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Incorporating your firm has a lot of advantages, including providing personal liability, facilitating the sale and transfer of ownership, establishing a corporate identity, and building credibility. Perhaps you have already assessed the advantages and disadvantages of incorporation and have decided to begin the process. Or perhaps you’re simply unsure of whether or when to incorporate your startup.
We’ll cover the fundamentals of incorporation in this article, bring you through the process step by step, and explain how to get started incorporating your firm.
When To Incorporate?
While you can draw inspiration and guidance from your favorite businesses, do not attempt to imitate anyone else’s formation date. When a business chooses to incorporate, the circumstances are unique. However, there are a few factors that may assist you in identifying the optimal time to incorporate. One is when you’re ready to expand your passion into a full-fledged business. Another instance is when two or more individuals work together. Another instance is when you begin contracting with third parties. If you find yourself in one or more of these situations, it’s time to commit to incorporating and invest the necessary money, time, and effort.
It is substantially easier to incorporate your business early and correctly, avoiding costly mistakes that could derail the operation later. Additionally, this is your chance to select the ideal structure for the startup, one that promotes growth.
Reasons why founders should make startup incorporation
Protection against personal liability
Founders frequently engage in agreements with co-founders, investors, developers, workers, and independent contractors early in the life of a firm. When you incorporate, your corporation assumes the risk of these contracts on your behalf. Reduced risk makes your firm substantially more appealing to investors. A properly structured corporation indemnifies its directors and officers against third-party lawsuits. In a sole proprietorship, for instance, any personal debt or liability of an owner entitles creditors to pursue the business, even though the owner has no connection to the business. In many situations, a corporate director or officer’s finances will be unaffected by third-party claims, and any personal claims brought against a director or officer will not be imputed to the corporation. Additionally, by incorporating, you assure that the business will continue uninterrupted if you leave or die unexpectedly. There are limitations to this, which a lawyer can discuss in greater detail with you based on prior case law and an examination of your formation documents.
Protection against other founders
Incorporation enables you to freely transfer your shares, subject to any restrictions imposed by state law or your stock purchase agreement. If approved, you may transfer your shares freely without obtaining the previous written agreement of all other shareholders. Most startups restrict this transferability to safeguard the corporation and its shareholders against certain share transfers by other shareholders. This is a sort of restriction under which the corporation has the first right of refusal to repurchase the departing founder’s shares in specific situations.
Investors require incorporation before investing
Investors throughout various stages of your startup’s development, from angel investors, to venture capitalists, will invest in your business in exchange for a stake in the company (usually stock or the option to buy it at a discounted rate later on). While you are a vital component of your business, any investor is mainly concerned with the return on their investment in your business. To this end, and for legal and tax purposes, any investor monies received should NOT be put in or mixed with your funds. You must incorporate or establish another type of legal entity to create a bank account in the company’s name, accept investments, and manage the corporation’s financial statements.
Your corporation will possess a venture’s intellectual property
When you, your team, and your contractors continue to develop your idea, whether it’s a new mobile application or an e-commerce site, you’re taking the first steps toward developing your company’s intellectual property (IP) portfolio. Patents, copyrights, trademarks, and trade secrets are all examples of intellectual property. The intellectual property (IP) of your business is what investors, partners, acquirers, other team members, and your users will value. The worth of your company’s intellectual property is frequently what drives the company’s overall valuation higher. If you invest in intellectual property protection and a strategy for developing a strong IP portfolio, your company’s valuation will improve proportionately. If you develop intellectual property before incorporation without completing the necessary measures to transfer it to the corporation, the corporation may not wind up fully owning the IP, resulting in a break in the chain of ownership. This will have a detrimental effect on future investments, collaborations, and acquisitions during the due diligence process. Consider acquiring protection for your IP under the company’s name as soon as possible to avoid a break in the chain of IP rights and title.
When to Incorporate?
Numerous factors can affect the time of incorporation. As a general rule, if you have confirmed your business idea and intend to pursue it seriously, the first order of business should be to form a corporation. Failure to incorporate on time can expose individuals to financial risk, result in the loss of intellectual property rights, and result in missed opportunities to attract people and finance. The following are some common business situations in which an entrepreneur should unquestionably incorporate.
Multiple Founders Involved
If your business has several owners, a compelling justification can be made for incorporating before the owners begin working on the business idea. By adopting bylaws and sharing ownership, you can significantly reduce the likelihood of future misunderstandings and problems. This is critical if one or more founders decide the firm is not for them and leave. It’s also critical to consider whether the founders contribute in uneven ways to the firm, such as one supplying funding while the other provides sweat equity or intellectual property. In other words, the sooner you incorporate, the sooner you can solve these difficult challenges and avert a future calamity.
Need to attract top talent
Many entrepreneurs discover that the most cost-effective method to attract outstanding talent is to provide stock options as an incentive. This cannot be accomplished without incorporation. Employee stock option schemes allow employees to purchase a specified number of company shares at a fixed price that is typically less than the shares’ true worth. This is the model followed by a large number of Silicon Valley firms.
