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If you are working on a startup, one of the hardest early decisions you will make is when to incorporate your company. Incorporation, when done properly, will cost money, which is why too many companies either do it wrong to avoid the expense, or put off the incorporation as long as possible. The issues are complex enough, however, that you should hire an attorney rather than just go try to do it yourself. The attorney should be knowledgeable about issues like choice of entity, jurisdiction, number of shares, par value, vesting, buy-sell provisions, and the 83(b) election. Setting up an LLC when you need a C corporation will just delay funding later and necessitate spending more money to convert the LLC into a corporation.
What are some of the factors to consider in deciding whether to incorporate your company now, rather than waiting until just before receiving funding from an angel investor or venture capital fund?
Do you have more than one founder? If so, there are bound to be differences about how the equity should be split. When you wait to incorporate the company, you run the risk that you won’t be able to resolve the differences, putting the entire venture in jeopardy. Incorporating sooner allows you to address these issues quickly, before a lot of work is done, and will help avoid painful disputes in case one founder leaves. One more plug for hiring a lawyer – typical DIY stockholder agreements won’t include vesting and buyout provisions, which means a founder might depart with all of his or her shares fully vested, and the company will not have a mechanism for repurchasing those shares.
Are you creating intellectual property? If you are, and there is more than one founder, you will want to incorporate sooner and assign that IP to the company. If you don’t, and a founder leaves without assigning the IP she has created to the company, there will be a dispute over who has the right to the IP.
Are you hiring employees and/or using independent contractors? If you are hiring employees, you will want the incorporated company to be the employer. If you are using independent contractors, you will want them to enter into agreements with the company, not with you as an individual. One of the key advantages of a corporation is to limit your personal liability. Take advantage of it. Also, if the contractor is developing IP for the startup, he should assign it to the incorporated company, not to an individual founder.
Do you need to issue stock or stock options? If you have employees or advisors, you will want to compensate them somehow, but many startups simply don’t have the cash available. By incorporating, you can issue stock options or restricted stock, rather than relying on agreements (between you as an individual and the employee/advisor) to make the grants after incorporation.
Starting the clock on the capital gains holding period. Suppose you develop a hit website or mobile app and accept a lucrative buyout offer shortly after launching. If you’ve held that stock for more than one year, then your capital gains tax rate is 15% if you are in the 25% to 35% tax brackets (and 0% if you are in the 10% to 15% tax brackets). If you haven’t held the stock for more than one year, you don’t get the benefit of long-term capital gains tax treatment, and you will pay at the higher ordinary income tax rate. The earlier you incorporate and issue company stock, the better your chances for getting long-term capital gains treatment.
Are you seeking angel/VC funding? When you seek funding from angel investors or venture capital funds, you will need the right entity to take the investment. I generally recommend pricing the founders stock at nominal prices when incorporating the company. When you incorporate just in advance of a Series A investment, it’s hard to explain why the common stock is priced at $0.0001/share while the Series A preferred is priced at $1.00/share.
As you can see, there are many different considerations impacting the question of when to incorporate. While incorporating properly does involve an outlay of money, there may be significant advantages to spending that money sooner rather than later. Creating the proper structure for your business will help your business grow, and make it easier for you to handle some of the problems many startups face.
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