Entity Formation Series :: Part 4 - Where to Form your Entity: Texas vs. Delaware

If you are going to form an entity, the only two potential states that should generally be considered when deciding where to form are your home state and Delaware. An exception to this rule would be if your business is in a specific industry for which a certain state has incredibly-friendly state regulations (for example, a lot of films have been shot in Louisiana over the last five to ten years as a result of Louisiana legislation that created large tax incentives for the film industry).

Outside of industry-specific situations like this, no states other than your home state and Delaware really should be considered. Nevada is often mentioned as a potential third option, but – if you decide to form an entity outside of your home state – the benefits of forming in Delaware seem to greatly outweigh those of forming in Nevada (unless you want to open a casino), so Nevada should generally not be considered as a state of formation for those who reside outside of that state.

While this post assumes Texas is your home state (since that is where this law firm is headquartered), this initial question of “home state vs. Delaware” should generally apply regardless of what state you call home. Although the analysis should remain the same, the relative benefits and disadvantage of forming in your home state are likely to vary widely depending on the state where you reside, so please keep this in mind if your home state is not Texas.

Many of the reasons that your home state should be considered as one of the two best options are probably pretty obvious: it is where your business and its assets, employees, contractors, offices, etc. are physically located and where you will be operating the business. However, when compared to other non-Delaware states, Texas - in particular -  also has some benefits independent of it simply being the state where the business operates. While forming in your home state (and that home state being Texas) comes with numerous benefits, Delaware should also be considered - especially if you are forming a C Corporation - for reasons addressed below. This is true even if your business has no connection to Delaware.

When it comes to determining whether to form your entity in Texas or Delaware, I like to use the following two-step analysis: (1) first, you must consider, from a general perspective, the relative benefits and disadvantages of forming an entity in one of these states as compared to the other; and, then (2) you must assign certain weights to the benefits and disadvantages of operating in each state based on how your business actually operates in practice. I will first go over some the general benefits and disadvantages of forming in each of these respective states, and then will address how much weight should be given to the benefits and disadvantages of forming in each state based on your business’ actual operations.

I. Benefits and Disadvantages of Form in Texas Versus Delaware

Delaware is and has been the long-standing favorite state of formation for entities (especially corporations), regardless of where the business’ principal operation center may be located. If you are unfamiliar with the history of legal entities in the U.S., it may seem odd that Delaware, of all states, is the go-to place for formation, but that is the reputation it has acquired and maintained for some time.

You will hear many different reasons why Delaware is the best place to form your business. I am going to list some of the reasons often given in support of formation in Delaware, and then I will provide some additional information that rebuts certain aspects of these commonly-listed benefits of forming in Delaware.

Some of the most common reasons given for Delaware being the best state for formation include:

1. The Delaware Courts of Chancery. Delaware has the Courts of Chancery (the “DCC”). These are specialized courts that have jurisdiction over and handle many issues involving corporate/business law. The DCC has no jury trials, which companies generally prefer to avoid. Rather, it is the judges of the DCC that decide the cases, and the DCC is known for having judges who are especially knowledgeable about entity-law issues (especially corporate law). The judges are appointed according to a merit system, which allows for the avoidance of political implications and, seemingly, favors experienced judges advancing over inexperienced ones. As Delaware has long been the favorite place to form entities, it is highly likely that more business-law issues and cases have been heard by DCC than any other court system in the country. Because of this, the DCC has very well established precedent on a wide-ranging set of legal issues and is less likely to face a question of law that has not arisen before. Therefore, the DCC provides for less uncertainty than other courts. Unlike Delaware, Texas does not have a special court for business law issues, so any lawsuits in Texas would be heard in standard, civil courts that lack any of the special benefits of the DCC listed above.

2. The Delaware Legislature. Delaware’s legislature is also known to be especially business friendly and receptive to business-friendly corporate law;

3. Business-Friendly Laws. Delaware is known for having better laws for corporations than most states (this derives from essentially combining numbers one and two above. The legislature creates business-friendly legislation, which is interpreted in a business-friendly manner by the DCC, and the DCC creates business-friendly common law).

Tort cases will generally be heard in the jurisdiction where the tort occurred, and the law of that jurisdiction will apply (and the DCC would not likely hear an ordinary tort case even if it occurred in Delaware). The jurisdiction and applicable laws that apply to a contract case are usually governed by the specific terms of that contract. So, when it comes to a state having particularly business-friendly laws, they will not likely apply to most torts and may be applicable to any given contract, but it is likely the terms of the contract, rather than the state of formation of the entity, that will determine where the case is heard and what law will apply.

