Delaware dominates the corporate chartering market in the U.S—it is the only state that attracts a significant number of out-of-state incorporations. As a result, incorporation decisions are “bimodal,” with public and private firms typically choosing between home-state and Delaware incorporation.
Much ink has been spilled in the debate over whether Delaware’s dominance arose because it offers high-quality or low-quality corporate law. Under the “race-to-the-top” view, Delaware has prevailed because its law maximizes firm value. Under the “race-to-the-bottom” view, Delaware has won by offering corporate law that favors insiders at other parties’ expense.
But a firm today may choose Delaware law not solely because of its inherent features but rather because, after decades of Delaware’s dominance, business parties—including investors and their lawyers—are now simply more familiar with Delaware law than the laws of other states. Indeed, the bimodal pattern of domiciling is itself strong evidence that business parties are familiar only with their home states’ corporate law and Delaware’s.
In our paper, Delaware Law as Lingua Franca: Evidence from VC-Backed Startups, recently made public on SSRN, Brian Broughman, Darian Ibrahim, and I show, for the first time, that familiarity does in fact affect firms’ decisions to domicile in Delaware rather in their home states.
We predict that, if the typical business party is “bilingual” in Delaware law and the law of its own home state, and familiarity with corporate law matters, a firm will be more likely to incorporate in Delaware rather than in its home state if the firm receives financing from out-of-state investors. In other words, Delaware law can be expected to serve as a “lingua franca”: firms seeking out-of-state investors will be more likely to use Delaware law so they can provide a common language to all of their investors.
To test for a lingua-franca effect, we exploit a database of 1,850 VC-backed firms that provides precise information on the firm’s location, the identity and location of its investors, and changes in the firm’s domicile as its investor base evolves over time. We find, consistent with the lingua-franca effect, that the presence of out-of-state investors in each round of financing significantly increases the likelihood of Delaware incorporation or reincorporation. We also find that a startup is less likely to incorporate in Delaware if its out-of-state VC investors have already invested in firms incorporated in the startup’s home state, and thus have greater familiarity with home-state corporate law.
In addition to controlling for numerous factors that may affect choice of domicile, we employ instrumental-variable and fixed-effect regression analysis. In each of these tests, we obtain results consistent with the lingua-franca effect: firms receiving financing from out-of-state VC investors, particularly those lacking prior exposure to the startup’s home-state corporate law, are significantly more likely to incorporate (or reincorporate) in Delaware. Our results are thus robust to alternative econometric specifications, and do not appear to be driven by unobserved differences among firms or VCs.
This project contributes to the empirical literature on corporate charters in two respects. First, it provides evidence that familiarity helps drives domicile decisions, and that this effect is likely to have as large an impact as other factors that have been identified in the literature, such as the quality of a state’s judiciary and the flexibility of a state’s corporate law.
Second, our study provides the first rigorous empirical support for the proposition that Delaware’s success is not due solely to the inherent features of its corporate law, but rather in part to investors’ familiarity with it. Our study thus implies that there is a potentially large hurdle for other states seeking to compete with Delaware; a competing state would not only need to provide “better” law, it would also need to overcome learning costs that may prevent parties from adopting its law. This barrier to competition may hinder desirable state-level innovation and lead to lower-quality corporate law across the nation.
While our study focuses on private firms, it also has implications for the domicile choices of publicly-traded firms. If the need to raise capital from a mix of in-state and out-of-state investors leads private firms to choose Delaware law to provide a lingua franca for all of their investors, it stands to reason that firms wishing to sell their shares to mostly out-of-state public investors through an IPO may also choose Delaware law in part to provide a common language to their shareholders, even if Delaware law is not optimal for firms.
The full paper is available for download here.