to California. The court rule that Delaware’s well-established choice of law rules and the commerce clause of the federal constitution mandated the application of Delaware law under the internal affairs doctrine to resolve the dispute.

When it comes to sizing up estates, hands down Delaware is the darling of the corporate world. In the corporate charter game, Delaware is the reigning king and there is no reason to think that any other state will ever threaten its crown. For the organizers of most closely held corporations, the threshold question is should we incorporate in our home state or Delaware? A number of factors may impact the answer to this basic question. The starting point is to focus on the reasons why Delaware is the king. And then evaluate whether those reasons have any relevance in the specific situation.

Delaware’s dominance, in large part, is attributable to its judiciaries, demonstrated competence to resolve corporate matters in an efficient and fair manner. Many of its judges are accomplished corporate lawyers who have a massive body of established corporate law to work with and a deep appreciation of the importance of Delaware’s corporate supremacy. Corporate managers and lawyers generally love the predictability offered by Delaware’s well-established case law and its favorable statutory provisions relating to compensation, self-dealing contracts, indemnifications, and that sort of thing.

Decades of doing deals with Delaware corporations have caused many money players and investment bankers to grow comfortable with Delaware’s corporate mindset. Everyone understands and appreciates the importance of corporate franchise fees in Delaware, and Delaware’s strong incentive to remain corporate-friendly on cutting edge issues.

Plus, unpopular changes to its corporate statutes are very unlikely. Delaware’s constitution requires a 2/3 vote of both legislative houses to change Delaware’s corporate code. The importance of these Delaware factors in any given situation will depend in large part on the nature of the company’s projected operations and ownership structure. If the company is going to do business in many states, it will be required to register as a foreign corporation in all those states and likely will end up dealing with important third parties in multiple states. In such a case, the company may prefer to organize in Delaware to bolster its national or regional image and to remove any local law taint or any questions relating to local law.

Similarly, a company that has any hope of going public or that is or may become dependent on capital from established brokerage or venture firms generally would be well advised to incorporate in Delaware from the get-go. The decision makers who run such firms and their lawyers will be saved the task of asking “Why not Delaware?” and then taking necessary corrective actions.

In contrast, a closely held corporation that is going to be owned and controlled by a select group of local shareholders often has no need to look beyond its local corporate law. The potential benefits of Delaware’s deep body of case law and the trappings of being a Delaware player may not be worth the added hassle and expense of incorporating in Delaware. In this very common situation, any specific oddities of the home state’s corporate statutes may need to be factored into the mix. Often when all factors are considered by such a closely held corporation, the ultimate conclusion is to stay local and to ensure that the organization’s documents are drawn to accomplish the key objectives of the owners consistent with the state’s corporate statutes.

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Nate Nead
Nate Nead is a licensed investment banker and Principal at Deal Capital Partners, LLC which includes InvestmentBank.com and Crowdfund.co. Nate works works with middle-market corporate clients looking to acquire, sell, divest or raise growth capital from qualified buyers and institutional investors. He is the chief evangelist of the company's growing digital investment banking platform. Reliance Worldwide Investments, LLC a member of FINRA and SIPC and registered with the SEC and MSRB. Nate resides in Seattle, Washington.
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