When is the Right Time to Incorporate Your Business?
Many entrepreneurs wait too long before setting up their corporation and formalizing the structure of their business.
This video explains some of the key reasons why you should incorporate sooner rather than later – Don’t wait to incorporate!
When should you incorporate your business?
When starting your new company, I recommend that you don’t wait to incorporate for the following reasons:
First, if your company is going to raise money, then you need to have a legal structure in place so that you can receive the investment financing from the investors. A corporation allows you to do this. The corporation receives the investment financing from the investors; and in exchange for the money received, the corporation issues shares to the investors and these shares represents the ownership positions that the investors initially will have in your company.
Team of Founders
Next, if you have a team of founders coming together, then the corporation will help define the roles, responsibilities and ownership stakes of the founding team. For example, the corporation will help determine who will be on the board of directors and who will be the officers of the corporation, including the specific officer positions that they will have.
Setting up the corporation also provides the opportunity to set up stock repurchase arrangements, so that the founders more likely will row the boat together and contribute to the company as initially planned. With a stock repurchase arrangement in place, if one of the founders decides to leave the company and stops contributing to the advancement of the company, then there are contractual structures in place so that the company can buy back some or all of the shares that the departing founder originally received.
Also, by setting up a corporation, you prevent the situation of the forgotten founder. Imagine five founders coming together and, before they incorporate the new business, one of the founders decides to leave the team. The departing founder may take some of the intellectual property, or may decide to use the business plan and intellectual property to set up a competing company or use the business plan or intellectual property for some other purpose. Without having a formal legal structure in place such as a corporation, there may not be too much that the other founders can do about this forgotten founder that decides to leave the company.
If your company is going to create valuable intellectual property, then setting up a corporation will help the company capture and collect the intellectual property, trade secrets and other “secret sauce“ or “valuable stuff” of your company – both at the startup stage when the founders assign all of the IP and business plan into the company and as the company advances.
Employees and Consultants
If your company is going to hire employees and consultants, then the corporation should be the legal person or entity that is hiring and firing these people. You individually and personally should not be on the hook for these activities. Imagine, for example, that an employment relationship goes sideways. In these situations, it is much better to have the corporation with its insurance handling the resulting termination or separation situation, rather than you individually and personally being on the hook for any related fallout from that employment relationship.
Also, reinforcing the point raised about intellectual property, after setting up a corporation, the company can enter into contractual relationships with the employees and consultants, using proprietary information and invention assignment agreements, for example, where the employees and consultants agree to assign all inventions, trade secrets and other IP created back into the company. By collecting and capturing these inventions, trade secrets and intellectual property, the value of the corporation will increase over time.
Related to employees and consultants, if the company needs to set up equity or stock incentives in order to attract the proper talent for the business, then you will need to have a corporation set up in order to do so. Many startups do not have sufficient cash and they need to supplement the cash compensation by offering to employees and consultants extra equity incentives. So, if you plan to grant equity incentives to employees and consultants, then you will need to set up a corporation.
A corporation should be the party that enters into important third-party relationships, whether with a landlord, supplier, vendor or customer. You will want to have the corporation as the legal entity that enters into these relationships in large part so that you can limit the personal liability that you and the other stockholders otherwise would have without a corporation. If something goes wrong, then the corporation is in place and has to deal with the resulting issues issue, and in most cases you will not be personally liable for related business expenses and other liabilities that may result.
Start the Capital Gains Clock
By setting up the corporation earlier, you will receive stock in the corporation sooner and the capital gains clock will start to run. Both for capital gains treatment and, if applicable, qualified small business stock treatment, when you sell your stock in the future, either in an individual stock sale or as part of the sale of the entire company, you will get a much better financial return upon the sale of the stock by receiving the stock early on and making sure that you hold it for the necessary holding periods.
So, for the above important reasons we recommend that you don’t wait to incorporate. Set up that corporation and start moving ahead with your business.