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Should I form my Austin startup in Texas or Delaware?

Note: The DE-related info in this post is really applicable to startups based in any state, but I’m speaking mostly to Texas entrepreneurs, particularly in Austin, in writing this.  Because of the depth of startup activity in California, which might translate to more sophisticated case and statutory law, forming a non-DE startup there might make more sense than it would in Texas.

The default incorporation state in forming a company is always the state in which the company operates, but there are several reasons why a Texas startup (or any startup outside of California) might consider DE instead:

  • Well-Established, Business Friendly Statutory and Case Law – Because DE is the legal home of (by far) the largest number of large corporations in the country, you’ll find the least amount of ambiguity in DE as far as corporate governance practices, contractual interpretation, etc. are concerned.  And DE Chancery judges are by far the most knowledgeable in complex business matters of any judges in the country.  Virtually every corporate lawyer in the country who operates a serious practice will be familiar with DE law, so if you call him/her up with a random question about whether a certain transaction is kosher, or how a particular provision would be enforced in court, you’re 10x more likely to get a quick answer if you’re a DE corporation.  For a Texas entity, the answer will often be “I’m not sure,” which leads to “Let me research that for you,” and that research won’t be pro-bono.
  • Sophisticated Investors will expect Delaware – Because of the above, institutional venture capital firms that manage large funds will (very) often refuse to invest in a Texas startup that isn’t a Delaware corporation.  Angel investors are more likely to be OK with Texas, but we’ve encountered a fair amount of professional angels who either insist on DE before making their investments, or at least expect a conversion to a DE entity before the Company’s first venture capital equity round.
  • Protective of Officers and Directors – Delaware courts have a history of deferring to the business judgment of the officers and directors of a Company, meaning that without evidence of gross self-dealing or negligence, they’re unlikely to use hindsight to second-guess business decisions. This makes finding reputable executives and directors easier, for obvious reasons.
  • Response Time – Ever needed to close that bridge financing in the next 2 hours in order to make payroll? I’ve seen it plenty of times, but surely that would never be your company. Ever. Well, just in case, DE has an amazingly well-greased system for filing legal documents.  For extra fees, you can get guaranteed 24-hour, 2-hour, and even 1-hour response times. Suriname should really consult with the Delaware Secretary of State to up its game.
  • Converting Later is More Expensive – When you’re starting out fresh, there are no contracts to review, consents to get signed, etc. You just form the Company where you want to form it. But as time progresses, and you get shareholders, sign contracts, hire employees, etc., the amount of diligence involved in ensuring that you can convert to a DE entity grows exponentially. Pay now, or pay more later.

The Downsides to DE:

  • Fees (Cost): This is really the only reason why a Texas startup that intends to eventually raise professional venture capital will consider not incorporating in DE.  By forming a DE entity that operates in Texas, you’ll have to file a form to qualify to do business in Texas as a “foreign” (non-Texas) entity. This costs about $750. You’ll also need to maintain a “registered agent” in DE, which will run you about $125 a year. Finally, you’ll have to pay franchise taxes in both DE and TX, although the added cost until your startup becomes profitable is likely to only be a few hundred dollars a year.

So the decision to incorporate in TX or DE really boils down to two questions:

Do you ever intend to raise professional venture capital?

If not, then unless you just find Delaware’s sophisticated business-friendly environment really appealing, you’re probably well-served by sticking with a Texas/home state entity.  A lot, if not most, startups will fall into this category. Save your money and use it to build a great product.

If you do intend to raise professional venture capital, are you willing to incur the additional cost of forming a DE entity?

At formation, the up-front cost differential between a DE v. a Texas entity is likely to be about $1,000, with a few hundred extra a year for registered agent services and franchise taxes.  As time progresses, the cost of converting to DE will increase in terms of legal diligence and logistics as you execute contracts, pick up shareholders, etc. While numbers obviously vary, you can probably expect about $5K-10K in fees in converting your TX entity to DE pre-Series A.

Most of our clients bite the bullet and pay the extra ~$1K to form in DE from the beginning. That’s because (1) we don’t really serve startups that don’t intend to raise professional capital, because they don’t need us, and (2) it sends a signal from the beginning that the Company intends to operate in the big leagues. Still, a handful take the approach that 5-10x in fees is fine down the road if, at least at that point, they’ve found investors or a good revenue stream to help pay the costs.  I generally say that, if you’re really that worried about losing $1,000 in a startup that you seriously think will pursue venture capital, perhaps you should reconsider entrepreneurship altogether.  But it’s ultimately a personal judgment call.

