Delaware

Delaware is often chosen for many reasons, including: 1) insistence of investors and underwriters; 2) established and efficient corporate law and court system; and 3) favorable protections for directors and officers. These are discussed in more detail below.

If you plan on raising money from venture capitalists, private equity groups, institutional investors, or other sophisticated investors you should definitely choose Delaware. Often times these investors will force you to convert into a Delaware company before they invest, so you might as well do it in the beginning and save the added time and money of having to convert at a later date when it might hold up a financing. Also, if you might someday take the company public, the underwriter will most likely force you to convert into a Delaware entity prior to the public offering. If either of these is a possibility for your company, choose Delaware and do it right the first time.

Investors and underwriters insist on Delaware because it has a very favorable corporate law system. It is the home of 60% of Fortune 500 companies and 50% of publicly traded companies for a reason. Delaware courts have extensive experience in corporate law due to specialty courts designed to only handle corporate law issues. This is turn leads to a highly developed body of corporate case law that provides corporations and their counsel with excellent guidance and more certainty on matters of internal governance and liability. In short, corporations and investors know exactly what they are getting into with a Delaware corporation, and this added certainty makes it easier to do business for everyone involved.

Also, officers and directors of Delaware corporations are afforded a great deal of protection when it comes to making business decisions. Absent fraud or self-dealing, the courts will generally protect the good-faith business judgment of the decision maker, which makes it less likely that they will be sued by shareholders who don’t agree with their decisions. And if they are sued, the corporation can compensate them for any losses incurred in the defense. This makes it easier for the lawyers to advise directors and officers on their fiduciary duties in a Delaware corporation.

There are two drawbacks to incorporating in Delaware: 1) you must register as a foreign entity to do business in your home state; and 2) you must pay Delaware franchise tax in addition to your home state corporate income tax and/or franchise tax. Registering as a foreign entity in your home state usually incurs additional legal and filing fees (in Texas you can expect an additional $1000 or so, $750 of which is filing fees). Delaware has no state corporate income tax, but they do have a franchise tax. During the first years of a company with limited assets and few shareholders, the franchise tax is usually negligible and can be calculated using the Franchise Tax Calculator provided by the state of Delaware.

Home State

If you do not plan on raising money from venture capitalists or private equity groups, don’t plan on taking the company public, want to avoid the added expense of foreign registration in your home state, and want to avoid paying Delaware franchise taxes, then you should probably incorporate in your home state unless a large portion of your revenue will be coming from off-shore activities.

Off-shore

There are generally two reasons for incorporating off-shore: 1) some foreign investors are prohibited from investing in U.S. companies; and 2) tax savings on income received from abroad. If you do significant amount of off-shore business you should consider incorporating off-shore to minimize paying U.S. corporate tax on off-shore income. This is an extremely complicated matter of law, beyond the scope of this article, and should not be undertaken without specialized tax and legal counsel.

1.) Equally: each founder get the same amount of equity. For example, with 2 founders each gets 50%, with 3 founders each gets 33.33%, with 4 founders each gets 25%, etc. This method is most often used by first-time entrepreneurs because it seems more “fair” and is easy to get everyone to agree on it at the outset.

2.) Unequally: each founder gets a different amount of equity/shares depending upon various factors such as:

      i. Past contributions: Who came up with the idea for the business? Who helped refine the idea? Who put money into the company to get it started? Who helped find another co-founder or investor?

      ii. Current contributions: Who is doing the most work right now? Are some founders more in an advisory role while others are the boots on the ground getting things done?

      iii. Future contributions: What role will each person play in the early months? Will that person still be playing a key role later down the road? Who will still be working for the company at all?

      iv. Opportunity cost: Is one founder giving up a great job, while the other is currently unemployed? Is one founder dropping out of a good school, while the other is unemployed?

      v. Your relationship: Do you trust your co-founder to make things right at a later date if you end up feeling like you contributed more than he did? Are you willing to fight over the equity and potentially sacrifice your relationship with the co-founders in order to get additional equity?

Common Problems with Founder Splits

One Founder Leaves Early

What happens when one of your founders decides to no longer participate in the startup and they leave after only a few months? Should they be entitled to the same amount of equity as the CEO who sticks around, working day and night, sacrificing friends and family, all to make the company a success? If you aren’t careful with how you divvy up founders shares this is exactly the situation you can find yourself mixed up in.

One Founder Works More Than Others

What happens when all founders receive the same amount of equity, but later realize that one or more of the founders is doing more work than the others? This often leads to resentment and burn-out, which in turn can cause a founder to leave early.