Intellectual Property Protection
Any firm that incorporates any form of intellectual property should immediately incorporate. Intellectual property generated before incorporation is the sole property of the inventor. After incorporation, the startup’s intellectual property becomes its property. Failure to incorporate before the development of distinctive goods, processes, applications, and other creative components might cast doubt on ownership. This ownership issue might result in conflict if the individual who created the intellectual property decides to leave the startup and wishes to retain the intellectual property. Incorporating before the development of intellectual property eliminates the need to resolve ownership disputes, which can be costly and time-consuming.
Need to Hire staff
If your organization is prepared to hire employees or third-party contractors, you should incorporate them immediately. Not only will it be easier to hire them through a corporation, but it will also safeguard your assets from any liability issues with employees, the workplace, or contracts. Additionally, incorporation permits the business to acquire ownership of any intellectual property developed by its workers or contractors while on the job.
Other operational activities
Before entering into any contracts with clients, such as office, equipment, or car leases, or service agreements, the startup should be incorporated. If you are not incorporated, you will engage in those contracts on an individual basis and will be personally liable if you are unable to fulfill them. Additionally, others may view an unincorporated startup as less established and will likely offer you less favorable conditions in exchange for the extra risk associated with dealing with an unsophisticated business. Finally, corporate taxes frequently offer deductions for expenses that are not allowed under individual or unincorporated business tax schemes. Before your business may generate revenue from sales, you must comply with the law and establish a suitable corporate structure.
If you are seeking investment, angel investors, venture capitalists, and other investors will often decline to engage with an unincorporated business. Sole proprietorships and partnerships appear undesirable to investors because they do not allow for the ownership and transfer of shares and do not provide for restricted personal responsibility.
Unincorporated enterprises are not eligible for bank business loans. Any loan would be made to the founders on a personal basis and would be contingent upon the founders’ creditworthiness. To get the loan, the founders may be required to pledge their homes or personal automobiles as collateral.
Types of Startup Incorporation
Essentially, this means that you are your business. The company is formed in your name, and all corporate obligations are funded entirely via your expenses. The benefits of this arrangement are that you have no one else to answer to and that it is quite straightforward. However, there are numerous downsides to combining personal and professional spending, and with a sole proprietorship, you are directly liable for corporate financial troubles. This type of agreement can quickly get complicated, particularly during tax season or in the event of a lawsuit filed against your organization.
Certain sole proprietors elect to register for a DBA, which stands for “doing business as.” A DBA is typically used for marketing purposes rather than for legitimate business goals. Your DBA is an alias that gives your sole proprietorship a more professional appearance.
If you decide to bring in partners, you will need to establish a general partnership, which often entails the execution of some type of official partnership agreement by all partners (usually not requiring a state filing). Additionally, this type of business structure is straightforward and uncomplicated to administer, and joining a partnership enables you to raise capital through the sale of partnership interests.
However, in a general partnership, the border between personal and corporate funds remains blurred, and all partners may find themselves in financial difficulty as a result of a business crisis. Additionally, there is some possibility for confusion regarding the duties, responsibilities, and liabilities of partners.
Limited partnerships are a subset of general partnerships. In a limited partnership, general partners are still responsible for the operation of the business, but investors can purchase a limited partnership interest.
Limited partners are not as ingrained in a corporation as general partners are—the worst-case scenario financially is that they lose their initial investment. Additionally, as a founder, a limited partnership ensures that such partners’ engagement is modest, ensuring that you retain control of your organization. Having said that, entrepreneurs are often opposed to this type of business due to the lack of built-in security for entrepreneurs.
Limited liability companies (LLC)
These types of businesses have a more established legal structure, which provides some liability protection. Finally, a framework exists that segregates your assets from your business’s debts. Additionally, while an LLC’s activities are governed by an agreement, there is no buy-sell provision, which might create complications if all members do not contribute equally to the organization. LLCs are not required to have boards of directors, hold annual meetings, or keep minutes.
There is no restriction on the number of members in an LLC, and ownership can be divided into several classes, which provides entrepreneurs with some flexibility when raising equity financing. An LLC makes appropriate if your business is just at the point of development where it can attract angel investors but not venture capitalists (i.e. you are expecting that your business will generate losses). Angel investors will be driven by the possibility of tax losses; venture capitalists will not. Venture capitalists continue to prefer owning equity in a firm over membership interests.
If your business is in its infancy (particularly pre-revenue) and your sights are set on venture financing, forming a C corporation makes sense. Venture capitalists are at ease investing in this type of business. Additionally, there are additional benefits to this type of business beyond finance, such as a separation of debts, taxes, and legal structure from your assets.
C corporation adds another layer of organization, such as the requirement to hold yearly meetings and keep minutes. The potential disadvantage is that the C corp gets taxed on its corporate profits, but since you’re just getting started, you’re unlikely to have any profits to tax, so this isn’t a significant issue.
