Over 60% of new venture capital managers are choosing Delaware as the domicile for their firms and funds. As Europe becomes more regulated and expensive, the UK faces Brexit-related isolation, and traditional tax havens like the Caymans grow costly due to new Anti-Money Laundering (AML) and Know Your Customer (KYC) regulations, Delaware shines. Its clear regulatory framework, cost-effectiveness, and stability make it the preferred choice for venture capitalists globally.
Why is Delaware the Top Domicile
Cost-effectiveness:
While some jurisdictions offer various incentives for venture capitalists, Delaware stands out for its cost-effectiveness. The state’s corporate franchise tax structure is favorable for venture funds of all sizes, and the cost of doing setting up and running a fund is three to five times less expensive than most other domiciles.
Europe’s increasing regulatory burden translates to higher compliance costs, making it less attractive for new venture capital funds. Similarly, traditional tax havens such as the Cayman Islands have seen a sharp increase in costs due to the tightening of AML and KYC regulations. Delaware, on the other hand, offers a cost-effective solution that does not compromise on regulatory rigor, offering a perfect blend of affordability and compliance.
Regulatory Clarity and Stability:
At the forefront of Delaware’s appeal is its well-established and clearly articulated body of business law, which provides a strong foundation for managers looking to set up new venture capital funds. The Delaware General Corporation Law (DGCL) is one of the most advanced and flexible corporation statutes in the nation. The state’s courts, especially the Court of Chancery, are well-respected for their deep expertise in business matters and their consistent, swift, and predictable rulings.
In comparison, Europe’s increased regulations have made it more challenging for venture capital funds to navigate the legal landscape. The UK’s regulatory framework, further complicated by Brexit, has left it somewhat isolated and its future relationship with the EU uncertain, which raises risk and complexity. In Delaware, venture capitalists can have the peace of mind that comes with a stable, predictable legal environment that promotes business growth.
Efficient Formation and Management:
In Delaware, the formation of a venture capital entities can be accomplished efficiently, measured in days or weeks. The state’s Division of Corporations offers expedited services for document filing and other administrative tasks, making the process straightforward and rapid. Furthermore, there are no requirements for directors or shareholders to be residents of Delaware.
In contrast, the UK, with its over-regulation, can pose bureaucratic challenges for venture capital fund formation. Brexit’s repercussions add another layer of uncertainty and potential complexity. The streamlined process in Delaware not only saves time but also reduces the likelihood of mistakes or delays, thus accelerating the timeline to launch.
Global Investor Familiarity and Confidence:
Delaware’s edge lies in the confidence and familiarity that global investors, including Limited Partners (LPs) and General Partners (GPs), have in its jurisdiction. Known for its advanced corporate law and the prestige of its courts, Delaware’s reputation instills comfort among international fund managers and investors. These stakeholders are well-acquainted with Delaware’s legal structures and governance norms, reducing due diligence efforts and fostering trust in investments and fund setups.
In comparison, the fluctuating regulatory climate in Europe, the UK, and traditional tax havens can introduce discomfort and uncertainty, deterring the establishment of new venture capital funds. Delaware’s consistent environment offers a contrasting sense of stability, helping both LPs and GPs concentrate on strategic investments that encourage growth and innovation.
Prolific Startup Ecosystem:
Delaware is not only a top choice for venture capitalists but is also the preferred location for startups worldwide to incorporate. The ease of incorporation, flexibility of company structure, and strong protection for directors and shareholders make Delaware an appealing choice for ambitious startups. In fact, no other country or region in the world has as many or as high-quality startups as Delaware.
By contrast, regions such as the UK, Europe, and other traditional startup hubs are seeing a decline in their startup ecosystems due to increasing regulations and Brexit-related uncertainties. This contrasts sharply with the steady growth and dynamism of Delaware’s startup scene, further enhancing the state’s appeal as a domicile for venture capital funds.
Tax Appeal of Delaware
Delaware remains a favored choice for foreign General Partners (GPs) and Limited Partners (LPs) considering its significant tax advantages:
- 1. Clear Tax System: Delaware-based funds, typically formed as Limited Partnerships (LPs), enjoy a “pass-through” tax status. This system simplifies tax management for foreign entities, who only deal with tax implications on their personal returns rather than at the entity level.
- 2. Effective for Foreign LPs: The majority of foreign LPs file US tax returns and pay US taxes on their portion of the fund’s income connected with a US trade or business. However, some income types, like capital gains from stock sales, may be exempt under US law or a tax treaty.
- 3. State-Level Tax Savings: Unlike many US states, Delaware does not impose a state-level corporate income tax on entities operating out of state. This exemption translates into considerable savings for foreign GPs and LPs.
The tax system in the US and Delaware, despite misconceptions, is clear and efficient, making it a compelling choice for foreign venture capital firms. The perceived complexity often stems more from unfamiliarity than from the actual intricacy of US tax laws. In reality, tax implications for foreign LPs largely depend on the respective tax treaty between the US and their home country, with certain income types potentially exempt from US taxes under these treaties. It’s important for foreign managers to seek appropriate tax advice to fully grasp the benefits and implications under these treaties. This guidance can help dispel fears related to US tax obligations.
