Post Category → Austin

Why incorporating your Texas startup is cheaper in Delaware (than in Texas).

Background:  When incorporating your Texas-based startup, one of the first questions you’ll have to ask yourself is: Should I incorporate in Texas or in Delaware? While it’s well-known that a startup intending to raise professional venture capital should eventually be a Delaware corporation, conventional wisdom is that it’s cheaper (by maybe $1-2K) to incorporate in Texas because of a few fees that Delaware entities have to pay for being “foreign” entities.  You’ll end up paying more later on to convert into a Delaware corporation in connection with a financing, but if your startup never reaches that stage, you’ve saved some $ on fees – or so the thought goes.

While it’s true that you will pay fewer state fees by incorporating in Texas, this argument fails to account for the differences in legal fees associated with a Delaware v. a Texas corporation.

  • Typical legal fees for a basic startup formation (incorporating, issuing stock with vesting, IP assignment by founders) will run around $2,500-3,500 if you rely on a competent, but efficient startup lawyer.  Many firms charge twice that or more.
  • As I’ve written before, quality automated startup formations can be done for ~$500.
  • But an automated (Clerky) formation is available only for Delaware corporations, not Texas.
  • Therefore, for an automated formation, you can save ~$2K+ on legal fees by going with Delaware, more than making up for the state fees.

Yes, I’m a lawyer, and I’m telling you that you should prefer paying fees to a state government over paying them to a lawyer: because the state is at least delivering something you can’t get elsewhere for less money.

This, of course, assumes you go with an automated formation, which may not be appropriate if you have some unique circumstances that can’t fit into standard formation terms.  But it’s important to keep in mind that post-formation legal documentation for Delaware corporations (option plans, seed round, random startup transactions) also tends to be far more standardized than it is for Texas corps, simply because of the volume of Delaware startups that are formed. So being a Delaware corp. will also save legal fees down the road because less drafting will be required.

Nutshell: Conventional wisdom is that incorporating your Texas startup in Texas (instead of Delaware), will save you some money.  But when you account for the legal fees that it takes to properly form your startup, Delaware will almost always come out cheaper (if you do an automated formation).  Even for a non-automated formation, the legal fee savings likely make it a wash.

When do I “really” need to qualify my Delaware-formed startup in Texas?

So you’ve formed your Texas-based startup in Delaware.  You’ve paid your filing fees, filed your 83(b)s, and, if applicable, paid your lawyer. What’s left? Qualifying as a “foreign” entity to do business in Texas. Think of it as Texas’ way to punish you, via a $750 fee, for not incorporating in the mother land. It’s also the mechanism by which Texas can begin to bill you annually for state franchise taxes.

Link to Qualification Form

Do I really need to pay this?

While the gut reaction of most lawyers is to just make you pay the fee at formation, $750 is a pretty sizable amount of money relative to a formation’s total cost. So the inevitable question is, can I hold off on paying it? Maybe. Registration must occur within 90 days of “transacting business” in Texas under the Texas Business Organizations Code. But what exactly is “transacting business?”

Under TBOC 9.251, these are some activities (the list is non-exclusive) that do not constitute “transacting business,” and hence don’t require registration (shortened for relevance):

  • Holding a meeting of officers or shareholders re: internal affairs of the Company;
  • Maintaining a bank account;
  • Effecting sales through an independent contractor;
  • Transacting business in interstate commerce;
  • Conducting an isolated transaction that’s (i) complete within 30 days, and (ii) not part of a longer series of transactions;
  • Owning real or personal property.

A general rule of thumb is that it’s time to qualify when you have employees in Texas, apart from founders.

What happens if I don’t pay?

Failing to register in Texas at the right time leads to the following:

  • Inability to maintain an action/suit in Texas court;
  • Possible injunction from the state of Texas;
  • Civil penalty equal to fees and state taxes that would’ve been imposed if you’d registered at right time;
  • Late filing fees equal to (i) number of whole and partial calendar years unregistered, multiplied by (ii) $750.

Summary

A. Issuing shares, having a bank account, performing internal corporate activities, selling through independent contractors, and doing one-off short transactions do not require you to qualify in Texas. Doesn’t this sound like a lot of pre-seed startups with one or two founders (no full-time paid employees) coding away on their MVP?

