The Entrepreneur’s Guide to Incorporation
Incorporation is a very important step in running your business, as it’s the moment when your business becomes realized as a legal entity. The implications of incorporation are far reaching, so it’s important to have a complete understanding of what type of entity you want to file under and ensure that you’ve done all your research to know what forms and information you need.
What are the benefits to incorporation?
- Business and personal finances are legally separated: if your business is sued or goes into debt, neither yourself, your shareholders or directors are personally liable.
- Transferability of ownership or shares: company ownership can be more easily transferred as owners’ rights and privileges are now represented by the shares of stock he/she holds.
- Taxation benefits: generally, businesses are taxed much lower than individuals.
- Ability to raise external capital: company stock can be easily transferred and sold to new investors.
- Protection of business’ lifespan: unlike some other business types, the life of a corporation is held separately from the life of the owner. If something were to happen to a business owner, the business can continue to operate and run indefinitely.
- Access to business resources: You can get easier access to retirement resources like 401Ks, etc.
When does it not make sense to incorporate?
There are a lot of opinions on when to incorporate and when not to incorporate. If your startup is still in the idea phase and you don’t need a business bank account yet, it may be a good idea to wait so that you make the right decisions when it comes to incorporation. That being said, it’s better to incorporate earlier rather than later in the business development process in order to protect your intellectual property and ensure people are signing confidentiality agreements, etc.
Startup Lawyer provides an excellent decision matrix for this which analyzes and weighs various aspects of your business arrangement, such as number of founders, risk for lawsuit, hiring plans, stock options and more, and then lets you know if you can wait or not. Startup Company Lawyer is another great resource. If you plan on putting your business through an incubator or startup accelerator, check your legal recommendations prior to incorporating.
What type of corporation should a business file as?
When choosing between incorporating as an LLC, C-corp, or S-corp, the key consideration at stake is the tax treatment of each entity. A C-corp is subject to “double taxation” which means that every dollar earned by a C-corp is subject to tax at the corporate and shareholder level. Conversely, LLCs and S-corps are referred to as “pass through” entities and are generally only taxed at the shareholder level. So all companies should file as LLCs or S-corps then, right? No, not necessarily. In fact, most technology and life sciences companies file as C-corps. Most startups won’t generate any revenue for an extended period of time, and when they do begin generating revenue, it is typically reinvested back into the business rather than distributed to the owners. In this case, there is no “double taxation” occurring. Full-time founders don’t usually have other income that can be offset against their business losses.
If you are a startup looking to receive any venture investment, it’s generally best to file as a C-corp. LLCs have certain tax implications which deter (and in some cases prevent) venture capitalists from investing. S-corps can’t have more than one class of stock which is problematic for VC investors, because they typically require preferred stock. Additionally, VCs are considered legal entities themselves, and S-corp shareholders must be U.S. citizens or residents and “natural persons.” If you are looking for a more comprehensive explanation, Startup Law Blog does an excellent job of breaking it down further.
Where should a business incorporate?
As a rule of thumb, most small/medium sized businesses that have less than five shareholders or members (i.e. no outside capital) should incorporate in the state where their business is physically located. If you are relying on external capital; however, it’s best to incorporate in Delaware. The state offers many advantages over other states (and has done so for years), and according to WilmerHale, “because so many other companies are incorporated in Delaware, lawyers, directors, investors and future acquirers of your business will all have a solid understanding of the laws governing your company, which makes it easier, more efficient and more comfortable for them to do business with your company (e.g., serve on your board or invest in/buy your company).”
What do businesses need to incorporate?
Your business will need a name, a registered company address and the name/personal details of at least one company director. You will also need details of the other founding shareholders or directors and clarity on your allocation of shares. Your board of directors should be created based on the founder structure and any outside advisors or investors. Once incorporated, they are legally bound to act in the best interest of the business.
For determining the allocation of shares, you will need to authorize a certain number of shares of common stock, as well as the par value of the common stock depending on the valuation of your business (at the time of raising capital). You will want to quickly have the conversation of how to split the equity between founders, and when and how it is issued further to other members of the team. We would recommend that all founders follow a vesting schedule, meaning when a founder can begin to exercise their stock options. The typical vesting schedule for startups is four years with a one-year cliff. After the founder’s one-year anniversary, each of the founders can vest 25 percent of the of their total shares, typically monthly after the cliff.
As always, consult with a lawyer (and an accountant, too) once you’re serious about incorporation. They can then help you draft and file all the necessary paperwork and forms.