When do I need to incorporate a company?
July 20, 2009
[It’s been awhile since I wrote anything. I am giving a presentation to some of the founders in TheFunded Founder Institute on incorporating their companies, so I thought I would recycle some thoughts.]
Founders of startup companies often wait to incorporate a company until they are confident that their concept is viable or fundable. At some point, however, an entrepreneur will need to formally incorporate a company. Several reasons exist for taking the step to incorporate.
- More than one founder. If there is more than one founder, the likelihood of an argument about how the equity should be split in the new company increases dramatically. Incorporating a company and issuing stock to the founders will help prevent misunderstandings among the founders about equity splits. Trying to clean up pre-incorporation promises to grant equity in a startup company is a painful task, especially if founders part ways before there are formal documents in place to deal with the situation. Please keep in mind that even if a company is incorporated, founder stock purchase agreements with repurchase rights over unvested stock if founders leave are not included with the documents from typical online incorporation services.
- Creating intellectual property. If there is any IP created and there is more than one founder, then incorporating an entity and assigning IP to the entity is important. Otherwise, if a founder leaves before incorporation and IP has not been assigned to the other founder or an entity, then use of IP created by the former founder may be problematic. Once again, please keep in mind that the documents from typical online incorporation services do not contain IP assignment provisions in connection with the purchase of founders stock or separate IP assignment documents.
- Hiring employees or third party contractors. Although I’ve run into a situation where the former CEO of a Fortune 500 company personally paid an “employee” out of his own pocket for a year prior to incorporation while incubating an idea, most founders will need to incorporate a company if they intend to hire employees. In addition, if an entrepreneur needs to engage third party contractors, it generally makes sense to incorporate a company so that the third party enters into an agreement with a company instead of an individual. In addition, any IP created by the contractor can be assigned to the company instead of an individual founder.
- Issuing stock options. Many entrepreneurs do not have the cash to pay third parties and may partially compensate third parties by granting stock options or giving them the opportunity to purchase equity at nominal prices. Although it is possible to have pre-incorporation agreements to grant equity upon incorporation, it is simply easier to incorporate a company and grant stock options or equity to satisfy these promises.
- Launching a service/product and general liability issues. One important reason for incorporating a company is to protect the stockholders against personal liability. If a company complies with corporate formalities, creditors of the company generally cannot reach the stockholders to satisfy the company’s liabilities. Thus, a company should generally incorporate before launching a product or a service due to potential liability issues, as the risk of liability to a founder increases with customers or users.
- Obtaining visas. If a non-U.S. citizen/non-permanent resident founder intends to work in the U.S. on a startup project, then the founder should work with an immigration attorney on a strategy to legally work in the U.S. Incorporating a company and demonstrating that it is a “real” business with sufficient capital is typically a prerequisite to a visa application.
- Starting capital gains holding period in the event of a stock sale. If a founder sells stock of a company in a taxable transaction and it is held for greater than one year, then the capital gains tax rate is 15% for founders in the 25% tax bracket and higher. These days, it is fairly easy to develop a hit iPhone app or Facebook app and sell a company fairly quickly. I represented a couple of Facebook app companies last year that were sold in taxable transactions. One app was sold by an individual founder and the app was only several months old. Unfortunately, the founder was unable to receive the benefit of long-term capital gain tax treatment on the asset sale (and ended up paying the same tax rate as ordinary income on the sale proceeds). The other app was sold by an individual founder and the app was only several months old, but he had the foresight to incorporate a company more than a year prior to the sale and assign IP to the company. The buyer bought the stock of the company as opposed to the app itself. Thus, even though the app was less than one year old, the shares of stock of the company were held for greater than one year, and qualified for long-term capital gain tax treatment.
- Funding. Obviously, if third party investors want to invest in a startup idea, there needs to be an entity to accept the investment. Generally, I prefer to incorporate and issue founder’s stock at nominal prices well in advance of a Series A preferred stock financing because it is difficult to justify that common stock should be priced at $0.001 per share while Series A preferred stock is issued at $1.00 per share.
Incorporating a company is a serious step that results in out of pocket costs and ongoing tax and other filing obligations. In addition, if a founder still has a day job as an employee of another company, then the founder will need to review the founder’s employment documents carefully in order to determine if there are any issues. The first step in deciding whether to incorporate or not is to discuss the situation with a competent attorney.