Don’t want to read? Listen to me talk about this topic instead:
Launching and forming a startup is stressful.
Simple mistakes early on invariably come back to hurt your company.
I have seen this countless times as a startup attorney.
Here’s the problem…
The problem with starting a business is that you don’t know when to take that next step to make it official.
Sometimes, founders will delay incorporation until they hit a wall and/or it’s too late.
It becomes extremely stressful when you are trying to rush around to start and finish incorporation including implementing any advice around the right capital structure, equity distribution, investment terms, IP ownership etc.
Your investors may be waiting on you to complete incorporation before they will fund you.
Your customers may want to pay for services but can’t because the Company’s bank account has not been setup.
You may be negotiating with a potential co-founder or employee but it turns out you can’t give him shares in the company because there is no company!
These time sensitive and critical issues come up in unexpected ways and at unfortunate times – best to take care of them early on and properly.
...one would incorporate their startup after they've started seriously working on a specific idea...
Defective Incorporations kill
An incomplete/defective incorporation is often worse than no incorporation.
A violation of § 351 of the Internal Revenue Code may result in negative tax consequences for founders purchasing stock in the Company.
Similarly, the exemption provided under § 4(a)(2) of the Securities Act may be blown resulting in a securities violation.
These problems are not insurmountable but they do make you look bad/unprofessional if they have not been appropriately addressed.
You should talk to an expert who can help you get ahead of these issues.
Partnering with the right expert can go a long way towards the smooth launch of your startup.
So, how do I decide…?
To help you decide when to incorporate, I have listed a few key factors below:
Co-founders can bring great expertise but co-founder conflict is also one of the biggest reasons for why startups fail.
Litigation that becomes public at a critical time can destroy a company. Even threats of litigation will need to be disclosed to investors.
In order to avoid co-founder conflicts, it is key to discuss equity ownership and technical/non-technical roles that each founder will have upfront.
When co-founders leave, they may be able to take any intellectual property they developed with them.
They may even claim that they own IP that they did not even develop.
They will be able to do so if the Company’s incorporation was done improperly – and you may not even know it!
Incorporation done right can avoid this.
When you can't stop thinking about your idea and it consumes you. Where you've done some research and are ready to quit your job to work on your idea. If you are confused about leaving your job and starting your company, better not to quit yet since the idea isn't fully baked yet.
It ensures that all founders assign any and all intellectual property that they created before or after joining the Company to the Company.
This avoids huge problems down the line.
Without incorporation, a Company’s ownership structure will remain up in the air and open to litigation.
You don’t want a disgruntled co-founder out there claiming that he owns half the Company even though he left a couple of months after joining.
Speak to an expert about setting these up in a way that structures the Company for growth – don’t over-complicate!
You pitched your business idea to a group of angels and the lead wants to fund you next week.
He asks you to send the company bank wire information.
You need a bank account!
You can not expect investors to fund into your personal bank account (advanced: or even into a cryptocurrency wallet not setup with the right smart contract).
Diligent investors will need to hear the following:
As you can imagine, this is a process and the right expert can help you incorporate in a timely manner so you can take investor funds quickly.
As soon as you have co-founders or employees, or take investment—basically, as soon as there are multiple people involved in the company—you should incorporate, and get agreements in place governing the relationship. For co-founders, you need to determine equity split and arrange for vesting. For employees (including co-founders), you need to make sure that IP is assigned to the company. Etc. Do it now, with a good lawyer who knows startups.
Avoid tax problems
The IRS may determine that since the shares were issued to the founders so close to being issued to the new investors, the value of the shares issued to the founders is much higher.
This will result in a greatly increased tax liability for the founders and the Company.
The founders will be deemed to have received a large amount of taxable income when they were issued the shares. This will remain the case even though the founders do not have any cash to pay these taxes!
The Company will also be at risk…
The IRS will determine that since the founders received a large amount of taxable income, the Company should have withheld taxes accordingly. Not doing so may result in penalties.
Incorporating early can prevent the IRS from coming down hard later on.
Hiring employees/consultants can be tricky early on.
You can not keep feeding them biscuits and promises of documents one day.
Any veteran employee will expect to see stock option paperwork and a vesting schedule that properly aligns everyone’s interests.
In order to issue stock options, you will need to incorporate your startup.
Incorporation will create a proper governing structure for your Company i.e. a Board of Directors will oversee the CEO and approve any stock option issuances.
I would suggest that entrepreneurs consider incorporating their startup when they think they have created enough value and to consider incorporating before doing formal seed or venture fund raising.
Employees bring risks too…
As with co-founders, employees bring risks with them.
Employees can also leave and take the IP with them if they have not entered into an agreement ensuring the Company’s ownership of any IP they produce.
Not just the Company’s IP is at risk.
Some bad-actor employees may try and threaten litigation by laying claim to a percentage ownership of the Company’s equity. They may even claim 50-50 co-founder status!
In this day and age, it has become increasingly important to clearly detail the relationship between employees and companies.
Putting in place proper confidential information and invention assignment agreements (CIIAs) and employment/consulting agreements is key to managing these relationships and resolving conflicts.
As you begin to sell your software online or start to ship products, you will need to think about personal liability.
Without incorporation you can not protect yourself from liability arising from your business activities.
Customers may file a complaint against you personally. These complaints can range from causing a burn to allowing critical services to go down for a prolonged period of time.
You want to make it very clear to your customers from the start that they are entering into an agreement with the Company and not you personally.
Your customers may not be the only source of liability…
Competitors may sue you personally for copyright infringement.
Enjoy the protections that a fully incorporated company provides and don’t open yourself up to personal liability.
Let me know in the comments if you have any questions and I’ll feature your questions here!
Q: For real, when should I incorporate?
A: For real, see my summary above! This is serious stuff and if you’re serious about your startup then you’ll follow my advice. Obviously, don’t incorporate when your company is just an idea in your head or if you are a one-man army with no investors in sight.
Q: Should I file an 83(b) election?
A: Yes, if your stock is subject to vesting.
Q: What are the disadvantages of incorporating?
A: Some disadvantages include:
Corporate maintenance (not much)
You may have to stop treating your startup like a hobby
You will have to dissolve the entity if your startup fails
Got a great comment? Let me know and I will feature it here!