Under what is called the “Internal Affairs Doctrine,” laws of the state of formation are applicable when there is an internal dispute between participants of the same company (in comparison to when there are disputes between the company and outside third parties). When it comes to disputes that arise internally within a company (each state usually has its own laws for which types of disputes are considered internal, such as lawsuits filed by shareholders against a director for a breach of fiduciary duty) this is where the laws of the state of formation (and how business friendly those laws may be) become greatly important.

a. It should be noted that the Internal Affairs Doctrine is only a default rule that can be amended, to some certain extent, depending on the jurisdiction. Under a recently passed Delaware statutory amendment, which clarifies similar precedent previously of the DCC and earlier versions of statutes containing similar language that were passed by the Delaware legislature, companies are allowed to include a choice-of-law provision (also known as a forum selection provision) in the company’s Certificate of Incorporation or in the company’s Bylaws that name Delaware as the exclusive jurisdiction for resolving “internal corporate claims” of corporations formed in Delaware.

b. This same recent amendment to Delaware law also prohibited a provision in the Certificate of Incorporation or the Bylaws that grant a non-Delaware jurisdiction exclusive jurisdiction to resolve internal corporate claims of a corporation formed in Delaware. Therefore, under Delaware law, a corporation is allowed to modify the Internal Affairs Doctrine by providing for one or more jurisdictions under which internal disputes of the corporation will be resolved, as long as Delaware is included in the jurisdictions under which the dispute may be resolved (naming Delaware and other jurisdictions is okay; Delaware just cannot be excluded). This amendment, which includes allowing for unilateral amendment of the bylaws by the board of directors without shareholder approval, can become hugely relevant when a corporation is already public or is involved in a merger or acquisition, but it is not nearly as impactful for corporations just starting out because startups are likely to get everyone to agree to an exclusive jurisdiction when there are only a few shareholders. However, even for small corporations, this law allows the corporation to ensure that courts in Delaware will hear any cases revolving around internal disputes, which is a good thing considering the business-friendly nature of the DCC and Delaware law.

4. Delaware Business-Law Attorneys. Delaware is known to have a large group of attorneys that are particularly skilled in business law (especially corporate law) when compared to other state Bars around the country;

5. The “Delaware Effect.” There is a theory called the “Delaware Effect” that hypothesizes, if all other factors of a business are equal, corporations based in Delaware are actually valued about three to five percent higher than corporations based in other states; and,

6. Habit and Inertia. Delaware has been the favorite place to form entities for so long. This reason, alone, is part of why everyone involved in the corporate world is comfortable with forming there, why the DCC has such with well-established legal precedent, and why Delaware has such a good community of excellent attorneys. This is also why many clients automatically feel that Delaware is the place that their entity needs to be formed without conducting any analysis of whether that would truly be the case or not.

While some of the above points are valid and most of them are true, there are also some flaws in the logic behind some of these reasons. Point by point, I will rebut some of these reasons for forming in Delaware below.

1. In regards to the Delaware Court of the Chancery: all of the things said above about the DCC are true. But, keep in mind that just because a corporation is formed in Delaware does not mean that all of its legal proceedings will be heard by the DCC or even heard in Delaware (or be governed by Delaware’s corporate law) at all. Some examples of how this could occur are: (1) while a corporation can make sure that all of its contracts list Delaware as the agreed to jurisdiction and venue, torts arising in any other state would likely be able to be brought in that other state; and (2) contract disputes with outside parties that arise in interstate deals could end up in federal courts rather than the Delaware Court of Chancery (even if the federal court is applying Delaware law);

a. Additionally, while having a judge who is highly knowledgeable in corporate law seems like a good thing from the perspective of an idealist, if you are a large corporation, would you necessarily want a “good judge” that moves proceedings along quickly and efficiently? Generally, a large corporation is going to have more money and resources than the plaintiff in a lawsuit. Proceedings that take longer do not matter as much to a large corporation because they have more money to spend on high-powered attorneys without needing to worry about costs as much as an individual plaintiff or smaller company. Longer, less precise proceedings may actually result in making it easier for corporations to settle, which may be what they are ideally looking to do when lawsuits arise. So, even if the DCC hears a case and applies Delaware law, this may not always be a good thing for a large corporation from a realism perspective. This is more speculative of a thought based on my own opinions, but I believe it to be a relevant and practical point in regards to the efficiency of the DCC.

b. Finally, so many corporate contracts call for arbitration that the arbitration provisions in a contract may be more relevant than a corporation’s state of incorporation.

2. In regards to Delaware’s legislature known as being especially business friendly: This is also true about Delaware. However, Texas’s legislature is also very friendly to business. In some instances, such as the extent of personal liability protection provided for limited partners in a limited partnership, the Texas legislature passed laws before the Delaware legislature did that provided more personal liability protection for Texas limited partners than Delaware limited partners. By now, Delaware has passed related legislation that provides for at least the same amount of personal liability protection for limited partners, but this is just one example of Texas being ahead of Delaware in regards to business law. From a logical standpoint, all states likely want to be business friendly. More business means more money for the state through taxes and generally result in a state being more prosperous.

