When a startup is incorporated, founders should understand the requirement to qualify to do business in a state where it is not incorporated and “doing business.”
Here’s the basic context: Most technology startups are incorporated in Delaware. However, in each state outside of Delaware that the tech startup is “doing business” the company must register to do business in that state — otherwise known as qualifying to do business. For example, when a tech startup incorporated in Delaware and has its principal office in California, I will qualify the startup to do business in California.
The Standard. Each state has its own definition of “doing business.” California deems an out-of-state corporation as “doing business” if any of the following are true:
- actively engaging in any transaction in California for the purpose of financial or pecuniary gain or profit.
- organized or commercially domiciled in California.
- Sales, as defined in subdivision (f) of R&TC Section 25120, of the taxpayer in California, including sales by the taxpayer’s agents and independent contractors, exceed the lesser of $500,000 or 25 percent of the taxpayer’s total sales.
- Real and tangible personal property of the taxpayer in California exceed the lesser of $50,000 or 25 percent of the taxpayer’s total real and tangible personal property.
- The amount paid in California by the taxpayer for compensation, as defined in subdivision (c) of R&TC Section 25120, exceeds the lesser of $50,000 or 25 percent of the total compensation paid by the taxpayer.
You can see the full text of the code on the California Franchise Tax Board page [https://www.ftb.ca.gov/businesses/Section_23101.shtml].
The Process. If a company is “doing business” in a state where it is not incorporated, then it should make a foreign qualification filing. In California it is called a Statement and Designation by Foreign Corporation. The filing is pretty straightforward and is a one or two page document filed with the Secretary of State. For example, here’s a link to California’s form. The state fees range from $100 to $300.
The Effect. The basic idea is that if a company is doing business in that state (even if it isn’t incorporated in that state), then it should have to abide by certain requirements of such state and pay taxes in that state. For example, once SnapTalk, Inc. (a fictional Delaware company), qualifies to do business in California the company must report and pay California state income and sales taxes and comply with California employment tax filings (if applicable). Also, SnapTalk, Inc. will have a registered agent in California to accept legal notices.
The Penalties. The potential risk of not qualifying to do business could be: (1) financial penalties (for example in California, the penalty is $250 plus $20 per day for willful failure to qualify); (2) some states impose personal liability on the company’s directors, officers and agents; and (2) the company is not allowed to bring a lawsuit in that state’s courts (a court may dismiss a lawsuit if the plaintiff company failed to qualify to do business).
SPEEDBUMP: The issue of qualifying to do business becomes very important during an angel investment round, a venture capital financing, or a merger or acquisition. Any financing or exit transaction will involve an agreement that requires the company to represent and warrant that the company is qualified to do business in any state as required by law. Here’s the language you usually see in financing or acquisition deals: “The Company is presently qualified to do business as a foreign corporation in each jurisdiction where the failure to be so qualified could reasonably be expected to have a material adverse effect on the Company’s financial condition or business as now conducted.” It’s not a good idea to scramble at the last minute to comply with these filings, or be required to inform the potential investor or buyer that there is additional liability that they didn’t know about because the company never qualified to do business in a certain state.