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When should I incorporate my startup?
There's no one single answer to this question — some people incorporate soon after coming up with an idea for a new startup, while others don't incorporate until they have an investor waiting to wire funds. To help you determine what's best for you, we've put together a list of the most common factors startups consider.
If you have co-founders, you'll want to make sure that the intellectual property they create is owned by the company. Many startups decide to incorporate when their founders start creating significant intellectual property.
In addition, incorporation is the first step toward being able to divide equity amongst the founders. If you're working with co-founders, there can be circumstances where you'd want to finalize the equity split and make sure everyone's shares are subject to vesting before moving forward.
As mentioned above, nearly all startup investors will require your startup to be incorporated before they'll invest. If you've lined up investors, you may need to incorporate urgently.
Some people say that incorporating ahead of fundraising can help your startup look more professional to investors. However, this isn't much of a factor for experienced early-stage startup investors. It could be a factor for investors less experienced with early-stage startups.
That said, it can still be a good idea to incorporate ahead of fundraising in order to minimize the delay between when you get a commitment from an investor and when you can receive their investment. The more time that elapses, the greater chance an investor will change their mind.
Some startup attorneys have concerns that if founders purchase their shares right before a financing, the fair market value of those shares may be higher due to the imminent financing. These startup attorneys advise startups to incorporate as soon as possible in order to avoid any possible questions about the fair market value. However, other startup attorneys argue that the fair market of the shares sold to founders at formation is still likely at or near par value, even if a financing occurs shortly afterwards. These startup attorneys point out that investors don't want to invest in an empty corporation, they want to invest in a corporation run by the founders and that owns the intellectual property created by the founders. The corporation is arguably not run by the founders until they purchase shares and appoint themselves as officers. In addition, any intellectual property developed by the founders won't belong to the corporation until the founders transfer it, which typically happens when they purchase their shares.
If you're hiring employees, consultants, or advisors, you may find it helpful to have a corporation in order to be able to issue equity compensation. Employees may find it unsettling to work for a business that doesn't have a registered legal entity yet. Finally, startups typically spend a fair bit of time setting up payroll and state tax registrations in order to be able to pay employees and consultants. You may be able to do that without incorporating, but you'll likely need to redo everything when you do incorporate.
Once your startup begins having customers, the risk of liability increases. If the startup hasn't incorporated, the founders may be personally liable. This means you could lose your savings, house, etc. if someone sues you and wins. For this reason, many startups decide to incorporate immediately prior to launching their first product or after they've acquired some initial customers.
Entering Into Agreements
If you're entering into legal agreements with other people (including with employees or consultants), you may want to incorporate in order to have the corporation bound to the agreements. This will help you avoid personal liability if there is ever a dispute about the agreement. In addition, service providers and other businesses may take your startup more seriously if it's been incorporated.
Unusual Liability Risks
Most startups won't incur much liability prior to having customers or entering into legal agreements. However, it's possible that some aspect of your startup's research or development may be riskier than normal from a liability standpoint. For example, if your startup is building rockets, its research and development might carry a risk of injuring others. If this is the case, you may want to incorporate sooner than later.
Some founders who have picked a name for their startup decide to incorporate sooner than later in order to secure the corporate name before someone else takes it. This is more of a minor factor though, because you can always pick another name if you need to. You can also reserve a corporate name in Delaware for 120 days, although this requires a fee and complicates the incorporation process.
In some circumstances, an employer may have a claim to intellectual property you develop while employed. This can depend on a variety of factors including state laws, the nature of the IP, how the IP was developed, and your contractual obligations with your employer. In order to determine with certainty whether this will be an issue, you should consult an experienced attorney.
Because of this, some startup attorneys advise trying to wait until all founders have left their current employers before incorporating, so that the corporation's paperwork doesn't overlap with your prior employment. This may make it less likely that investors or acquirers will have questions about whether a former employer has a claim to your startup's intellectual property. It's worth noting that waiting to incorporate may only affect the likelihood of a claim, as opposed to the validity of a claim; the date of incorporation doesn't change when the IP was first developed.
If you must work on your startup while employed elsewhere, most startup attorneys would recommend that you don't use your employer's equipment, time, or resources (including office space, electricity, internet, etc.).
Some founders find it advantageous to incorporate sooner than later in order to be able to issue shares to themselves and start the capital gains holding period as soon as possible.
If you sell the shares you own in your startup at some point, the difference between what you paid for them and what you get from the buyer will be taxable as capital gains. If you hold your shares for at least a year before selling them, your capital gains will be eligible to be treated as long-term capital gains, which come with a lower tax rate. And if you hold your shares for at least five years before selling them, you might be able to avoid taxes on up to $10 million of capital gains through QSBS.