Most Entrepreneurs Should Incorporate Locally

One of the most hotly debated topics in the start-up community is whether the founders of a new business should incorporate in Delaware or locally.  For entrepreneurs located in the Puget Sound Region that would, of course, be right here in Washington State.  I used the term “incorporate”, because angel investors are generally not interested in pass-through entities for tax purposes.  Choice of entity, another hotly debated issue, is a topic for another day.

The arguments for incorporating in Delaware revolve around the advantages of the depth and predictability of Delaware corporate law and the fact that investors expect to get those advantages.  In my experience, the substantive legal advantages are both narrow and esoteric and often don’t apply to start-up corporations.  Public companies and their executives have good reason to choose Delaware corporate law, but few of these reasons apply to angel investors. Rather, the discussion with angels tends to focus on valuation, with the investors saying “if you had only incorporated in Delaware, we might be able to justify the pre-money valuation on your term sheet.”

While this argument may score negotiating points, it is a straw man that lacks any real substance.  In an effort to refute the argument or, perhaps, out of concern that a mistake has in fact been made, the founders turn to their attorney for a response.

First, let’s look at the situation practically.  Angels tend to invest locally so that they can meet with the founders of the start-up face to face. Therefore, choosing Delaware law will not help a Puget Sound start-up attract investors from other communities. Yes, many lawyers are familiar with Delaware law besides their local law, but an East Coast or even a Bay Area based angel isn’t usually interested in investing in a Seattle start-up.

Second, assuming that your founder’s agreement, the shareholders’ agreement and the investor subscription agreements require disputes to be heard in Seattle, do you really want to be using another state’s law in a Washington court or a Washington arbitration proceeding?  Washington lawyers and arbitrators are most comfortable and familiar with applying Washington law. The choice of Washington law will be both cost-effective and predictable.  Even worse, if dispute resolution is not restricted to Washington, do you want to be flying to Delaware and hiring Delaware counsel to defend against a lawsuit brought by one of your investors in the Delaware Court of Chancery?

One argument I have heard mentioned is that by incorporating in Delaware or Nevada you can avoid Washington’s Business and Occupation Tax.  The reality is that if you do business in Washington, you will owe B&O Tax.  That has nothing to do with where you incorporate.  Sure, if you incorporate in Delaware, it will take the Washington Department of Revenue a while to catch up with you, but the moment you pay salaries in the Puget Sound Area, DOR has all the nexus it needs to establish taxing authority.

To summarize: (1) the reasons for incorporating in Delaware don’t apply to most start-ups, (2) you can’t escape Washington’s B&O Tax by incorporating in another jurisdiction, (3) the investors who might not want you to incorporate in Washington won’t invest in your company in the first place, and (4) legal risks and costs are much easier to control if you incorporate at home.

I invite your comments to this blog post and look forward to posting another missive in the near future.

John A. Myer is a corporate and securities lawyer with Myer Law PLLC in Seattle, Washington.   This posting does not constitute legal advice.