When it’s time for your startup lawyer to shut up.

Hypothetical scenario at doctor’s office:

Me: Doc, I’m here for my annual kidney checkup. (note to reader: I donated a kidney)

Doc: Sure, Jose, I’ll take care of that for you. But while you’re here, let’s cover a few other things just to be thorough. How have you been feeling emotionally? Any signs of depression? And what about your sleep habits? Getting 8 hours a day? Your back looks a little arched. We should check for a spinal problem.

Me: I came here for a kidney checkup.

Doc: Your hair seems to be thinning out prematurely. That could be a sign of a hormone imbalance. Your skin also seems a bit pale. Are you getting enough sun? We’ll check you for a Vitamin D deficiency. And how about your sex life?

Me: Please shut up.

Overlawyered.

The billable hour is to startup law what fee-for-service is for most of healthcare. In some contexts it’s necessary, but it often creates incentives for overtreatment; or in the case of law, overlawyering.  There are lawyers who properly see early-stage transactional law through the eyes of their clients: a mechanism to get a deal done, while ensuring that the contract drafting, negotiation and diligence performed are appropriate for the context. And then there are lawyers who, notwithstanding the needs of their clients, try to achieve some kind of legal nirvana on everyone else’s time and dime.

You want to spend hours ruminating on arbitration provisions, or ensuring that the registration rights language in your docs is air tight? Awesome. Go work for Wachtell and get the hell out of early-stage work. This here’s startup law, son, and this deal needs to close.

Perfection v. Materiality

Now, this definitely doesn’t mean that closing the deal is all that matters, and that legal counsel’s role is purely mechanical.  Experienced entrepreneurs understand the transactional insurance mechanism that good lawyering provides.  The point here is that a high quality startup lawyer isn’t the one who drafts perfect contracts, understands every nuance of securities law, and can spot every minute issue while diligencing the deal.  The best startup lawyers build a deep understanding of what’s material to their clients and their business, and aren’t afraid to close the deal knowing that there may be issues in the docs that would make a law review editor cringe. Good enough? Close the deal. These people have a business to run.

An ounce of prevention.

Business Judgment and Experience Matter

This is also not an argument for going with the cheapest lawyer you can find. Remember, the hourly rate is only half the equation. If anything, I’ve found that boutiques (lower hourly rates) are more likely to run the clock in the name of (air quotes) “higher quality”, knowing they can get away with it and that it drives their BigLaw counterparts nuts. BigLaw attorneys (higher rates), without thought-out processes in place, are incentivized to do the opposite: cut corners and close the deal sometimes too quickly.  This is a topic for a later post.

It is, however, an argument for caring very strongly about the business judgment of your attorney, and steering clear of those whose sense of materiality seems wildly disconnected from your own.  You won’t always see eye-to-eye, and that’s a good thing.  Having been to the rodeo many times before, a good lawyer can see risks that you’d miss.  But if you’re paying attention, you’ll notice fairly quickly when mountains are being made of molehills.

A focus on early-stage work is also crucial.  A lawyer with a history of billion-dollar deals or public company work will likely waste everyone’s time far more than a true early-stage lawyer who understands what’s worth negotiating, what’s standard, and when it’s time to shut up and close the deal.

Set Deadlines

This should go without saying: always set an expected closing date.  It doesn’t need to be insanely aggressive, but if your lawyer isn’t capping her fees, at least cap her time. If it needs to be extended, that’s fine, but a sense of urgency can go a long way toward focusing everyone’s eyes on the material.

Read the redlines; Require explanations

Don’t just let your lawyers go through rounds of redlines without business guidance. After the first round or two, get on the phone and start asking questions about comments that are being made. How is this material? What is the likelihood that this is going to actually become a problem? If it becomes a problem, how much would it cost? Is the language clear enough to prevent litigation if there’s a misunderstanding? You’ll pick up very quickly on whether (a) real business needs are driving these comments, or (b) your attorney’s aesthetic sensibilities are.  If the latter, it’s time for him to shut up.

Startup Law is not for law review editors with OCD. It’s for closers. Anyone who thinks otherwise is likely overshooting the needs of early-stage entrepreneurs/investors, and wasting a lot of time and money in the process.

What’s my startup’s stock worth?

Stepping back a bit from current events and meta issues, let’s talk about something more mundane, but nevertheless frequently asked by startup founders. What’s my stock worth, and why should I care?

Categories: I’d say there are three different types of “worth” that could be discussed here:

(1) worth to you,

(2) worth to others (what they would pay), and

(3) fair market value (FMV).

