When forming a corporation, choosing the right state for incorporation can significantly impact how your business operates and how much control you, as an owner, retain. Delaware and California are two popular states for incorporation, but they have distinct differences in corporate governance. For business owners, understanding these differences is critical to making informed decisions about structuring your company. Below, we’ll examine key areas where Delaware and California laws diverge, using practical examples for clarity.
1. Cumulative Voting: Protecting Minority Shareholders
Cumulative voting is a method that allows shareholders to concentrate their votes on fewer candidates when electing directors, giving minority shareholders more influence over board composition.
- Delaware: By default, cumulative voting is not permitted unless explicitly allowed in the company’s certificate of incorporation.
- California: Cumulative voting is automatically allowed unless specifically prohibited in the company’s governing documents.
Example: Let’s say you own 20% of a corporation’s stock. In a company with five board seats up for election, under California law, cumulative voting lets you pool your votes (20% x 5 = 100% of one vote) to elect one director of your choosing. In Delaware, unless the company’s incorporation documents allow cumulative voting, you would have to spread your votes equally across all candidates, making it harder for minority shareholders to elect a director.
2. Changing the Number of Directors: Who Has the Power?
The power to change the size of the board of directors differs between Delaware and California corporations.
- Delaware: The board of directors generally has the authority to change the number of directors.
- California: Shareholder approval is typically required to change the number of directors, unless a company’s articles of incorporation or bylaws allow the board to make such decisions.
Example: If you are a majority shareholder in a Delaware corporation and want to increase the number of directors to bring on more strategic expertise, the board can simply vote to expand the board without needing shareholder approval. In California, however, unless shareholders have granted this power to the board, you would need shareholder approval to make this change.
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3. Staggered Board of Directors: Long-Term Control
A staggered board means only a portion of directors are up for re-election each year, making it harder for hostile takeovers to replace the entire board in one election cycle.
- Delaware: Staggered boards are allowed unless explicitly prohibited in the company’s bylaws or certificate of incorporation.
- California: Staggered boards are generally not allowed, except for corporations listed on the NYSE or NASDAQ.
Example: In Delaware, you can set up a staggered board where only one-third of directors are elected annually. This allows you, as a founder or majority owner, to maintain control over the company’s long-term strategy, even if new investors come on board. In California, unless your company is publicly listed, you must elect all directors annually, potentially giving activist shareholders more influence.
4. Promissory Notes for Stock Purchases: Financing Flexibility
When purchasing stock, particularly in early-stage companies, using promissory notes (a promise to pay in the future) offers flexibility in financing.
- Delaware: Allows the use of promissory notes to purchase stock, provided that the purchaser pays for at least the stated capital portion of the stock in valid forms like cash, services rendered, or property.
- California: Does not allow promissory notes for stock purchases, except in certain limited circumstances, such as employee stock purchase plans or when collateral other than the purchased stock secures the transaction.
Example: Suppose you’re raising capital for a Delaware LLC, and a potential investor offers to buy $100,000 in stock but can only provide $50,000 upfront. They offer a promissory note for the remaining amount, payable over two years. Delaware law permits this arrangement, giving you the flexibility to accept the investment immediately. In contrast, if your business were incorporated in California, you might have to reject the offer unless the note is secured by other collateral or offered through an employee stock purchase plan.
5. Loans to Officers: Empowering Management
Loans to officers can be an important tool for startups and growing businesses, often used to help key employees or founders purchase company stock or meet other financial obligations.
- Delaware: Permits loans to officers if the loan is reasonable and approved by the board.
- California: Restricts loans to officers unless several conditions are met, such as shareholder approval by a majority vote and a minimum number of shareholders.
Example: In Delaware, you could offer your CEO a loan to purchase additional company stock or relocate for business purposes, as long as the board approves the loan. In California, however, such loans are generally prohibited unless specific conditions are met, which can add layers of complexity and delay.
6. Special Meetings of Shareholders: Flexibility in Decision-Making
Special meetings allow shareholders to address urgent matters outside the normal annual meeting schedule.
- Delaware: Limits the right to call a special meeting to the board of directors or those explicitly authorized in the bylaws or certificate of incorporation.
- California: Allows shareholders holding at least 10% of voting shares, in addition to the board or other officers, to call a special meeting.
Example: Imagine you’re facing a critical issue that requires shareholder input, such as approving a new round of financing. In Delaware, only the board or authorized persons can call a special meeting, giving you more control over the timing and agenda. In California, any shareholder with 10% of the voting stock could call a meeting, which might force you to address issues on someone else’s timetable.
7. Shareholder Voting on Mergers: Class Voting Requirements
Shareholder approval is generally required for significant corporate actions like mergers and acquisitions.
- Delaware: Generally requires approval from a majority of shareholders, but does not mandate class voting (i.e., common stock and preferred stock voting separately) except in certain cases.
- California: Requires class voting for mergers and other significant corporate transactions. Each class of shares (common, preferred, etc.) typically votes separately on such matters.
Example: If you are merging your Delaware corporation with another company, a simple majority vote of shareholders is generally sufficient unless the merger adversely affects a specific class of stock. In California, however, each class of stock (e.g., common and preferred) may have to vote separately, adding complexity to the approval process and potentially giving minority shareholders in a specific class veto power.
8. Restrictions on Payment of Dividends: Cash Flow Considerations
Dividend payments are an important way to return value to shareholders, but states impose restrictions to ensure financial stability.
- Delaware: Allows dividends to be paid out of paid-in capital, earned surplus, or net profits from the current and previous years.
- California: Restricts dividends to retained earnings or situations where the company’s tangible assets exceed its liabilities by at least 1.25 times. These restrictions apply to companies subject to Section 2115, regardless of incorporation state.
Example: If your Delaware corporation had a profitable year and wants to issue dividends, you could do so out of either current profits or paid-in capital. In California, however, you would need to ensure your retained earnings or asset-to-liability ratio meets specific legal thresholds before issuing any dividends, which could limit your flexibility in rewarding shareholders.
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Weighing Flexibility Against Protections
When deciding between Delaware and California for incorporation, business owners must weigh the flexibility provided by Delaware’s corporate laws against the protections California offers to shareholders. Delaware is often the preferred choice for companies seeking operational flexibility, especially when it comes to corporate governance and raising capital. California, on the other hand, imposes more stringent shareholder protections, particularly for smaller companies and those with significant in-state operations. Understanding these nuances can help you make the best decision for your business structure and long-term growth.
For business owners looking to grow and expand, it’s important to consult legal and financial experts who understand these state-specific laws to ensure your company operates smoothly and avoids potential pitfalls.
