Even though COVID-19 continues to wreak havoc on the world and the U.S. economy, we continue to work on interesting and complex business deals with our cannabis clients with many clients either looking to acquire or be acquired as the industry matures and inevitable consolidation occurs. And because many deals continue to have a Delaware component, this post addresses relevant issues when forming a Delaware entity, specifically a Delaware C corporation.
In a prior blog post my colleague Vincent Sliwoski said the following regarding Delaware entities:
- People will say things like “half of all public companies are registered there,” or “my other company is a Delaware company,” or “Delaware has no state income tax.” Most of the time, none of these are great reasons to register a cannabis company in that state. This is because nearly all cannabis companies are small, privately held businesses that receive no tax benefits and no meaningful liability protection by registering in Delaware, or anywhere out-of-state.
- Large, publicly traded companies, on the other hand, may prefer Delaware registration for various reasons, including: 1) Delaware law protects directors and officers from derivative liability (to shareholders and non-managing members); 2) Delaware has a unique “Court of Chancery” solely dedicated to corporate law disputes and significant business cases; 3) Delaware has no state corporate income tax; and 4) Delaware’s LLC Act and General Corporation Law are both perceived as cutting-edge, on topics from fiduciary requirements to series LLCs.
- A founder may have access to venture capital that insists on seeing a Delaware C-corp, or perhaps she is motivated to keep her name off formation documents at all costs, given the status of federal law. (Delaware allows this; certain states do not.)
When working with clients who have decided upon forming a Delaware corporation, they often raise these same issues. I usually only run into these issues when my client has a very good reason to form a Delaware corporation.
I generally do not suggest reasons why Delaware is good because I want to know whether my client is sophisticated enough to raise these issues themselves. If they only want to form a Delaware corporation because they like the idea of having a Delaware corporation, then I generally give them my reasoning as to why Delaware may not be ideal for their situation.
Here are some common questions I receive when my clients want to form a Delaware C corp on the foundational issues that arise when filing the certificate of incorporation:
How many shares should we authorize?
10MM authorized shares is a common standard, though the only relevant standard is determining what is best for your company based on your current and future goals and the requirements of your future investors and key employees. If you are a startup company that does not have investors and therefore has no need to require a large number of shares, then you can start with a minimal amount of authorized shares and increase the number in the future when you have a reason to do so.
How many shares should we issue?
If you intend to add a large number of investors, you will generally want to have more shares. This is true if you intend to have a pool of stock that you will grant to key employees. Then the number of shares is more of a psychological question: will your employees and investors feel better about receiving 100k shares or 10 shares, even though economically we are dealing in absolute percentages and the number of shares is irrelevant? And if you grant options to your employees or investors, then you need to think about the per-share exercise price for those shareholders, which would lead you to want more shares so their per-share exercise price is lower.
What should we use for par value?
Par value is largely arbitrary, so you can choose $0.01 or $0.0001 or some other value. However, Delaware uses a particular formula to determine assumed par value, which matters when you pay your annual Delaware franchise tax. The formula for assumed par value is: gross assets / issued shares, and then the assumed par value times your authorized shares equals the total assumed par value capital. Click here to use the downloadable Delaware franchise tax calculator so you can input varying scenarios based upon your future goals.
For instance, if you do not intend to take on additional investors initially or issue stock to employees, you could issue 1,000 shares and pay $175 under the authorized shares method for your franchise tax. Keep in mind that you can always adjust the number of authorized and issued shares if something changes down the road, such as taking on additional investors or increasing the company’s gross assets (though there is a DE filing fee to do so).
What are the Delaware franchise tax implications?
Your initial goal in deciding how many shares to authorize and issue is to minimize your Delaware franchise tax payment. Delaware uses two different formulas to calculate its franchise tax for corporations: (a) the authorized shares method and (b) the assumed par value capital method. You want to choose the method that results in the lowest tax payment based upon your company goals.
Under the authorized shares method, you are taxed based only upon the total number of authorized shares, and 1-10,000 authorized shares will result in a $175-250 annual tax payment. If you authorize a large number of shares, like 10MM, you would pay an annual tax of over $85k under this method.
In contrast, under the assumed par value capital method, it is to your benefit to both authorize and issue a large number of shares relative to your capitalization. Under this method, a company with $1MM in gross assets, 10MM authorized shares and 5MM issued shares (assumed par value of $0.20) would owe a franchise tax payment of $800.
$400 is the lowest annual tax payment under this method, and you would arrive at that number by authorizing and issuing 5MM shares with $1MM in gross company assets. In order to have the $400 payment under this method, you need to issue nearly all of your authorized shares, which is probably not what most growth-oriented companies intend to do.
How would you advise use based on starting capitalization table of around $1,000,000?
You probably want to either authorize 1,000 shares so you pay $175 annually under the authorized shares method or 10MM authorized and 5-7MM issued so you pay $800, which will let you keep a pool of authorized but unissued shares for employees and future investors.
Delaware’s franchise tax is one of the early significant factors you need to grapple with when you are deciding whether to form a Delaware corporation and how my shares to authorize and issue. As with most foundational business decisions, you will need to think through many different scenarios in your company’s future and plan with the various probabilities in mind. Of course, you will not be able to plan for every contingency, as COVID-19 has taught and continues to teach us all.