Solutions to Divvying up Founders Shares

In my experience, the best way to distribute founders shares is through unequal distribution with vesting. By getting all of the founders to sit down at the beginning to assess the relative value of their various past, present, and future contributions, often they come up with a more equitable (yet unequal) ownership split. If later on the founders all agree that things should have been distributed differently because their initial estimates were off, the situation can be remedied through the issuance of additional stock options to the deserving parties. These adjustment meetings can also be built into the founders shareholder agreement.

After the initial split is determined, the founders need to discuss the vesting plan. The typical vesting plan is setup so that a founder receives a certain amount of stock every month over a 4 year period. Depending on the circumstances, a few vesting plan options exist: (i) adding a “cliff”; or (ii) vesting a certain amount of stock up-front. A “cliff” is typically one year in length, and means that the founder doesn’t receive any shares until they have been with the company for that amount of time. Vesting a certain amount up-front is the opposite of a cliff, the founder receives a certain amount of shares right away, with the rest vesting over time. Between unequal distributions, adjustment meetings, stock options, and vesting, most problems that typically plague startups can be addressed at a time before the problems arise and when they are easiest address.

At the Copeland Law Firm, we love dealing with entrepreneurs and emerging growth companies, it is our passion. We have advised many entrepreneurs on the formation of new companies, capital structures, financing transactions, employment matters, intellectual property matters, as well as provided counseling on day-to-day legal issues that arise in startup companies. Our clients cover a wide range of industries including software, technology, energy, real estate, insurance, healthcare, manufacturing, construction, advertising & marketing, publishing, and retail.

We realize that not all startups are alike, therefore we offer a range of flat-fee packages and add-ons, so you only pay for what you need when you need it. We will help you figure out what is best for your individual company and we won’t sell you anything you don’t need.

Our most comprehensive startup package calls for the formation of a new Delaware corporation structured for a venture capital investment, registered to do business in the home state, and contains everything you see listed below. This comprehensive package is offered for an up-front fixed fee cost of $4,000 (plus out-of-pocket expenses, such as state filing fees in Delaware and the home state, if applicable). For an additional cost we can establish a payment plan or work out a deferred fee agreement.

Our startup organization package consists of the following documents and services:
• Incorporation and Organization
• Capitalization Matters
• Founders Stock
• Stock Option/Stock Issuance Plan
• Employment and Consulting Matters
• Intellectual Property Matters
• Consultations

Incorporation and Organization

• Reservation of corporate name, if necessary
• Preparation and filing of Delaware Certificate of Incorporation
• Preparation of Bylaws and Certificate of Secretary
• Preparation of Action By Incorporator

Preparation of Organizational Board Consent regarding the following matters:
• Ratify actions of Incorporator
• Approval of organization expenses
• Adoption of Bylaws
• Authorization of principal office, foreign qualification, fiscal year and Employer Identification Number
• Designation of the size of the board of directors and election of officers
• Designation of management powers
• Approval of issuance of Founder’s stock
• Approval of stock option grants to Founders, if applicable
• Approval of minutes books, corporate seal and stock certificates
• Approval of subchapter S election, if applicable
• Authorization to open bank accounts
• Approval of form of Proprietary Information and Inventions Agreement
• Approval of form of Indemnification Agreement for officers and directors
• Approval of Stock Option/Stock Issuance Plan and forms of Option Agreements

• Preparation and filing of Form SS-4 Application for Employer Identification Number (and state tax application for the home state where the business is located)
• Preparation and filing for registration as a foreign corporation in the home state where the company is located, if applicable
• Preparation of corporate records book

Preparation of Stockholder Consent regarding the following matters:
• Approval of form of Indemnification Agreement for officers and directors
• Approval of Stock Option/Stock Issuance Plan
• Preparation of form of Indemnification Agreement for officers and directors

Capitalization Matters

Entry of all initial capitalization data into capitalization tracking spreadsheet that allows you to:
• Track all stock and option issuances and cancellations
• Produce a wide variety of capitalization reports

Preparation and Issuance of Founder Stock

• Preparation of Founders’ Restricted Stock Purchase Agreements for up to four Founders (with standard vesting terms)
• Preparation of Stock Certificates and Receipts for up to four Founders
• Preparation of 83(b) Elections Memorandum for Founders
• Preparation and filing of state securities documents for stock issuances to Founders

Preparation of Employee Stock Option/Stock Issuance Plan

• Preparation of form of Early Exercise Stock Option Agreement
• Preparation of form of Standard Stock Option Agreement
• Preparation of form of Stock Issuance Agreement
• Preparation and filing of Form U-2 Uniform Consent to Service of Process (in connection with securities filings)

