Why should you incorporate your business?
You will face this question once you launch your business and start to formalize its structure. We explain below eight reasons why forming a Corporation is an important first step in starting and structuring your business.
The formation of a Corporation establishes a distinct legal entity that is separate from you and the other Stockholders. A Corporation provides your business with formal and well-defined ownership and management structures, which clearly establish the rights, roles, and duties of the owners and managers of the business. A Corporation is owned by its Stockholders, managed by its Board of Directors and operated by its Corporate Officers. When you incorporate your business, the resulting corporate structure will help you manage, evaluate and grow your company.
Here are 8 important reasons why you should incorporate your business:
1. Good Fences Make Good Founders
It is important to know how the business is owned and what the roles and responsibilities of the stakeholders are. The incorporation process often smokes out the personal agendas and hot-button issues of the Founders and serves as a good test to see who your business partners really are and what their egos and motivations are like. Even if you believe that you have a fantastic working relationship with your Co-Founders at the beginning of your new company, it is important to put a solid ownership and management structure in place, because people often change and your business certainly will evolve. For example, Vesting is an important tool to align the Founders’ ownership of the company with the interests of the company.
Check out these blogs to learn more about stock vesting:
2. Improve the Possibility of Raising Money
A properly structured Corporation may help your company to raise money. For example, Investors typically understand the structures and agreements used by Corporations to raise money, which may facilitate the Financing process. In addition, the Corporation provides various ways for your company to be financed, which can be attractive to potential Investors and lenders and the particular Financing bells and whistles that they require. As explained below, Investors also like various features of the Corporation, including the Limited Liability Protection for Stockholders, unlimited life, and ease of ownership transferability. For larger capital requirements, it is important to remember that many Venture Capital and other investment funds cannot invest in legal entities that are not Corporations (such as Limited Liability Companies) given the particular tax requirements of these Investors.
3. Protect Your Personal Assets
A core feature of the Corporation is the limited liability of its Stockholders. If properly structured and maintained, a Corporation can reduce your personal exposure to the Debts, Liabilities, lawsuits and other obligations of the business. With the limited liability feature in place, the Creditors of the Corporation are limited to the Assets of the Corporation for payment and may not collect directly from the Stockholders, even if there are not enough corporate Assets to pay all of the outstanding Debts and Liabilities.
4. Create More Favorable Equity Incentives
The equity incentive or Stock Option Plans used with a Corporation are well-known and often provide more attractive incentives and benefits for employees and other individual service providers than alternative options. For example, employees may have the ability to take advantage of the more favorable tax treatment of Incentive Stock Options, which only are available with Corporations. In addition, a Corporation may have different classes of Capital Stock, which may support lower and more favorable exercise prices and therefore more potential value for the recipients of the equity incentive awards. It typically is easier for employees to understand how equity incentives in a Corporation work. And it is important that employees understand the features and benefits of these instruments so that there will be more opportunity for positive incentives that benefit the Corporation and ultimately them.
5. Unlimited Life
A Corporation does not have a limited term or life and it continues in existence even upon the death of a Stockholder or after other changes in the ownership or equity structure of the Corporation. It is important that a Corporation can continue advancing its business even though its ownership is changing and evolving.
6. Ownership Transferability
Stockholders can transfer their equity ownership without disrupting the operations of the business. A Corporation generally provides the ability to transfer its ownership interests more easily than with other legal entities, which is a favorable feature for Investors who may want or need to transfer their equity positions in the future. This ease of transferability also lessens the administrative burdens of maintaining and managing the ownership structure of the Corporation. For these reasons, a Corporation often is the best legal structure when there will be many owners.
7. Corporate Clarity
The Corporation, especially Delaware Corporations, is governed by a well-developed set of laws, which provides stability to the Corporation and how it is owned and managed. The corporate structure and governance laws also are familiar to Investors, Stockholders, Directors, Officers, and employees, which help facilitate the operation of the Corporation.
8. Financial Benefits
An S-Corporation (or other tax flow-through entity like a Limited Liability Company or LLC) sometimes should be used if the business intends to distribute its earnings right away, thereby avoiding the second level of tax that would otherwise be imposed on a C-Corporation. A tax flow-through entity also may have additional benefits when structured to allow the Stockholders to take advantage of the initial tax losses of the business on their individual returns. An S-Corporation also may serve as an efficient vehicle to manage the payment and distribution of salaries and dividends and the resulting mix of income and employment taxes. If your goal, however, is to build long-term value with your business, then there is an important reason to structure your business as a C-Corporation. When a C-Corporation qualifies as a Qualified Small Business Corporation (not available for an S-Corporation), the shares of Qualified Small Business Stock that you hold for at least five years will receive a significant reduction in the amount of capital gains tax to be paid upon the transfer of such shares.
Incorporating Your Business – Here’s How to Start
You incorporate your business by preparing and filing the Articles of Incorporation (California) or Certificate of Incorporation (Delaware) with the Secretary of State of the corresponding state. There are various other documents that are prepared and/or filed in connection with the Incorporation process, including:
- Action by Incorporator;
- Initial Action of the Board of Directors (in lieu of the first meeting);
- Contribution Agreements;
- Subscription Agreements;
- Stock Ledger;
- Stock Certificates and Receipts;
- Proprietary Information and Invention Assignment Agreements;
- State Securities Law Filings;
- Federal Employer Identification Number;
- Foreign Qualification Document (if the principal operations of the Corporation are in a state other than its state of incorporation);
- Stock Restriction Agreements (and related IRS Section 83(b) Election filings); and
- Other structural and governance documents.
A word to the wise: whether you want to do it yourself or hire someone to help you structure your corporation, you must put the necessary pieces in place when you incorporate your business. It is very important that you prepare the proper foundation for your business in the right way at the start so that you can focus on your business and avoid the distractions and additional costs associated with a premature (and often complicated) rework of your corporate structure.
You should incorporate your business sooner rather than later. By forming the Corporation, you will put a solid ownership and governance structure in place and avoid a situation where one or more Co-Founders start to fall by the wayside (with resulting instability and confusion). If properly structured, the new Corporation will begin to capture and own the “secret sauce” of the business, so that all of the new value of the business will be directed to the Corporation. Conversely, a delay in the corporate formation could subject the Founders of the business to additional personal liability and a breakdown in the team and business opportunity.
Practical tips & next steps:
Below are some practical tips and next steps to consider as you form and operate your new Corporation:
- Invest the necessary time and resources to establish the proper ownership and governance structure for your new business;
- Launch the Corporation with sufficient capital and insurance;
- Pay particular attention to the capitalization and equity structure of your newly formed Corporation (so that you do it right the first time);
- Make sure that the Intellectual Property of the business is assigned to the Corporation;
- Have all of the Founders and other participants sign the documents that are prepared for the incorporation;
- Hold Annual Board and Stockholder Meetings;
- Keep the Corporation’s Assets and records separate from the personal dealings of the Stockholders (no commingling of Assets);
- Make sure that transactions with Stockholders, Directors and/or Officers are commercially reasonable and at arm’s length, with proper corporate approvals and documentation;
- Obtain and document Board and Stockholder approvals for required corporate actions (e.g., the issuance of Securities by the Corporation, etc.); and
- Use the Corporation to enter into contractual and other commercial arrangements and properly sign documents on behalf of the Corporation.
We hope that your new Corporation helps propel your business forward. We’d love to hear about your incorporation experience and the successes and challenges that you have faced along the way.