Reincorporating a California entity to a Delaware corporation

If you formed your startup in California or any state other than Delaware, you may at some point consider whether to reincorporate your business venture into a Delaware entity. If your startup is based in California, then this can be a particularly elaborate undertaking that involves legal filings, shareholder approval, and regulatory considerations.

Why would you convert your business from a California entity to a Delaware entity?

As our article on where to incorporate explains, Delaware has a well-established set of corporate laws: compared to all other US states, the Delaware General Corporation Law (DGCL) is more modern, flexible and business-friendly – allowing for customizable governance structures, efficient procedures for charter amendments, and stronger protections for directors. Delaware is a leading force in the development of business law; most recently, amendments to the DGCL have clarified the rules around conflicted transactions and shareholder rights. Delaware courts are consistent and predictable, often deferring to the decisions of corporate boards under the Business Judgment Rule. Moreover, the C corporation entity in Delaware presents certain preferred tax treatments for investors.

Why do venture capital investors and buyers prefer business ventures to be organized as Delaware C corporations?

In order to address the needs of a growing national or international business, an entity may wish to reincorporate in Delaware for a number of business and legal reasons ranging from requirements imposed by institutional investors to the need for enhanced regulatory clarity. The purpose of the entity’s reincorporation will in many ways drive the process of reincorporation.

There are a variety of external parties, ranging from institutional investors to potential acquirers, that may prefer or even require reincorporation. You may be about to raise a financing round, and your venture capital investors may require that you "re-incorporate" in Delaware prior to the financing. You may be in the middle of an exit, and the buyer may want you to become a wholly-owned subsidiary operating in the form of a Delaware C corporation.

What is the problem you need to address?

"Reincorporation" is a categorical term for various transactions that result in a business entity moving to a different state and/or switching entity types. In most cases, reincorporation involves a simple and quick statutory mechanism generally involving the filing of certain forms – called a "conversion." However, in order for a conversion to occur, both states must accept the process; the state where you are already incorporated must allow the entity to move to the new state, and the new state must accept the entity moving into that state.

Unfortunately for many entities, California is one of a handful of states that does not recognize the concept of direct conversion and thus will not allow a domestic corporation to convert into what it deems a "foreign" corporation. That means that to reincorporate a California corporation, we need to get creative.

How do you reincorporate your business from a California entity to a Delaware entity?

If a California entity decides to reincorporate in Delaware, there are three basic methods to combine the Delaware entity and the California entity, all of which are subject to a multitude of variations regarding the surviving stock, existing charter, and voting requirements. These are a merger, an asset sale, and a stock-for-stock exchange.

How do I reincorporate via merger?

If the reincorporation is to be effectuated using a merger, then specific and detailed statutory requirements must be followed. A technique frequently employed when a entity desires to reincorporate in another jurisdiction is called a "downstairs merger."

A downstairs merger occurs when, for example, the converting California corporation creates a new, wholly owned Delaware subsidiary. This subsidiary is merely a shell corporation which has no business or assets. The converting California entity then merges into its Delaware subsidiary, with the Delaware entity as the surviving entity. The stock and other securities of the Delaware subsidiary will have rights, preferences, privileges and restrictions identical to the outstanding stock and other securities of the California entity and is exchanged for all of such outstanding stock and other securities of the California entity.

Under the California Corporations Code (the CCC), the board of directors of the California entity and the Delaware subsidiary and the shareholders of each constituent entity must approve the merger and the agreement of merger. The constituent entities to the merger must be party to the agreement of merger, and the agreement of merger must contain the terms and conditions of the merger, the amendments (if any) to the articles of the surviving entity, and the manner of converting the shares of each of the constituent entities into shares or other securities of the surviving entity, among other items.

Thereafter, the surviving entity must file with the Secretary of State of California a copy of the agreement of merger, along with an officers' certificate of each constituent entity attached stating the total number of outstanding shares of each class entitled to vote on the merger and that the principal terms of the agreement in the form attached were approved by that entity by a vote of a number of shares of each class which equaled or exceeded the vote required, specifying each class entitled to vote and the percentage vote required of each class.

Through this method, the California entity is turned into a Delaware entity without any other change whatsoever in its business or assets or in the rights of its security holders. This is a "clean" transfer.

How do I reincorporate via asset sale?

During an asset sale, the California entity sells all of its assets to the Delaware entity and then liquidates and dissolves. The new Delaware entity to which the assets are transferred will first need to be formed, with all the desired securities, interests, and stockholder rights and privileges. The shareholders of the California entity will then receive stock in the Delaware entity as payment for the assets. Thereafter, the Delaware entity owns all of the California entity's former assets, and the shareholders of the California entity are stockholders of the Delaware entity.

This method provides the entity with a fresh start, as the Delaware entity is a new legal entity. This is advantageous if the company does not want to automatically inherit all the liabilities and contractual obligations, but it is also burdensome as the asset sale is a taxable transaction and the new entity must affirmatively assume any contracts, licenses, or regulatory approvals that it wishes to keep. For a large entity with many stakeholders, replicating the rights of owners, creditors, and debtors in a newly formed Delaware entity may be more difficult

How to reincorporate via stock-for-stock exchange?

A stock-for-stock exchange occurs when the Delaware entity, which was first formed, issues and exchanges shares of its authorized and unissued common stock to the shareholders of the California entity in exchange for all of the outstanding shares of the California entity stock. This method can only be employed if the California entity is relatively closely held and all of its shareholders are willing to make the exchange. The Delaware entity may continue to operate the business of the California entity through its new wholly owned subsidiary – the California entity – or it may effect a merger. This may be the most flexible of the reorganization techniques, because it is entirely a matter of private contract and is not governed by statutory requirements and regulation (although still subject to securities, corporate, and tax law).

Key takeaway

Depending on the form the transaction takes, different corporate and tax issues may arise. Reorganization structures may also trigger one or more change-of-control provisions in the entity's existing contracts, and it is advisable to review and identify them at the outset. Additionally, each of the above vehicles may have different obligations regarding stockholder voting and dissenters rights.

The absence of a statutory method for converting a California entity into a foreign entity is, in a way, an opportunity for the entity to reorganize its structure through reincorporation.

The method of reincorporation will depend on your purpose for reincorporation and the nature of ownership and business of the entity in question.