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5 Questions (Almost) Every Entrepreneur Asks Us About Incorporation

As you launch your business, you should focus on creating a stable foundation upon which to build your new venture.

In many cases, a Corporation will be the best legal option to put your company on the right path to business funding, growth and success. Now that you have planted the seeds of your business, think of the incorporation of your company as creating the trellis that will support your entrepreneurial beanstalk as it grows and grows until you reach that pot of gold.

If that plan sounds good to you, then pat yourself on the back, because it has been the successful first move of thousands of entrepreneurs who we have assisted over the years.  While every entrepreneurial venture involves its own unique set of circumstances, we continually answer variations of the same five questions from entrepreneurs as they prepare to launch their businesses.

Top 5 FAQs Regarding Incorporation: 

 

1. Which is better, an LLC or a Corporation?

It’s not a case of po-tay-to vs. po-tah-to.

The decision to form an LLC versus a Corporation depends on what you want to accomplish as the founder. Both legal entities offer limited liability protection for the owners (i.e., corporate stockholders and LLC members), but their relative benefits are unique and must be weighed against your goals.

An LLC generally is more suitable for a business model that will not involve raising significant money, issuing stock options or bringing on new team members. For example, this structure is often preferable for consultants, real estate holdings or operating companies that intend to spin out cash to the owners on a regular basis. As pass-through tax entities, LLCs allow members to allocate profits and losses amongst themselves. However, this means that the members are responsible for paying tax on the profits of the LLC on a continuing basis.  Consequently, the operating agreements for LLCs need to include provisions that address adherence to regulations governing these tax distributions, among other important provisions. Before and as you set up an LLC, you should consult with a tax advisor to ensure that an LLC is the most tax efficient vehicle for your business and its owners, currently and in the future in light of your business goals.

In our experience, a corporation generally is better suited for many startups (especially tech and biotech startups), and they often are less expensive than an LLC in the long run. For example, the operating agreement for an LLC seems to require a revision every time you make a change to the business, such as bringing on a new member or issuing ownership equity, which can greatly increase your legal expenses. Changing the ownership structure of a corporation is much more straightforward and efficient, both from a time and cost perspective. In addition to its cost-saving potential, the formation of a C-corporation in particular provides great options for high-growth technology companies where you intend to:

  • Pursue investors and growth capital;
  • Engage employees, consultants and advisors; and
  • Grant stock options and other equity compensation;

C-corporations also may provide a significant potential tax advantage over LLCs. For example, the formation of a C-corporation might help you exclude up to 100% of the capital gain tax imposed upon the future sale of your stock in the corporation, if your company meets the requirements (including holding the stock for at least five years) to qualify as a small business under IRC Section 1202 (also known as “Qualified Small Business Stock”).

2. Where should I incorporate my startup?

Dela – where?

You might assume that you should incorporate in the same state in which your company will do business. While in some cases this might be the best choice, you aren’t limited by geography.

In fact, Delaware is considered the gold standard for incorporation. Why, you might ask? Delaware has well established and comprehensive legal precedence for its corporate laws, which often is attractive to seasoned investors and founders alike, as it provides for more legal certainty. Furthermore, in terms of corporate governance, Delaware corporations only need one director, regardless of the number of stockholders, which initially may give you more control over your company and facilitate more efficient decision-making and corporate governance.

Although we frequently recommend starting with a Delaware corporation, there are certain situations where it may be more beneficial to incorporate in your primary state of business. For example, if you don’t plan to seek funding from outside investors, then you may save some money on state franchise taxes by incorporating in the state where your company will maintain its principal place of business. Obviously, the determination of where to incorporate your business is unique and must be made on a case-by-case basis, but we do not recommend that your decision be based solely on saving a couple hundred bucks a year.

3. How many shares should I issue at incorporation?

Enough for today, as well as tomorrow.

You need to structure your company with an eye toward raising money and granting stock options in the future. This requires a basic understanding of the difference between Authorized Shares and Issued and Outstanding Shares.

Authorized Shares represent the total inventory of shares that are available for issuance by your company as set forth in your corporate charter document (i.e. Certificate of Incorporation in Delaware or Articles of Incorporation in California). Issued and outstanding shares, on the other hand, represent the actual ownership of your company at a given point in time.

It is important that at the start, you authorize a large enough pool of Authorized Shares in your charter in order to accommodate your future plans. We typically authorize 10,000,000 Authorized Shares of Common Stock at the time of incorporation; and, depending on the founders and their equity split, we will issue approximately 2,000,000-4,000,000 of the Authorized Shares to the founders.  As with most of these questions, there is no one-size-fits-all answer and it is important to carefully consider the unique circumstances of your startup and its legal formation.

There are two additional topics that you should consider when issuing shares at the time of incorporation.  Don’t forget about stock vesting, documented with a stock restriction agreement, which helps to keep your key players cultivating the opportunity and providing services to the company for the long term.  You also will need to weigh the pros and cons of introducing a stockholder or buy-sell agreement at incorporation.  Although these agreements are nice to have, they can get complicated and soon may be superseded or replaced if your company raises money from experienced investors.  In light of the potential expense, you should consider skipping a stockholder or buy-sell agreement early on if you plan on seeking funding down the road.

4.  How long will the incorporation process take?

Not long if you do it right.

The time needed to incorporate your business depends on your preparation and willingness to obtain the right help. An experienced startup attorney can incorporate your business quickly, as long as you have ready answers to the various structure, ownership, governance, and vesting questions required for incorporation.

When done properly, the time it takes to incorporate can range from a day to two or more weeks, depending on the number of founders involved and the complexities of the business. Dealing with multiple founders can be like trying to herd cats and the incorporation timing will depend on the founders’ ability to reach agreement on the tough questions, such as the ownership split, contributions, vesting and governance roles.

A word of caution: while DIY incorporation solutions may appear quick and easy, if they are not completed properly, then it is likely that you will need to spend significant time (and expense) in the future to cleanup your corporation and its documentation.

5.  How much is it going to cost?

Remember: You get what you pay for, and you pay for what you get.

Each new company has unique needs that will need to be addressed during incorporation, so it’s difficult to quote an exact price. That said, in most cases, assuming that you are working with experienced and qualified startup counsel, the total price likely will not exceed $2,500, including filing fees and costs. If your company only has one founder, then it should cost less, and if you have more than five founders, then you might pay more depending on the bells and whistles required to bring the founding team and the key assets together for the new company.

Of course, you can always consider cheaper routes, but we strongly advise against it. The form approach of do-it-yourself services like LegalZoom or Gust often fail to address the nuances of incorporation, especially when you are launching a company with significant business prospects or unique situations.  As a result, you might end up with even bigger legal fees when it’s time to grow, and you may need a substantial amount of corporate cleanup in order to attract investors and assure them that your legal and business structures are solid.  The latter is a scenario we see all too often.

Now that you have all the important answers, you know that incorporating provides a solid framework to help you manage and grow your business from those magic beans you planted at the inception of your startup journey.

 

Want to learn more about the incorporation process? Check out these related posts and webinars:

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