Downsides of Delaware
While Delaware offers numerous advantages, it is important to acknowledge potential downsides when considering it as a domicile for a venture capital firm. Here are a few points to consider:
- 1. Involvement of the IRS: Delaware’s location within the United States means that firms domiciled here are subject to oversight by the Internal Revenue Service (IRS). For some Limited Partners (LPs), particularly those outside of the US, this association could be seen as a potential risk or complexity, as they may wish to avoid potential scrutiny or complexities related to the US tax system.
- 2. US Federal Regulations: Delaware-based firms are obligated to comply with US federal regulations, including the Securities and Exchange Commission (SEC) rules around investor accreditation, ensuring that investors meet specific income or net worth criteria. Firms also need to navigate general solicitation rules, which govern public fundraising activities and require particular attention to avoid regulatory complications.
- 3. Potential for US Legal Disputes: Firms domiciled in Delaware might be more exposed to US legal disputes. The US is often seen as a litigious society, and the potential for lawsuits could be seen as a risk factor by some venture capitalists.
These points underscore the importance of thorough research and professional advice when choosing the best domicile for a venture capital firm. Despite these potential downsides, Delaware’s compelling benefits, including a stable legal environment, efficient fund formation, and global investor confidence, continue to make it a favored choice for many venture capitalists.
Exceptions to Delaware
While Delaware is an attractive option for most venture capital funds, certain circumstances and specific regional considerations might make other jurisdictions more suitable:
- 1. Canadian Funds – Ontario: The tax treaty between the US and Canada creates incentives for Canadians to domicile in Canada. Ontario has the best legal and administrative talent in Canada to run funds professionally.
- 2. Cryptocurrency Funds – British Virgin Islands (BVI): For funds focusing on cryptocurrency, the British Virgin Islands (BVI) is the most cost effective and regulatory friendly domicile, versus the US, which is hostile. BVI supports having funds with multiple assets types, such as crypto currencies, and funds in BVI can use vendors from other sanctioned domiciles, opening up the talent pool.
- 3. Home Country Option – Europe or Israel: If all portfolio companies and all Limited Partners (LPs) are located within the same European country or in Israel, it can make sense for a venture capital fund to domicile in the manager’s home country. While the EU regulations are excessive, some individual EU countries have favorable regulatory regimes for local funds. There are some tax advantages in Israel.
- 4. Government Restrictions – Singapore: For venture capitalists based in Singapore, local regulations necessitate getting the appropriate licenses and domiciling funds in the city-state. Unless the General Partner (GP) chooses to move, Singaporean funds typically stay within the country, and the minimum practical fund size must be larger to cover the regulatory costs.
These exceptions underscore the point that while Delaware is often a top choice, the optimal domicile for a venture capital fund can vary depending on a range of factors, including the fund’s specific focus, the location of its LPs and investments, and the GP’s personal circumstances. Regardless of jurisdiction, the goal remains the same: to create an environment that supports the fund’s operations and growth while providing clarity and protection for all stakeholders.
Myth of Popular Domiciles
Certain jurisdictions have built a strong brand reputation over time as attractive domiciles for venture capital firms, including the United Kingdom, Luxembourg, and the Cayman Islands to name a few. However, in the face of regulatory changes and evolving market dynamics, these previously top domiciles are no longer viable for new managers.
- 1. United Kingdom: Known for its robust financial sector and strong regulatory framework, the UK has long been a popular choice for domiciling venture capital funds. However, the aftermath of Brexit has introduced a level of complexity and uncertainty, affecting the country’s appeal. Furthermore, the UK’s regulations have become more stringent, slowing down the process of setting up funds and making it more expensive.
- 2. Luxembourg: Luxembourg’s strong financial services sector and favorable tax laws have traditionally made it an attractive domicile. However, recent regulatory changes have increased the cost and complexity of establishing and managing funds in the country. These regulatory burdens have made Luxembourg less competitive compared to more streamlined and cost-effective jurisdictions like Delaware.
- 3. Cayman Islands: The Cayman Islands have long been favored for their tax advantages and relative ease of setting up a fund. However, the tightening of Anti-Money Laundering (AML) and Know Your Customer (KYC) regulations has increased costs and slowed down the setup process. As a result, the Caymans are no longer as cost-effective or as efficient as they once were.
Despite their brand reputation, these jurisdictions are facing an uphill battle to maintain their attractiveness in the light of regulatory shifts and market trends. Their rising costs, slower processes, and increased complexity underscore the importance of considering a range of factors, beyond reputation, when choosing a domicile for a venture capital fund. These changing dynamics have given rise to more efficient and cost-effective alternatives, with Delaware leading the way.
Conclusion
To conclude, Delaware, with its unique blend of regulatory clarity, cost-effectiveness, swift fund formation, and access to resources, makes it the domicile of choice for setting up new venture capital funds. In a global landscape marked by increased regulations, isolationism, and heightened costs, the First State is a beacon for venture capitalists. Over 60% of new managers worldwide are choosing Delaware to domicile, and this is growing.