From an economic perspective, (1) and (2) are the most important.  But from a legal perspective, (3) is the one you should care the most about. Think of FMV as something related to, but conceptually distinct from, what others think the stock is worth. And to be as absolutely straight-forward and jargon-free as possible as to why you should care about it, one word: taxes.

Why should I care?

A. Taxable Gain

First, virtually any time that someone gets stock with a fair market value above what they paid, that’s taxable gain. Naturally, whenever possible, you want to ensure that when you issue someone stock or options, they aren’t also being handed a tax bill with it. Unfortunately, the IRS doesn’t let you pay your taxes with options. Equity in your hand + cash out of your wallet = bad.

B. Regulatory Compliance

Second, with the understanding that promoting equity incentives can be valuable to companies and the economy as a whole, the IRS has provided some safe harbors (of sorts) through which you can issue options to employees while being able to defer taxes down the road, preferably around the time of a liquidity event (cash in your hand to pay that tax). Your attorney can discuss details with you in more detail, but the most important one for purposes of this discussion is: the exercise price of the option needs to be at fair market value.

C. Key Relationship between (1) and (3)

Notice the key relationship between (1) the value that you place on your stock and (3) fair market value. To the extent FMV is below what you and your employees view (subjectively) as the value of your startup’s stock, you’re able to give something that, at least to you and them, is worth more than what needs to be paid to avoid taxable gains. If FMV for tax purposes is $0.50 per share, but to me the stock is worth $2.00, I can pay $0.50 per share, get $1.50 worth of (subjective) gain, and not pay tax.

Nutshell: a low FMV relative to subjective value is a good thing.

So what’s the fair market value of my startup’s stock?

It depends.

Never Sell Common Stock in an Outside Financing

The number one determinant of FMV is always (2) in the above list: what people are willing to pay for it. If/when the IRS chooses to look back at the FMVs you applied to your stock, that will be the first thing they look for. This is precisely why any competent startup lawyer will tell you that, while Common Stock is good for founders and equity incentives for services, you should almost never sell Common Stock in a financing. This will likely “taint” the FMV of your Common Stock, and effectively force you to set a significantly higher FMV for your stock options than you otherwise would have to. For that reason, it’s almost always recommended to do a financing either through preferred stock or convertible notes that will eventually convert into preferred stock. Because preferred stock has various preferences/privileges that Common Stock does not, you can sell preferred stock for, say, $2.00 per share, while still making a credible claim that the Common Stock is worth a fraction of that.

At Formation

So how is it that founders and early employees are able to get millions of shares in their startups for practically nothing, without being taxed? Simple. At formation, the FMV of your startup’s stock is considered virtually nothing. Now, it’s certainly not worth nothing to you. But because you haven’t built an actual Company yet, the IRS accepts the argument that the huge amount of uncertainty and risk of failure make the stock worth fractions of a penny.

We generally issue founder stock at a price per share equivalent to par value (usually $0.0001 per share). So an issuance of 2,000,000 shares to a Founder would require a check for $200.00. Assuming that founder files her 83(b) election (bad news if she doesn’t), she won’t realize taxable gains until she decides to sell her stock.

Note that this is also an argument for getting your founder shares and early employee equity issued as soon as possible.  The further along in your Company’s trajectory that you are (customers, revenue, investors), the greater likelihood that your Common Stock will have a higher FMV, and that the recipient will need to hand over meaningful cash either to you or the IRS in order to receive it.

After Formation, Financing

After formation, and as you move into seed funding, setting the fair market value of your Company’s stock becomes much more complex. Section 409A of the Internal Revenue Code is largely what drives that complexity, which this post is not meant to cover. The nutshell is that before a full venture capital financing, your lawyer will recommend that your Board of Directors use various “illiquid startup” guidelines to set the FMV of your stock.  After a VC financing, you’ll likely get a formal 409A valuation from a bank or valuation firm, and use that to set the exercise prices of your options. There are a number of reputable valuation firms in Austin that we recommend to our startup clients, and, as with hiring a lawyer, you should be careful about going with the firm that offers the lowest price. That can come back to bite you.

Take-home message:

  • FMV is related to (but not the same as) your or a potential investor’s value of your stock.
  • Issue equity and equity incentives as early as possible to avoid taxable gains.
  • To avoid “tainting” the FMV of your Common Stock, never sell Common Stock in a cash financing.
  • Consult with your attorney about setting the FMV of your stock as your company progresses.

Obligatory Disclaimer: I know you’re smart enough to know this, but this is not tax or legal advice. Things might be different in your particular context. Contact a professional before making a decision you might regret.