B. If you ever need to maintain/defend a suit in Texas courts, or if for some crazy reason the State of Texas decides to file an injunction, you can just register at that time, and

C. If it turns out you register too late, the penalty is $750 for each year you were unregistered, and any taxes you would’ve had to pay anyway.

I’m not going to make any recommendations here, but I think a lot of founders might read between the lines and choose to delay that $750 check to the State of Texas until either (i) funding is on the horizon, (ii) they’re actually doing deals instead of just building a product, or (iii) it’s otherwise more clear that they’re “transacting business” in Texas.

The Deflation of Startup Law Continues: Clerky

Almost exactly a year go, I wrote a post (The Economic Deflation of Startup Law) in which I (i) documented how the rapid adoption of technology and standardized contract language in early-stage startup law was dramatically deflating the cost of quality (crappy law has always been affordable) very early stage legal services available for founders, and (ii) made a few predictions about how this might affect the segment of the legal market that serves early-stage tech entrepreneurs.

Background

  • Contractual Changes – Standardization of contract language within law firms  & the emergence of universally standardized documents like the NVCA model docs, Series AA, and Techstars Docs, to name a few.
  • Technological Changes – Proofing software, Document Automation, Electronic Closing, etc. – reducing the amount of lawyer time required to complete a formation, bridge financing, etc.
  • Operational Changes – Technology and standardization simplify the labor input required to complete a transaction, allowing less trained, less expensive professionals to perform more of the back-end work.
  • Deal Platforms – Technology is moving from being merely a tool within the traditional law firm process to a bilateral platform that allows parties on both sides of a transaction to close, from beginning to end, with significantly less lawyer time required.
  • Freemium Startup Law – Very early-stage legal work (formations, bridge/seed financings, routine forms), once the bread-and-butter of solo lawyers and boutiques serving entrepreneurs, will no longer support those practices, no matter how efficient they try to be.  The margins will be too thin.  Those attorneys able to serve higher-quality, later-stage clients (those that make it to Series B, C, exit) where legal work will remain much more high-touch, high-margin will dominate the market and cross-subsidize their work for premium early-stage clients.  In short, Startup Law will move closer to a freemium model, where standard work is significantly cheaper, and being able to attract “premium” clients is essential for profitability.

The point of this post is not to comment on the accuracy of my predictions. One year is too short a time-frame to judge (we’ll see in 3-4 more years), though I will say that in Austin’s legal market I’ve seen a definite trend of solo and almost-solo lawyers attempting to expand their practices into multi-specialty firms, suggesting their desire (or need) to move up-market. Nationwide, I’ve also encountered a few small firms with much higher-caliber partners/associates, broad networks of specialists, and low-overhead platforms to compete head-on with BigLaw: this is where things will get very interesting.

Deflation 2.0 – Clerky

Instead, I’d like to talk about how the above developments have manifested themselves in the form of a Y-Combinator startup called Clerky. Details:

  • Founders are UPenn and Harvard (represent!) JDs of Orrick pedigree, and the head partner of Orrick’s Emerging Companies Group is an advisor; lest you question the quality of the drafting.
  • Appears to have handled formations for several Y-Combinator classes (note: classes – hundreds of companies) over the past several years; lest you think they haven’t been vetted and won’t get traction.
  • For formations, founders fill out online questionnaires very similar to those used by startup-focused law firms, and documents are automatically populated with the appropriate names, numbers, vesting schedules, etc.
  • There is a “reviewer” option where the founders can designate a person (an attorney) to review the final documents pre-execution to give a thumbs-up.
  • Execution is handled electronically on the platform.
  • Delaware filings and registered agent registrations are handled by Clerky.
  • Final executed documents are stored online.
  • Currently Available: Simple Incorporation (no equity, IP docs, etc.) – $99. Full formation (equity docs with vesting, IP assignment, bylaws, etc. – option plans and indemnification agreements coming soon) – $398.
  • Coming Soon (In Private Beta): Employee Offer Letters, Consulting Agreements, Advisor Agreements, NDAs, Convertible Notes., LLC to C-Corp Conversion

So what exactly has Clerky done? Once they get option plans and indemnification agreements up and running, they will have taken what would cost $5K-10K in legal fees at an inefficient law firm (or $2.5K-$5K at a more efficient one) and reduced it to $398 by going one step past building tools for lawyers to developing a platform that effectively replaces them – or at least ~95% of the work they do for early-stage clients. LegalZoom prices, but for premium, startup-focused documents.

