For the lazy among you, I’ll summarize this post in a single sentence: If you’re incorporating in Delaware, don’t authorize more than 5,000 shares of stock unless you absolutely, positively have to. If you absolutely, positively have to issue more, check with a lawyer to make sure you’re right about that.
There’s a fashion in Delaware corporations these days whereby companies authorize millions (or tens of millions) of shares in their Delaware corporation because “we might get VC money one day” or “we’re looking for an investor.” Indeed, many online online incorporation services have 10 million shares set as the default (even those working with law firms who should know better). Aside from the fact that only a tiny percentage of companies are ever going to get even a sniff of VC money, it’s irresponsible because of the way Delaware calculates its annual franchise tax.
First of all, the franchise “tax” isn’t really a tax in the proper sense, it’s really just a fee for the privilege of forming a Delaware company, and it’s intended to be more expensive for “bigger” companies, where “bigger” means more investors. There are two ways of calculating the tax, the Authorized Shares Method and the Assumed Par Value Method, and you pay the lower of the two taxes. The Authorized Shares Method is very simple – you pay a certain amount of franchise tax for the number of shares which are authorized when you form the company, from a low of $175 for companies with 5000 shares or fewer up to a maximum of $200,000. It doesn’t matter whether the shares are issued, or even if they are all issued to one person, the mere act of authorizing the shares creates the tax obligation.
The Assumed Par Value Method uses the number of issued shares and the total assets of the corporation to come up with an “assumed par value,” which is then used to calculate the franchise tax, starting at $400 and going up to a maximum of $200,000 (even if the formula results in a higher tax calculation). If all of the shares are issued, it’s no problem, although it seems kind of silly to issue 10 million shares to a sole shareholder. If you don’t understand this, however, and you issue only a few shares (or, as often happens with companies formed over the internet, you forget to issue any shares at all) the Assumed Par Value calculation results in a very high franchise tax, even for companies with relatively little in assets.
By starting out at 10 million shares, most business owners effectively wipe out the opportunity to pay the minimum tax under the Authorized Shares Method. If that same business owner forgets to issue shares, or issues too few shares, they may also end up with a franchise tax due of tens or hundreds of thousands of dollars. If you didn’t need those shares in the first place, that’s a significant cost for no benefit whatsoever. To make things worse, fixing the unnecessary problem can cost thousands in legal fees and, in many cases, will still require the payment of pro-rated franchise taxes for the period before the correction.
For example, a company which issues 100 out of 10 million shares, with only $1,000 in assets would pay the lower of $85,165 per year under the Authorized Shares Method and $200,000 under the Assumed Par Value Method. That’s an awful lot of money for a company with only $1,000 in assets. That same company would pay $175 in franchise tax if they had only issued 1,000 shares. If you want to check out the calculations or download an Excel calculator to play with the numbers, check out the franchise tax calculations page of the Delaware Corporations website.
If you’re really in the market for venture capital money, work with a lawyer to make sure your company is set up properly for that purpose. It’s worth the extra money. Otherwise, 5,000 shares (or 1,000, or maybe even 10 shares) is more than enough.