Employment and Consulting Matters

• Preparation of form of At-Will Employment Offer Letter
• Preparation of form of Proprietary Information and Inventions Agreement
• Preparation of form of Independent Contractor Services Agreement

Intellectual Property Matters

• Preparation of form of Unilateral Nondisclosure Agreement
• Preparation of form of Mutual Nondisclosure Agreement
• Preparation of Assignment of intellectual property from Founders to the company
• Preparation of Memorandum re Trademark Matters for a new company

Consultations

Up to five hours of consultation regarding all documents drafted as part of the package, typically broken down as follows:
• One hour regarding Venture Capital, Angel funding, and Private Placement
• One hour regarding Founders’ Shares and Vesting
• One hour regarding Stock Options
• One hour regarding Intellectual Property
• One hour regarding Employment Matters

Par value is the minimum price that a share can be sold for. This is typically the price founders pay for their shares, although sometimes I recommend issuing founder shares at a multiple of par value (i.e. Par Value x 10) in order to avoid problems down the road if the company needs to execute a forward stock split and the value of the shares hasn’t increased much. This avoids the situation where a forward stock split would require the new share price to be below par value, something not allowed.

Par Value Price

For stocks, I typically recommend par value be set somewhere between $0.001 and $0.0001. Some states such as Delaware and Texas allow for issuance with no par value, but this can create other unintended consequences. For example, issuing shares without par value in Delaware triggers a different franchise tax calculation, usually resulting in a higher franchise tax burden. This can be easily avoided by setting a par value.

Example

For example, a startup company authorizes 10M shares with a par value of $0.0001, with 8M shares set aside for two founders, split 50/50 between the two. The lowest price each founder would have to pay in exchange for 50% of the shares is $400.00 (4M * $0.0001). Payment of the $400.00 could be made in cash, contribution of services, or contribution of property (real or intellectual), whatever the founders decide is fair for the situation.

It depends. The number of authorized shares only matters if you plan on issuing stock options to employees, raising outside money from investors, or taking your company public. If you plan on any of these, you need to pay attention to the capital structure of your company from the beginning because if setup correctly, it can save you significant time, effort, and legal fees in the long run. If you do not plan on issuing stock options, raising money from investors, or taking the company public, you can pick any number you want (but pay attention to possible tax and filing fee consequences) and divvy them up between the co-founders accordingly. Otherwise, we recommend authorizing somewhere in the neighborhood of 10M shares, with 8M to 9M set aside for the founders and if necessary, the rest set aside for an option pool.

Why?

The 10M shares number is derived by working backwards from the requirements of a successful IPO. Conventional wisdom suggests that a $300M market cap is the minimum needed for a successful IPO because many institutional investors will not even touch a company with less than a $100M market cap. To get there, one needs to assume that you have 20M outstanding shares priced at $15/share for the initial IPO price. Starting with 10M shares at authorization leaves plenty of room to authorize additional shares when needed during a later financing.

Monetary Consequences: Taxes and Filing Fees

Some states, such as Delaware base their filing fees and franchise taxes off of the number of initially authorized shares and/or initial capital, so generally the larger the amount of authorized capital, the higher the filing fee or franchise tax bill. On the other hand, Texas does not base filing fees or franchise tax on the number of authorized shares. Texas has a fixed filing fee, and the franchise tax (now called margin tax) is based off of revenue.

We offer flat fee, upfront price quotes ranging from $2,500 to $7,500 for either company counsel or investor counsel on a debt / bridge financing. With us, you know how much you will be charged from the beginning and won’t be shocked when you receive your legal bill. Many large law firms routinely charge in excess of $15,000 for the same debt financing service (See http://www.askthevc.com/blog/archives/2007/07/how-much-should-1.php). Prices vary depending on how many parties are involved in the financing, how much due diligence is expected or required, and how much corporate house cleaning needs to take place. As a general rule of thumb, the newer the company, the less the cost.

Contact us now to arrange for a free consultation and quote.

We offer flat fee, upfront price quotes ranging from $5,000 to $20,000 for company counsel on a Series A funding from a VC firm that agrees to use one of the model document sets. For investor counsel, our prices range from $2,500 to $10,000 for a Series A funding based on one of the model document sets. With us, you know how much you will be charged from the beginning and won’t be shocked when you receive your legal bill. Many large law firms routinely charge in excess of $50,000 for the same Series A service (See http://www.startupcompanylawyer.com/2007/12/08/what-should-legal-fees-in-a-series-a-financing-be/, and http://www.askthevc.com/blog/archives/2007/07/how-much-should-1.php). Prices vary depending on how many parties are involved in the funding, how much IP and regulatory due diligence is expected, and how much corporate house cleaning needs to take place. As a general rule of thumb, the newer the company, the less the cost.

