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.

Comments

  • http://www.k9ventures.com Manu Kumar

    Yokum, thanks for another great post! EAU (Excellent as Usual) as one of my favorite customers used to say! :)

    You provided a great overview of the reasons to incorporate from a legal point of view, I wanted to chime in with some more subtle, but hopefully useful comments:

    I maintain that the best time to incorporate is 'yesterday' — or as soon as you are 100% sure that you want to give this idea/company a real shot. To me incorporation is a 'show of commitment'. It sets a date and time in stone for the inception of the company, and, it starts the clock running. This has several advantages:
    1) If you are going to be bringing on co-founders or employees, the fact that the company has already been incorporated, and is official, can have an impact on how the equity split gets portioned out.
    2) Incorporating starts the clock on the corporate history — which can often be useful when dealing with customers. For example, when asked, 'How long have you been in business?' you can confidently point to your date of incorporation as the 'start of business.'
    3) The same also applies when having valuation discussions with VCs. If the company hasn't even been incorporated yet, then they are likely to try and push you more on valuation. I'm sure several folks will disagree with this, but I am confident this happens — even if it happens subconsciously.
    4) Likewise, the date of incorporation often plays a role in what portion of the founders' stock is already vested at the time of a venture financing.
    5) Incorporating forces you to start maintaining the books (or so I hope!) and also forces you to learn all the administrative details it takes to run a company. While this isn't something that directly adds value to the company, it is something that needs to be done. The sooner you learn this, the better it is. Doing this from the beginning and keeping things clean will be something you appreciate when you get into due diligence.

    There are of course some disadvantages to incorporating as well:
    1) Cost — even though most law firms will defer some of the legal costs involved, incorporating through a law firm is still an expensive process (deferring is not the same as not charging!)
    2) Administrative overhead — once you incorporate, you are expected to comply with federal and state regulations. So you have to file taxes for the entity every year (Federal Taxes, DE Franchise Tax, California Tax ($800 minimum if I remember right)).

    Tip: If you are thinking of incorporating and it's close to November/December already — WAIT till January! That way you don't have to file all this paperwork for just a month or two of existence! And you'll have a full year ahead of you to find an accountant/tax person to help for tax time.

    But all in all, I say, incorporate as soon as you are sure you want to give this a real shot. Stop hedging, and just do it! :)

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  • http://www.cfowise.com/ Ken Kaufman

    This is a very informative summary of the triggers for incorporating a new business. Great points on capital gains tax treatment, IP protection, and the necessity that more than one owner should be a trigger for formalizing the entity.

    Most entrepreneurs and founders have a lot of questions on the right entity for their business as well as the timing, legal, tax, and operational implications of their entity selection. I appreciate this and the other content on this website to help educate them on these important matters!

  • notalawyer

    In theory, but in reality:
    1. VCs dont care about IP or patents. You have them great. Otherwise don't bother.
    2. LLC can provide liability coverage and pay employees MUCH cheaper.
    3. C corps have double taxation, the last you need when starting out.
    4. You have to have a certain number of employees to even apply for a visa. And for the most part, the quota is filled almost right away.
    5. Funding…sure, but it better be close otherwise you are paying fees, taxes, IRS, registration, services to keep minutes, etc…
    6. Splitting founders — can be handled via LLC or via simple agreement.

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  • http://www.mpba.com/attorney_farris_obrien.php Seattle Business Attorney

    Also having very good legal counsel is key when incorporating. Online legal forms certainly do not cut it these days. Too many traps and omissions with forms.

  • http://www.mpba.com/attorney_farris_obrien.php Seattle Business Attorney

    Also having very good legal counsel is key when incorporating. Online legal forms certainly do not cut it these days. Too many traps and omissions with forms.

  • http://disqus.com Danzr_1

    ` ~ * ” … And most critically and lastly , were you dear soul referring specifically to Zoom.com or to their practices or ilk in general ?

  • newbiefounder

    If only two of the five founders are ivesting cash (all five are investing sweat) ; how should the equity be alloacted? What should be the ratio between cash and sweat?
    Aprreciate any help for our software startup in the northeast.

  • http://www.startupcompanylawyer.com Yokum

    @newbie founder – that's entirely up to the five of you to come up with a rationale that everyone can support.

  • newbiefounder

    Thanks, our principal founder had formed had formed an LLC in New Hampshire for our software product start up company but now we realize that we need to have a C corp. and include all founders in the new incorporation.
    Can we convert it to C Corp in Delaware?
    How do we go about it?

    Regards
    Nawroz

  • http://www.startupcompanylawyer.com Yokum

    @newbie founder – you will need an attorney to convert your LLC to a C corp.

  • assa stefanel

    I am Maria Stefanel from Romania and I am interst to startup a subsidiary in Irak guvernorate Babilon and Dywania. Can you help my?? The mother company is in Romani Sibiu county
    thank you and i am looking for your answer
    maria stefanel

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  • http://twitter.com/netlawman09 netlawman

    The process to incorporate is fairly straightforward.The main steps are acquiring appropriate incorporation forms from the state of your choosing, assembling required documents like corporate bylaws that limit investor liability and submitting forms, documents and required fees. Although the steps are straightforward, business owners seeking to incorporate may seek the assistance of an attorney

  • Omidi

    Hi Yokum, thanks for your comprehensive articles.

    I'm planning to apply for e2 visa so I have to setup c-corp and make investment. Do I have to restructure the corp when I'm raising vc/angel money to reflect new term sheet? Is it ok to use legalzoom.com et al. to keep business setup affordable when applying for visa and then hire a lawyer when raising money, or should I contact a (startup) lawyer from beginning?

  • Matt

    VCs very much care about IP. Ownership of IP is ownership of all the products the business produces. If you can't demonstrate a clean IP chain, you risk not being funded, because the business risks being sued by others with claims over your IP.

    Double taxation does not matter when you're starting because you're not turning a profit.

  • Levensoccer

    I’m a U.S. citizen living in Canada (Landed Immigrant status). Im starting an online biz and thinking of incorporating but worry about being a Director because of U.S. tax obligations. Any idea if there would be an advantage to remaining a sole proprietor in the tax sense? Anyone able to point me to some info on this?