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.

Why I left a big law firm, but not BigLaw.

While I’ve devoted the majority of this blog to providing free resources on startup law and finance to startup entrepreneurs, I occasionally take the time to write about the economics of law firms and why entrepreneurs would be wise to understand it at a high-level.  This post will start out with a historical summary of positions I’ve taken on the subject, with links to applicable posts, and then branch into my decision to move my own practice and clients to a new type of firm – not BigLaw, but not quite traditional BoutiqueLaw.

  • The Economic Deflation of Startup Law – Early stage startup law, much to the benefit of entrepreneurs and top-tier lawyers, has become increasingly automated and commoditized. The end result is a form of “freemium” law practice, where (i) entrepreneurs can obtain quality representation for very little money, and (ii) quality lawyers can, thanks to automation, engage entrepreneurs early on without having to discount fees, defer, or any of the other old-school ways of obscuring the cost of legal services. Low-quality or narrowly focused “cottage” lawyers will struggle because their bread-and-butter work will have little to no margin, while higher-tier lawyers will thrive on their pipeline of later-stage, funded clients, which cross-subsidize early-stage work.
  • In Startup Law, Big Can Be Beautiful – Breadth and scalability are absolutely essential to the proper representation of a startup, and large firms have historically been where to get that.
  • Integrated Startup Law – Specialists Matter – Technology startups do not need and should not want unscalable, narrow “small business” legal representation. By their nature, they will need a broad set of legal specialties – Tax, Labor, IP, Regulatory, etc. – along the course of their business cycle, and failing to choose a firm at the beginning that can efficiently coordinate all those specialists will become a big problem. The analogy to healthcare is important. Also see – The Cost of “Staging” Your Startup Lawyers.
  • The Ad-Hoc Law Firm – The ability of networks of small law firms to coordinate efficiently will allow for (i) the replication of BigLaw’s breadth and experience, without its overhead and inflexibility, and (ii) the scalability that boutique firms alone can’t provide.

Nutshell Summary: BigLaw offers experience and breadth, but is largely over-priced and inflexible. Boutiques are cheaper, but often narrow and incapable of truly scaling, and their work is being commoditized.

BigLaw Beginning

So in my own career, I started out at a big firm with a group of fantastic lawyers whom any startup would be well-served by, but I increasingly butted heads against the firm’s (separating the lawyers from the institution is important) policies, including (i) IT policies with respect to new technology that needed to be adopted, (ii) billing policies around how to charge startup clients, and (iii) personnel that simply didn’t want to do things differently and weren’t incentivized to care anyway.

Your Boutique Can’t Scale

I watched the market, and had some overtures from boutiques in the area, but every time I came away underwhelmed:

  • Lower Pay, Lower Lawyers – Often the boutiques had very low rates, but their lawyers made a lot less income.  True innovation is about doing more for less while earning more – it should be win-win economically on both the client and the lawyer’s end. That’s why the most disruptive startups aren’t in it to make less money, they’re in it to make more money, but on a model that makes the end-price lower by cutting out fat, not muscle. If your firm is built on paying lawyers less – guess what? You’re just going to attract lower-quality, less ambitious lawyers. Surprise, surprise. Anyone can lower their price tag.
  • Where are the partners? – A lot of BoutiqueLaw firms will advertise that their attorneys offer “partner-level” service.  The reality is that most boutiques are run by senior “associates” (never made partner) from large firms who started their own firms and donned the partner label.  Early-stage clients might not care about this because their interactions are usually with associates anyway, but a lack of true partner experience within a firm can mean (i) your late-stage company is effectively funding on-the-job training, and (ii) that training can lead to mistakes.  A scalable firm needs true partners with the credentials and experience to actually provide partner-level service, otherwise top clients will have to go elsewhere.
  • Where are the specialists? – No one had a good answer for how to efficiently provide full service legal representation to clients. Asking them to engage a dozen firms on a piece-meal basis and manage a dozen different bills is not the right answer.
  • Where’s the technology? – If you think a lot of law firms haven’t joined the 20th century with respect to technology, check out some boutique law firms.  A lower rate is often used as an excuse for being inefficient and taking longer to do something.  Smart clients realize that their legal bill is a two-part equation: rate * time spent.  And if their lawyer is taking forever to do basic stuff, the lower rate is a mirage.  Startup law is for technologists, not cottage industry practitioners.

So why did I move my practice to a smaller firm (Miller Egan)?  Addressing the above issues in order:

  • The compensation structure is designed to attract top talent lawyers, not people who are looking for semi-retirement.
  • The firm is built and run by partners who were partners at the country’s leading law firms, but got fed up with the bureaucracy and inflexibility.  This means the firm can truly provide the “partner-level” counseling that is traditionally found only in BigLaw and that large, late-stage clients will require.
  • The firm has a well-developed network and process for coordinating specialist counsel for clients when needed, so clients can get the full service representation they’d receive at a big firm, but under a far more efficient model.
  • Technology? I’m CTO. #Howyalikedemapples

The above post should be read as a clear message to both traditional BigLaw and traditional BoutiqueLaw. Big can be important, and boutique can be cheap, but small, flexible, and scalable may eventually eat your lunch.  And let me tell you, that lunch is delicious.

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.