3. In regards to Delaware being known for having more corporate-friendly laws: Nowadays, so many states have adopted uniform laws that very similar, if not identical, for numerous areas of law, including corporate and business laws, so the variation in law between states may not be as great as it was in the past;

a. In addition to Texas also having a business-friendly legislature, Texas courts also are pretty friendly to business. For instance, Texas courts have repetitively emphasized their strong belief in the freedom of parties to contract without interference from the courts (in most situations), which is one of the aspects of Delaware law that is often touted as being a hallmark of a business-friendly state.

b. In regards to the Internal Affairs Doctrine, Texas law does not allow companies the ability to alter the basic principles of the Internal Affairs Doctrine as much as Delaware does. Generally, under Texas law, except for certain qualifying transactions involving at least $1 million dollars, the laws of the state of formation will govern internal disputes of a company and the Internal Affairs Doctrine will generally apply in regards to internal disputes. However, as stated in section describing benefits of forming in Delaware, this is something that becomes more important when a company begins receiving large investments and/or begins having a large number of different owners. For a company just starting out, the way that Texas and Delaware handle internal corporate disputes are not going to matter as much.

4. In regards to Delaware having a great group of attorneys licensed in that state to handle corporate law issues: Once again, this may be true, but, as stated in rebuttal number one, there is no guarantee that just because a corporation is formed in Delaware, Delaware law will apply and that this group of attorneys will be able to be utilized in a given case. Additionally, I have no doubt that Texas has plenty of great corporate-law attorneys while also likely having expert attorneys in other areas, such as experts in litigating any personal injury suits that a business may face, for which Delaware is not likely to have as strong of a group of attorneys.

5. In regards to the “Delaware Effect”: It is possible that this was true at one point, but it is likely that it is now much more negligible than it may have been in the 90’s, if it even continues to exist at all.[1]

6. In regards to simple habit and inertia: This is likely the most accurate reason why Delaware continues to be a favorite place to incorporate amongst corporations. The reasons Delaware has all these other advantages that make it a good place to incorporate have arisen as a result of Delaware being such a popular incorporation destination for so long. As more and more companies form in other states (especially with the rise of the LLC, which is the type of entity that founders seem more likely to automatically form in their home state rather than in Delaware), other states, especially large, business-friendly states that are continuing to develop more and more case law and business-friendly legislation on an ongoing basis (i.e. a state, for instance, like Texas) are likely to begin catching up a bit to the past and current network effects experienced by Delaware.

In addition to all of this information, there are reasons, independent from the rebuttals listed above, that forming in Texas may be more beneficial for a Texas-based business than forming in Delaware, even if forming a corporation. These reasons all focus on the simplicity and costs associated with forming and operating a company in your home state versus in a foreign state.

For example, if you form an entity in Delaware but are operating the business in Texas, then you are likely required to register the business as a foreign company conducting business in Texas. The filing fee, alone, for this registration $750.00. This would also subject the company to the Texas Franchise Tax and require the corporation to make Texas-specific filings on an annual basis – in addition to any Delaware-specific taxes and filing requirements that would automatically be required because the business incorporated in Delaware.

The business would also need to have a registered agent/office in both Delaware and Texas and also likely need to hire accountants and/or attorneys to handle the tax requirements and filings referenced above.

Additionally, if a lawsuit does arise, and it is to be conducted in Delaware, then this can be greatly inconvenient, from a practical perspective, if you are truly operating only out of Texas and your only connection to Delaware is the fact that you incorporated the business there.

II. The Relative Weight that Should be Given to the Benefits and Advantages of Forming your Entity in Texas vs. Delaware.

Now that the relative benefits and disadvantages of each individual state have been covered, I will address the relative weight that should be given to whatever the outcome of your comparison of these two states’ laws resulted in.

Any benefits that may exist for forming in Delaware over Texas and vice versa need to be assigned different weights when making your decision based on the operations of the business. The key question in regards to this analysis is whether the business will only be operating in Texas, or if the business will be operating in multiple jurisdictions? If the business will only be operating in Texas, then any benefits that may be derived from forming in Delaware should be given less weight and any benefits derived from forming in Texas should be given more weight. Any negatives aspects of forming in either state should be weighed in an opposite fashion. This is because of the additional filing requirements and regulations that must be met when you form an entity outside of your home state.

If a business is operating in multiple jurisdictions, then the benefits of forming in Delaware should become more attractive and be given more weight, while the benefits of forming in Texas should be given less weight. This is because of the fact that if your business is conducting multi-jurisdictional operations, then it is going to have to make multiple state filings, comply with multiple state regulations, etc., regardless of where it initially forms. Therefore, it should form in the state with the most favorable business law, which is likely still Delaware.

Now, this does not mean that just because you are going to be operating in two states that you should automatically form in Delaware whereas if you were only forming in Texas you should have formed in Texas, although this could be the case. Rather, each company should view itself on a sliding scale and recognize that there will be a tipping point at which it operates in enough jurisdictions that it should likely choose to form in Delaware over Texas.

For some companies (such as those that are going to form as corporations and have a market-disrupting business model), Delaware may be the best place to form an entity even if they will only be operating in Texas. However, another business may be best served by forming in Texas even if they will be operating in several states.

Generally, the more states in which the business is going to operate, the more likely it will be that the business should be formed in Delaware. On the other hand, business should start with the premise that their home state of Texas should be the best place to form and not form elsewhere without being able to identify specific benefits of forming in Delaware or elsewhere that outweigh the costs of multi-jurisdiction operations that arise simply by forming the entity in another state.

Footnotes

 

 

[1] See http://www.law.harvard.edu/programs/corp_gov/papers/Subramanian_Paper.pdf