• December 1, 2015

Tips for Entrepreneurs Incorporating a Business

Tips for Entrepreneurs Incorporating a Business

Incorporating your business is a very important step. It is the moment when your business idea becomes real. There are a lot of opinions on when to incorporate – once you have a solid business plan, once you’ve found co-founders, once you are ready to raise money, etc. Ultimately you should take advice from entrepreneurs and advisors you can trust on timing that fits your style and goals. Here’s a good framework of the benefits and factors to consider:

If you don’t need a bank account, delay incorporating until you feel confident this will become a business. If your startup is still in idea phase, you don’t need to raise money for it yet, and you don’t need a bank account to deposit money you’re making, you should wait until you have a better sense of the direction of the business so that you make the right decisions when it comes to incorporation. Dealing with an incorporated business that is no longer operating can be an unnecessary pain.

The Startup Lawyer pulled together a very useful “When to Incorporate Decision Matrix,” 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.

There are many benefits for businesses that are ready to incorporate.

  • Your business will become a separate legal entity, meaning personal finances and credit ratings are separated from the finances of the business, and owners, shareholders and directors are not personally liable if the business is sued or goes into debt.
  • Company ownership can be more easily and legally transferred, if needed.
  • Generally, businesses are taxed much lower than individuals.
  • You can get easier access to retirement resources like 401ks, etc.
  • And one of the biggest and most popular reasons for incorporating – the ability for owners to sell stock of the business, helping them to raise money for future growth.

Before exploring incorporating, understand rules for accelerators or incubators. If you plan on putting your business through an incubator or startup accelerator, check their legal recommendations prior to incorporating. For instance, TechStars and YCombinator both have their own term sheets. YC even suggests not incorporating if you can wait – “We can probably help any startup that hasn’t already raised a series A round from VCs. Don’t incorporate, though, if you can avoid it. It’s easier to start with our paperwork than to transfer an existing LLC to a corporation.”

Checklist for incorporation: There’s a lot to think about once you know you’re ready to incorporate:

LLC/S corp or C corp? A Limited Liability Company (LLC), also known as an S corporation, is a hybrid business entity having certain characteristics of both a corporation and a partnership or sole proprietorship (depending on how many owners there are). A C corporation, under United States federal income tax law, refers to any corporation that is taxed separately from its owners. The biggest differences come down to taxes – C corps are taxed at the corporate level and the shareholder level, whereas LLCs and S corps are typically only taxed at the shareholder level. LLC owners can also offset personal income from other sources (if you have another job) against other losses from the incorporated business, which can reduce personal taxes.

While C corporations are typically thought of as only appropriate for larger businesses, the double tax consideration typically does not apply for startups as any revenue generated is going right back into the business (versus to owners or shareholders), for years to come. Finally, if you intend on raising capital from venture capital partners, there are many tax limitations placed on a VC’s ability to invest in S corporations. For most startups that need outside capital and are interested in leveraging equity to pay employees & stakeholders, C corporation is right for you.

Where to incorporate? Most companies that rely on external capital to run their business choose 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).”

Create a board of directors. This should be simple 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.

Determine stocks & vesting schedules. You will need to authorize a certain amount 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 4 years with a 1-year cliff. After the founders one year anniversary, each founders can vest 25% of their total shares, typically monthly after the cliff.

Don’t forget to… Get a certified copy of your Certificate of Incorporation. You will also need to apply for a business license at the applicable city or county level. These are the forms that will let you open bank accounts, etc. If you lose them, you will need to order new certified copies – you can’t get by with photocopies so take care of them.

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 paperwork with the Secretary of State and the IRS to get an Employee Identification Number.

They can also help you with a number of other important forms that you won’t be familiar with without their guidance, such as your Stock Purchase Agreements and any paperwork associated with raising outside capital. Refer to our blog on how your legal counsel can break your funding round – it is critical you choose the right lawyer for this important step in your business.

This can be a daunting process, but it’s also incredibly important and a step you can’t avoid. Need help? We can help you find a lawyer and accountant that can walk you through the incorporation process.

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