Contact us now to arrange for a free consultation and quote.

TITLE 3. LIMITED LIABILITY COMPANIES

CHAPTER 101. LIMITED LIABILITY COMPANIES

SUBCHAPTER J. DERIVATIVE PROCEEDINGS

Sec. 101.451. DEFINITIONS.

In this subchapter:

(1) “Derivative proceeding” means a civil suit in the right of a domestic limited liability company or, to the extent provided by Section 101.462, in the right of a foreign limited liability company.

(2) “Member” includes a person who beneficially owns a membership interest through a voting trust or a nominee on the person’s behalf.

Sec. 101.452. STANDING TO BRING PROCEEDING.

A member may not institute or maintain a derivative proceeding unless:

(1) the member:

(A) was a member of the limited liability company at the time of the act or omission complained of; or

(B) became a member by operation of law from a person that was a member at the time of the act or omission complained of; and

(2) the member fairly and adequately represents the interests of the limited liability company in enforcing the right of the limited liability company.

Sec. 101.453. DEMAND.

(a) A member may not institute a derivative proceeding until the 91st day after the date a written demand is filed with the limited liability company stating with particularity the act, omission, or other matter that is the subject of the claim or challenge and requesting that the limited liability company take suitable action.

(b) The waiting period required by Subsection (a) before a derivative proceeding may be instituted is not required if:

(1) the member has been previously notified that the demand has been rejected by the limited liability company;

(2) the limited liability company is suffering irreparable injury; or

(3) irreparable injury to the limited liability company would result by waiting for the expiration of the 90-day period.

Sec. 101.454. DETERMINATION BY GOVERNING OR INDEPENDENT PERSONS.

(a) The determination of how to proceed on allegations made in a demand or petition relating to a derivative proceeding must be made by an affirmative vote of the majority of:

(1) the independent and disinterested governing persons present at a meeting of the governing authority at which interested governing persons are not present at the time of the vote if the independent and disinterested governing persons constitute a quorum of the governing authority;

(2) a committee consisting of two or more independent and disinterested governing persons appointed by the majority of one or more independent and disinterested governing persons present at a meeting of the governing authority, regardless of whether the independent and disinterested governing persons constitute a quorum of the governing authority; or

(3) a panel of one or more independent and disinterested persons appointed by the court on a motion by the limited liability company listing the names of the persons to be appointed and stating that, to the best of the limited liability company’s knowledge, the persons to be appointed are disinterested and qualified to make the determinations contemplated by Section 101.458.

(b) The court shall appoint a panel under Subsection (a)(3) if the court finds that the persons recommended by the limited liability company are independent and disinterested and are otherwise qualified with respect to expertise, experience, independent judgment, and other factors considered appropriate by the court under the circumstances to make the determinations. A person appointed by the court to a panel under this section may not be held liable to the limited liability company or the limited liability company’s members for an action taken or omission made by the person in that capacity, except for acts or omissions constituting fraud or wilful misconduct.

Sec. 101.455. STAY OF PROCEEDING.

(a) If the domestic or foreign limited liability company that is the subject of a derivative proceeding commences an inquiry into the allegations made in a demand or petition and the person or group of persons described by Section 101.454 is conducting an active review of the allegations in good faith, the court shall stay a derivative proceeding until the review is completed and a determination is made by the person or group regarding what further action, if any, should be taken.

(b) To obtain a stay, the domestic or foreign limited liability company shall provide the court with a written statement agreeing to advise the court and the member making the demand of the determination promptly on the completion of the review of the matter. A stay, on motion, may be reviewed every 60 days for the continued necessity of the stay.

(c) If the review and determination made by the person or group is not completed before the 61st day after the date on which the court orders the stay, the stay may be renewed for one or more additional 60-day periods if the domestic or foreign limited liability company provides the court and the member with a written statement of the status of the review and the reasons why a continued extension of the stay is necessary.

Sec. 101.456. DISCOVERY.

(a) If a domestic or foreign limited liability company proposes to dismiss a derivative proceeding under Section 101.458, discovery by a member after the filing of the derivative proceeding in accordance with this subchapter shall be limited to:

(1) facts relating to whether the person or group of persons described by Section 101.458 is independent and disinterested;

(2) the good faith of the inquiry and review by the person or group; and

(3) the reasonableness of the procedures followed by the person or group in conducting the review.

(b) Discovery described by Subsection (a) may not be expanded to include a fact or substantive matter regarding the act, omission, or other matter that is the subject matter of the derivative proceeding. The scope of discovery may be expanded if the court determines after notice and hearing that a good faith review of the allegations for purposes of Section 101.458 has not been made by an independent and disinterested person or group in accordance with that section.

