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Why do startups incorporate?
Startup founders typically incorporate their startup to limit their personal liability, allocate ownership, make recruiting easier, reduce co-founder risk, and raise money from investors. Many startups are either sole proprietorships or partnerships prior to incorporating (even if they don’t know it), but these business structures don’t offer the same protections and opportunities for growth as corporations. As a result, most startup attorneys advise incorporating at some point.
You may be able to get some of these benefits without incorporating by forming a different kind of legal entity instead. However, it’s uncommon for startup attorneys to recommend that. See What about LLCs?.
One of the benefits of having a corporation is that it can protect its founders from personal liability. If someone sues for some harm your corporation caused, you typically won't be personally liable for damages, even if the corporation is liable. This is known as limited liability.
Limited liability is important because the more your startup does, the greater the chances that it'll be sued. If that happens, it's bad enough that your startup may be at risk — you don't want your personal finances to also be in danger.
Limited liability isn't absolute or guaranteed. For example, if you commit crimes as part of doing business, you can be held personally liable. When the limited liability doesn't apply and an individual is held personally liable, it's known as piercing the corporate veil.
Ability to Allocate Ownership
Corporations make it possible to allocate ownership by issuing shares to founders, employees, consultants, advisors, and investors. Ownership of shares helps determine who has control of the startup and how much of the proceeds each person will get if the startup is acquired or IPOs.1 In addition, issuing shares to people helps align their financial interests with the success of the startup.
Ownership also helps determine how dividends are distributed, though it's rare for startups to issue dividends because they typically prefer to reinvest profits in order to optimize for growth.
Startups that have incorporated are able to issue equity compensation (typically after adopting a stock plan), which makes it easier to recruit. Ownership in a startup is often the only opportunity many people will have to acquire generational wealth, so it can be critical when it comes to hiring. Potential employees will also generally feel more confident about an offer from a corporation than one from an individual.
Reduced Co-Founder Risk
Along with allocating ownership, corporations make it easy to reduce co-founder risk with vesting. When a founder's shares are subject to vesting, the corporation has a right to repurchase those shares from that founder if they leave the startup. As founders keep working, the number of shares the corporation can repurchase decreases. This provides a time-tested mechanism for helping make sure departing founders don't end up with an unfair level of ownership. It can also incentivize founders to work through difficulties with each other.
In addition, if you're working on a startup with co-founders and haven't incorporated yet, it's possible that you'll be deemed to have a partnership. Every state has laws governing how partnerships operate, which can lead to surprises when there's a dispute, especially if you didn't realize you had a partnership. Incorporating your startup can be the first step toward making it clear how everything will work between co-founders.
Incorporating can be the first step toward more easily raising money from startup investors. This is because most startup investors generally expect to get stock, or a security convertible into stock, in exchange for funds — and only corporations can issue stock. Startup investors also typically feel more comfortable sending funds to a corporate bank account than a founder's personal bank account.
Incorporating also enables a startup to clearly own intellectual property. This is appealing to startup investors because it ensures that the startup — not the founders — own the IP. Investors don't want a founder to be able to leave with critical intellectual property, which could have serious consequences for the startup.