Without going into detail, S corporations are so named due to the way they utilize Subchapter S of the federal internal revenue law, which exempts them from corporate income tax (at the federal and state level).
This is a fantastic option if you are OK with a small number of stockholders but require liability protection. An S corporation separates your assets from the debts of your business and gives some tax advantages (which may not be significant if your business is in its infancy and not producing any money). S corporations are not the best structure for raising venture capital because they are limited to a single class of stock, preventing you from undertaking repeated financings.
It is possible to convert your firm into another corporation in the future, so do not be overly concerned about being locked into your decision. Having said that, it’s critical to sit down and evaluate your financial objectives and goals (along with possibly meeting with a lawyer or finance professional) to identify which business structure will be most advantageous for your firm at the present.
What documents do you need for startup incorporation?
The primary incorporation documents for a startup that wishes to become a corporation are the following:
- Certificate of incorporation – The certificate of incorporation is an official file with the appropriate Secretary of State that normally includes the company’s name, allowed number of shares, and par value of the shares.
- The action of incorporator – The incorporator’s action is a document signed by the “incorporator” (often the founder of the startup’s lawyer) that adopts the bylaws and names the inaugural board of directors.
- The bylaws – The bylaws are a legal document that establishes the startup’s corporate governance and includes rules and regulations for the internal administration and management of the startup.
- The stock purchase agreements – Stock purchase agreements formalize the issuance of the startup’s shares to the founders and often include vesting provisions.
- Technology assignment agreements – Typically, a technology assignment agreement protects intellectual property established before the incorporation date (more on this below).
- Confidential Information and Inventions Assignment Agreement (CIIAA) – The CIIAA (also known as a private information agreement) is perhaps the most frequently ignored document that is either not completed during incorporation or is never completed at all. A good CIIAA incorporates nondisclosure and nonsolicitation provisions. Additionally, the CIIAA allocates associated patents, domain names, and business plans to the startup. It is the output of the project or venture.
- Board consent – The initial board consent will authorize the issuing of shares to founders as well as other items such as the appointment of the startup’s officers.
How to make your startup incorporation?
The entity, jurisdiction, number of shares to authorize, number of shares to issue, and vesting schedules for founders. These are the primary considerations while incorporating your startup. With these considerations in mind, how do you incorporate them? There are several alternatives available to you:
1. Hire an attorney
Historically, the majority of companies engaged a lawyer to handle the incorporation procedure on their behalf. A good attorney will walk you through the types of decisions discussed above, generate the necessary documents (Certificate of Incorporation, Bylaws, Initial Board Consent, stock purchase agreements, and others), and file your Certificate of Incorporation with Delaware (or another jurisdiction). They will also frequently assist with other details such as obtaining a Federal Employer Identification Number (EIN) and obtaining a State Employer Identification Number (SIN) (a third-party registered within the state who receives correspondence from the state on your behalf).
We recommend that you use UpCounsel to engage an attorney to assist you with business formation, which will cost between $1,000 and $2,000. The formation fee for higher-end law firms is frequently more than $5,000.
2. Do It Yourself
If you’re not willing to spend several thousand dollars on attorneys and are willing to roll up your sleeves, you can incorporate it on your own. However, a word of caution: if you make a mistake with your incorporation, it could result in significant complications down the line, or at the very least make you appear incompetent, so proceed carefully.
- First, apply for Federal Employer Identification Number (EIN).
- Second, establish a required “registered agent.” Harvard Business Services is a popular choice that costs $50 per year. They are not particularly useful and are largely interchangeable, yet you are required to have one.
- You may create all of the documentation for free with Cooley Go’s Delaware Incorporation Generator. Cooley is a globally respected law firm with a thriving startup practice.
- Then, you must fax the Certificate of Incorporation (produced by Cooley Go) and a Filing Memo to the Delaware Division of Corporations at the fax number indicated in the memo. It will set you back $89.
Thus, for $139 and some do-it-yourself elbow grease, you’ve created a Delaware C-Corporation. However, before filing with Delaware, we urge that you consult with someone—an advisor, another founder, or an attorney—to ensure that everything is in order.
3. Stripe Atlas
If you don’t want to spend $1,000+ on legal expenses but lack the financial means to handle it yourself, a fantastic third alternative emerged only last year: Stripe Atlas. Stripe will incorporate your business, arrange for a registered agent, generate your federal EIN, and even open a bank account for you for just $500. That is as simple as it gets.
And voila! You’re all set for your startup incorporation.
From the extensive overview of all the processes and details that are directly involved in the startup incorporation process, an entrepreneur can easily make his way through it. Knowing all of the incorporation types, documentation, the incorporation process, and other related information. However, one thing that is also integral and has an irreplaceable point in this process as well as the product development process, which can a hassle for some startups. What if you’re not sure how exactly your product or service should evolve further on? What if you don’t know which features to include for getting the right attention both from your target audience and investors?
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