When Should I Incorporate?
It isn’t hard or expensive to form a company. An experienced lawyer will charge you a small fee and a few hundred dollars in filing expenses to do the basic work. You may owe some minimal taxes ($800 per year in California). Beyond that, there’s not much to it. So think about how much you care. If you don’t care much, it’s better to form a company and turn your attention back to building your business. That said, the lawyers’ fees, state filing fees and minimum taxes can seem like a lot of money, especially if you’re not sure you’re going to move forward. So I’ll discuss why you might or might not want to do it.
Experienced lawyers and seasoned business people generally advise tech entrepreneurs to form a company before doing much else. For example, take a look at this post by Mark Suster: http://www.bothsidesofthetable.com/2009/08/17/most-common-early-start-up-mistakes.
There are several reasons for this advice.
First, forming a company formalizes ownership arrangements between co-founders. That’s not an issue for the solo entrepreneur, but if you have co-founders, it’s a very bad idea to put off incorporation. Each of you may have a very clear idea of the deal between you. If you never try to write it down, however, you may find out down the line that each person had a very different idea (or are claiming they did). Not only can that deprive some of the co-founders of some or all of their equity, it can also block financings and acquisitions, since potential investors and buyers won’t be able to figure out who they should be dealing with and paying.
Second, forming a corporation allows the founder to grant stock options to early non-founding team members at very low valuations. Once a round of outside investment is on the horizon, tax rules will require a higher valuation of the common stock and, consequently, a higher strike price for employee options. For a bit more information on this topic, you might look at Fred Wilson’s discussion here: http://www.avc.com/a_vc/2010/11/employee-equity-the-option-strike-price.html. If no one is getting equity before the first investment comes in, this is also not a concern.
Finally, forming a company is important because it creates a repository for IP rights that the founder and any employees, contractors or consultants create for the business. This is particularly important if there are multiple founders, since bitter, business-crippling fights can break out over who came up with what. It is also an issue, however, if employees, contractors or consultants will be developing any IP, including logos, graphics and websites. Again, any uncertainty about ownership of your IP can greatly diminish valuation in any financing or sale of the business. In extreme cases, IP ownership can make it impractical to finance or sell an otherwise attractive business.
Most of these problems can be solved by forming a company before starting serious development. On forming the company, the co-founders formally agree (in writing) to contribute whatever IP they have to the corporation at the outset and formally agree (in writing) to an IP assignment/”work for hire” agreement to make sure everything they develop, going forward, belongs to the company. Everyone else who develops IP (including contractors and consultants) signs similar written agreements. The result: When you go to investors for financing, their lawyers can quickly determine that the company they’re investing in has clear title to the IP.
If you decide to put off forming a company you have to be extremely sensitive to any changes that might raise one of these three concerns. For that reason, it is important to be very realistic about your own personality and habits in deciding not to incorporate immediately. Some entrepreneurs are consistently meticulous, methodical and cautious. Many others have a tendency to get enthusiastic as new opportunities come up, focusing on the business and forgetting or putting off the “legal niceties.” Remember that fixing mistakes in this area (if they can be fixed) can take a lot of time, money and effort. Don’t choose a path that you’re not sure you can follow. When in doubt, form your company right away.