WHEN should you incorporate? The answer is actually also tied to WHY you should incorporate. If your idea is just an idea and you’re happy with keeping it that way with no plans for turning it into a business, then there may not be any need to incorporate at all.
When Should You Incorporate Your Startup?
As soon as you’re ready to materialize your idea and take the next steps in forming a team, building the idea or developing the application, entering into contracts, seeking investor funding, issuing stock options to your employees, advertising, or making a sale, you should consider incorporation. Some non-US residents also choose to incorporate in the United States to satisfy investor visa requirements or attract US investors.
In short, incorporation is one of the EARLIEST steps that a founder should take in launching a startup venture. Note that a stock corporation (C Corporation) may not be the best choice for your specific goals and, if you have any doubts, you should consult an experienced startup lawyer.
Some good reasons for WHY founders should incorporate and do it EARLY:
Incorporation provides protection against personal liability.
Early on in a venture, founders tend to enter into agreements with co-founders, investors, developers, employees, and independent contractors. When you form a corporation, your corporation takes on the risk of these contracts so that you don’t have to. Reducing your business risk will be significantly more attractive to investors. A properly formed corporation provides directors and officers with indemnification against claims from third parties. In a sole proprietorship, by way of example, any personal debt or liability of an owner will allow the creditors to pursue the business, even if there are no ties between the owner and the business itself. A corporate director or officer’s personal finances will not, in many cases, be affected by any third party claims and any personal claims against a director or officer will not be imputed to the corporation. Also, by incorporating, you will ensure that the company will continue without disruption if you depart or suddenly die. There are limitations to this, which a lawyer can explain to you in more detail, based on prior case law and a review of your formation documents.
Protection against other founders and minority shareholders.
Incorporation allows you to freely transfer your shares, pursuant to state law and any restrictions in your stock purchase agreement. If permitted, you may be able to freely transfer your shares without the prior written consent of all the other shareholders. Most startups place restrictions on this transferability to protect the corporation and shareholders from certain share transfers by other shareholders. This right of first refusal is one type of restriction, where the corporation has a priority right to repurchase the departing founder’s shares in certain circumstances.
Investors will require you to incorporate prior to investing in your startup.
Investors at every stage of your startup, from angels to venture capitalists, will invest in your company in exchange for some corporate interest (usually stock or the option to buy it at a discounted rate later on). Although you are an integral part of your company, any investor is most interested in their return on investment in your company. To this end, and for other legal and tax reasons, any investor funds you receive should NOT be deposited in or co-mingled with your personal funds. You will need to incorporate or set up another form of legal entity so that you can open a bank account in the company’s name and proceed to receive investments and maintain the corporation’s financial statements.
Your corporation should own your venture’s intellectual property.
When you, your team, and your contractors continue to turn your idea into reality, whether its an iPhone app or an e-commerce site, you are taking the first steps in building your company’s intellectual property (IP) portfolio. Your IP will include things like patents, copyrights, trademarks, and trade secrets. Your company’s IP is what investors, partners, acquirers, other team members, and your users will perceive as valuable. The value in your company’s IP is often what will increase the company’s valuation as a whole. If you invest in IP protection and a strategy for building a solid IP portfolio, then your company’s valuation will also increase accordingly. If you develop your IP prior to incorporation without taking the necessary steps to assign the IP to the corporation, then the company may not end up owning the IP in full, which may result in a break in the chain of title. This will negatively affect future investments, partnerships, and acquisitions at the due diligence stages. Remember to consider seeking protection for your IP in the company’s name as early as possible so that the chain of IP rights and title are not broken.
Build credibility in your venture.
Corporations are able to use certain designations such as “Inc.” or “Corp.” as a suffix to their names, which may increase your credibility to investors, partners, and users of your products or services, particularly at the earliest stages.