What about free options?

Major law firms have attempted to address the large portion of the founder population for which even $2.5K-$5K is too high a formation price tag by offering documents online for free. I even wrote this post offering my own checklist for forming your own startup and issuing equity, lawyer-free, via publicly available documents.  But $398 is close enough to free that founders in this same category will be willing to pay for peace-of-mind, knowing that their docs are filled-out and filed properly, and that a reputable service is helping them maintain them. Plus it’ll save them hours of having to read the forms themselves.

Curmudgeon Criticism 1: Founders will want more customization than Clerky Offers

Yes, there will always be a segment of the founder population that wants high-touch, more flexible lawyering from the very beginning and will pay for it.  But the reality is that for the large portion of the pre-funding founder population that just wants to “get the job done” and focus on their product, Clerky, with its 80-90% discount on even the most efficient startup lawyers, will be a viable option. I don’t see Clerky taking up 90% of all startup formations, but it absolutely will be chosen by the most cash-strapped portion of the founder population for which a barebones formation makes sense.  Instead of relying on bottom-of-the-barrel lawyers peddling cheap prices, those founders will get a solid legal foundation.

Also, I think it’s well understood by many that there is a period of time during the very early stages of a company, before third-parties or circumstantial nuances have creeped in, and before the company has a larger budget, where serious automation is considered a very viable path, notwithstanding the inflexibility it introduces. Long-term, complexity and diversity of legal needs tend to grow exponentially, and automation becomes far less viable; but that doesn’t necessarily harm the value proposition of something like Clerky. They are a way to “fill the gap” between when many startups can only afford the bare minimum legal services, but need some security that it will be done properly, until their needs, and ability to pay for those needs, allows them to step off of the assembly line.

Curmudgeon Criticism 2:  Good lawyers will never accept a third-party service’s drafting language for their own clients.

After an inevitable phase of whining, kicking, and screaming, smart lawyers will accept whatever good clients and the market dictate, or they’ll just leave the space.  As stated above, there will always be clients who are willing to pay a premium for ensuring that all of their lawyering is 100% airtight.  And you can certainly expect a chorus of lawyers poking through the Clerky docs with a laundry list of ways their own documents are better. But like many disruptive innovations, it’s about the ratio of quality to cost, not absolute quality. At $398 for documents based on those used by one of the country’s leading tech firms and delivered by a YC company run by Ivy-League JDs, the value for the most price-sensitive founders is unquestionable.

Clerky will allow founders to engage quality, scalable lawyers earlier on.

Clerky’s “reviewer” option and its clear intent to incorporate lawyers in their processes shows that the goal here is not to completely replace lawyers, which would clearly be silly and reckless. The nuances of individual circumstances, the need for sound professional judgment that can’t be reduced to an algorithm, and the general realities of running a company will always require good, human legal counsel.

What a service like Clerky does is allow founders with very low legal budgets to stop having to settle for low-quality, mismatched lawyers who end up costing a whole lot more money (in mistakes) than founders expect. As I wrote in a previous post, a lot of founders know they need a lawyer, but can’t afford a good one, so they take the “staging” approach of going cheap up-front with plans to “upgrade” later. The consequences of this approach can be very expensive, and often disastrous.  Founders need lawyers that can serve them at all stages of development, not just when they’re tiny and the stakes seem low.

With Clerky, the “cost” of hiring a good lawyer at the very early stages of a startup can be the time it takes to quickly review some Clerky docs and answer any questions a founder might have about non-standard matters. For quality startup lawyers who stop pretending that all document drafting, no matter how routine, needs to occur in private silos, this is liberating. They can focus their practices on more complex matters that are far more profitable and interesting from a professional standpoint, while still maintaining relationships with early-stage clients who might one day require their skills. It also means the need for deferring fees will be dramatically reduced.

For lawyers who’ve built their practices on charging clients thousands of dollars for basically filling in forms and doing some cutting-and-pasting, the future looks increasingly grim. For those of us who love working with entrepreneurs and tech companies, but find cookie-cutter legal work utterly boring and a waste of our intellect, life is getting a whole lot better.