Sec. 101.457. TOLLING OF STATUTE OF LIMITATIONS.

A written demand filed with the limited liability company under Section 101.453 tolls the statute of limitations on the claim on which demand is made until the earlier of:

(1) the 91st day after the date of the demand; or

(2) the 31st day after the date the limited liability company advises the member that the demand has been rejected or the review has been completed.

Sec. 101.458. DISMISSAL OF DERIVATIVE PROCEEDING.

(a) A court shall dismiss a derivative proceeding on a motion by the limited liability company if the person or group of persons described by Section 101.454 determines in good faith, after conducting a reasonable inquiry and based on factors the person or group considers appropriate under the circumstances, that continuation of the derivative proceeding is not in the best interests of the limited liability company.

(b) In determining whether the requirements of Subsection (a) have been met, the burden of proof shall be on:

(1) the plaintiff member if:

(A) the majority of the governing authority consists of independent and disinterested persons at the time the determination is made;

(B) the determination is made by a panel of one or more independent and disinterested persons appointed under Section 101.454(a)(3); or

(C) the limited liability company presents prima facie evidence that demonstrates that the persons appointed under Section 101.454(a)(2) are independent and disinterested; or

(2) the limited liability company in any other circumstance.

Sec. 101.459. ALLEGATIONS IF DEMAND REJECTED.

If a derivative proceeding is instituted after a demand is rejected, the petition must allege with particularity facts that establish that the rejection was not made in accordance with the requirements of Sections 101.454 and 101.458.

Sec. 101.460. DISCONTINUANCE OR SETTLEMENT.

(a) A derivative proceeding may not be discontinued or settled without court approval.

(b) The court shall direct that notice be given to the affected members if the court determines that a proposed discontinuance or settlement may substantially affect the interests of other members.

Sec. 101.461. PAYMENT OF EXPENSES.

(a) In this section, “expenses” means reasonable expenses incurred by a party in a derivative proceeding, including:

(1) attorney’s fees;

(2) costs of pursuing an investigation of the matter that was the subject of the derivative proceeding; or

(3) expenses for which the domestic or foreign limited liability company may be required to indemnify another person.

(b) On termination of a derivative proceeding, the court may order:

(1) the domestic or foreign limited liability company to pay the expenses the plaintiff incurred in the proceeding if the court finds the proceeding has resulted in a substantial benefit to the domestic or foreign limited liability company;

(2) the plaintiff to pay the expenses the domestic or foreign limited liability company or other defendant incurred in investigating and defending the proceeding if the court finds the proceeding has been instituted or maintained without reasonable cause or for an improper purpose; or

(3) a party to pay the expenses incurred by another party relating to the filing of a pleading, motion, or other paper if the court finds the pleading, motion, or other paper:

(A) was not well grounded in fact after reasonable inquiry;

(B) was not warranted by existing law or a good faith argument for the extension, modification, or reversal of existing law; or

(C) was interposed for an improper purpose, such as to harass, cause unnecessary delay, or cause a needless increase in the cost of litigation.

Sec. 101.462. APPLICATION TO FOREIGN LIMITED LIABILITY COMPANIES.

(a) In a derivative proceeding brought in the right of a foreign limited liability company, the matters covered by this subchapter are governed by the laws of the jurisdiction of organization of the foreign limited liability company, except for Sections 101.455, 101.460, and 101.461, which are procedural provisions and do not relate to the internal affairs of the foreign limited liability company.

(b) In the case of matters relating to a foreign limited liability company under Section 101.454, a reference to a person or group of persons described by that section refers to a person or group entitled under the laws of the jurisdiction of organization of the foreign limited liability company to review and dispose of a derivative proceeding. The standard of review of a decision made by the person or group to dismiss the derivative proceeding shall be governed by the laws of the jurisdiction of organization of the foreign limited liability company.

Sec. 101.463. CLOSELY HELD LIMITED LIABILITY COMPANY.

(a) In this section, “closely held limited liability company” means a limited liability company that has:

(1) fewer than 35 members; and

(2) no membership interests listed on a national securities exchange or regularly quoted in an over-the-counter market by one or more members of a national securities association.

(b) Sections 101.452-101.459 do not apply to a closely held limited liability company.

(c) If justice requires:

(1) a derivative proceeding brought by a member of a closely held limited liability company may be treated by a court as a direct action brought by the member for the member’s own benefit; and

(2) a recovery in a direct or derivative proceeding by a member may be paid directly to the plaintiff or to the limited liability company if necessary to protect the interests of creditors or other members of the limited liability company.