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Where’s Europe’s Delaware?
Today: The state of Delaware performs a very important role for US tech companies. Europe lacks an equivalent.
The Agenda 👇
(Almost) all US tech companies are incorporated in Delaware
But why exactly? What makes Delaware so special?
Important issues: issuing employee equity, maintaining founder control
Europe lacks its own Delaware, and it’s a problem
Thumbs up/down for last week
We’re all aware that there’s something special about incorporating a company in Delaware. It’s even referenced in The Social Network: there’s a scene in which a fictional Peter Thiel confirms he’ll invest in Facebook, but a prerequisite is that the company be reincorporated in Delaware (from Florida, where it was first incorporated because Eduardo Saverin was a resident there).
But why does it matter so much that a company be incorporated in Delaware? I was reminded of that question by the recent developments over facilitating employees’ ability to receive stock options in European tech companies. Following an impressive PR campaign under the banner #NotOptional, our friends at Index Ventures, supported by many other pillars in the pan-European ecosystem (incl. my firm The Family), appeared to be getting the German government to move forward with a more favorable regime. However, as you can see, the outcome ended up being disappointing:
I once wrote a piece explaining why exactly employee equity is so critical in the world of tech companies. Read more in Why Employee Equity Matters (February 2019):
Once a Silicon Valley startup reaches escape velocity, allocating equity to employees makes it easier for its founders to hire the best talent they can find, which in turn makes it easier to convince VC firms to invest. It’s not the salary that attracts those early employees (even if that does need to match the cost of living in the Bay Area). Rather it’s the equity and the vision. Because the startup that wants to hire you is entering the phase of exponential growth, being part of that growth means that your options could turn into millions as the valuation grows accordingly.
But what exactly makes it so difficult to allocate equity to employees? The obstacles fall into two categories:
One category relates to the taxes that the employees (and, in some cases, the employer) have to pay when allocating low-priced equity that hasn’t turned into cash yet.
The other category relates to making existing shareholders agree that equity should be allocated to employees at a relatively low price, resulting in additional dilution.
In our (mostly European) experience, the problems don’t arise because of major shareholders. Those, usually venture capital firms, are perfectly aware that it’s critical to allocate equity to employees, and they tend to agree with the resulting dilution.
Minority shareholders, on the other hand, are typically the ones that are reluctant to agree. Unfortunately, there are still many angel investors who are worried about dilution across consecutive rounds, and who often then use the powers vested in them by the company’s by-laws to prevent employees from getting their share and thus adding to the dilution.
Enter Delaware, whose corporate law is typically helpful when it comes to preventing resistance from the inside. There are two dimensions (or so it seems, from what I’ve been reading):
One is that the actual provisions in the law make it easier for founders to retain control over their company, even after several rounds of funding and the resulting dilution—including for allocating appropriately priced equity to employees and founders themselves.
The other is the Delaware Court of Chancery, which has “jurisdiction to hear and determine all matters and causes in equity” and a long history of swiftly deciding on equity and fairness between parties in a corporate context.
Indeed, a good legal system is not only about favorable rules enacted by law. It is also about anyone being able to pursue litigation and to expect a swift decision that’s as predictable as possible based on a long series of precedents (the system also creating competent lawyers able to analyse those precedents).
This means that you can’t emulate Delaware simply by changing the local corporate law. You’d also need the equivalent of the Delaware Court of Chancery and the jurisprudence it has been building over the course of two and a half centuries!
I have a few other ideas as to why such a regime matters in an era of transition and in the context of corporate executives having to focus more on customers and less on shareholders, but I’ll save that for a longer essay in the coming weeks. In the meantime, let me go back to the question in the title:
Does Europe have its own Delaware? And if not, can it create one?
I alluded to that two weeks ago in Government in the Entrepreneurial Age
As an investor whose day-to-day life is about dealing with lawyers and accountants and bankers, I'm still amazed by the fact that we don't really have such a thing as the center of the pan-European ecosystem in Europe—a place where you can be sure of finding the best, the most responsive and effective providers in each of those these categories. So I would say that could be the next step for Estonia: become the platform for the entire pan-European tech ecosystem from a professional services perspective, benefiting from the fact that they're used to digitizing everything and playing on that strength. (I’d still bet on Amsterdam, though.)
Indeed, when you have a closer look at Delaware, it’s more than professional service providers: it’s a rather favorable corporate law, plus a court system able to enforce it in a swift and predictable manner, plus competent and available professionals to help corporations move things along.
The question in the title is rhetorical, of course: there is no such thing as Delaware in Europe 😞 It’s neither Luxembourg nor the Netherlands, despite both places having a reputation for business-friendliness (which, as it turns out, is something entirely different from founder- and VC-friendliness). It’s certainly not France or Germany, which are absolute nightmares when it comes to corporate law. It’s not Switzerland either (which is not part of the EU) or the UK (where corporate law is not that favorable to founder control and employee equity, and which has left the EU anyway).
And it’s not Estonia, despite it being the most digitized country in Europe—although I think it’s the country that has the best chance of succeeding in such an effort, along with English-speaking Ireland (having the local system function in English is a HUGE advantage).
The absence of a European Delaware creates two sets of problems:
It’s impossible for European startups to optimize from Day One. Since there’s no obvious choice for the country of incorporation, by default most founding teams incorporate in their country of origin, at a point when there are so many things that they don’t know: who they’ll raise from, at what valuation, what kind of talent they’ll need to attract, what their key markets will be.
Even worse, it’s very difficult to correct course and reincorporate so as to prevent further problems and create new opportunities, as Facebook once did when they left Florida for Delaware. Once a European founding team realizes that the local setting is suboptimal, some will reincorporate in the UK, Ireland, or the Netherlands; but the only place where you can actually reach the same level of flexibility and responsiveness as a US company is… still Delaware.
I really don’t blame European founders who elect to reincorporate in Delaware: they’re doing what’s in their company’s best interest. But from a European perspective I believe this creates a vicious circle:
What attracts a European company to Delaware? It’s not the quest for a more favorable corporate law, but rather either the express demands of US-based investors (like Peter Thiel in Facebook’s case), or the expectations of US-based customers or employees.
What Europe loses in the process of European companies “exiting” to reincorporate in Delaware is the internal pressure of its own companies demanding that a European Delaware exists. In turn, this European Delaware never comes into being, which makes European companies only more prone to reincorporating in the US. (And, as seen in the past, once there’s been an IPO, there’s no coming back, because the SEC won’t allow it.)
What do you think? Do you see a European country emerging as the continental equivalent of Delaware? Or should the European Union create the equivalent of Delaware’s corporate law and the Court of Chancery at the EU level?
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From Munich, Germany 🇩🇪