5 Reasons To Incorporate Your Startup As Early As Possible

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5 Reasons To Incorporate Your Startup As Early As Possible

Imagine you’ve spent the past 3 years building a startup from the ground up, watching it grow and become a success. Now imagine that somebody who barely contributed to the project claims to own 30% of the company. This horror story is a reality for many founders who don’t incorporate their startup soon enough.

First-time entrepreneurs often struggle with when to incorporate and formalize equity split between founders. The legal cost of incorporation is often the first major expense founders face, at a time when funds are scarce.

Since the benefits aren’t immediate, it’s easy to delay incorporation. Yet, unlike first-time entrepreneurs, serial entrepreneurs often learn the hard way just how quickly things can get ugly, and eagerly incorporate as early as possible.

To the question “when to incorporate my startup?” the answer is simple: the earlier the better. The shareholder agreements, bylaws and other corporate documents lay the foundations upon which a startup can thrive.

Here are the top five reasons to incorporate your startup sooner rather than later.

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1. Establish Co-Founder Ownership and Avoid Fights Between Founders

Coming to an agreement with co-founders as to equity split is the number one reason to incorporate early.

Once it is agreed upon in writing, it is set in stone. Until that happens, as founders sacrifice Sundays and time with friends and family, every founder is likely to feel entitled to a larger percentage of ownership until the time that a formal agreement is reached.

To avoid misunderstanding and last minute renegotiation, do things right from the get-go by granting stocks (especially restricted stock subject to vesting) at the time of incorporation.

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2. Buy Stocks at a Nominal Price

Founders must generally buy stock in their company at the fair market value. The earlier you are in the business cycle, the less valuable the stock of your company is.

If you incorporate sufficiently early, you may be able to purchase the stocks at a nominal price, such as $.0001 per stock. A nominal purchase price could work because the IRS recognizes that the value attached to startup stocks is inherently uncertain. This doesn’t hold true when founders incorporate after all the intellectual property has been developed and thousands of users are using your product or services.

At that point, the fair market value is no longer nominal.

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3. Avoid Adverse Tax Consequences

Naturally, investors only invest in incorporated entities, but if you wait to find investors to incorporate you will run into valuation problems. While founders usually get a different class of stocks than venture capitalists and angel investors, it is important for founders to buy their stocks at fair value.

If you incorporate just before receiving $300,000 in funding from a seed round while granting stocks to founders on the basis of a $3,000 valuation, you risk receiving a sizable tax bill. Those incorporating too late may have to contribute sizable sums of money to purchase their company stocks only because the company is now valuable.

Similarly, employee stock options cannot be sold at a price below fair market value, so the earlier in the startup’s trajectory they are granted, the cheaper their exercise price can be and the higher the potential for profit becomes.

Note also that if you wish to offer sweat equity to co-founders and/or employees, you must incorporate. Promises to give a percentage ownership in a company yet to be created are inherently uncertain, and difficult to enforce.

Flickr | Taxes

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4. Keep Your Intellectual Property Safe and Sound

The safest course is to start developing intellectual property assets (writing code, building software, app and website and any other proprietary assets) only after incorporation. This way, all intellectual property belongs to the company from the start, which simplifies investors’ due diligence.

Indeed, if only employees of the company developed the intellectual property, the intellectual property chain of title is likely to be clean and easy to track, which is a huge relief to investors.

That said, developing all intellectual property after incorporation is often impractical. While it’s better to keep pre-incorporation development to a minimum, it’s unrealistic to expect that no IP will have been developed by then.

Most of the time, one or two founders have already made substantial efforts if only to establish the viability of their product or service. In such a typical case, the founders should transfer all rights to the startup at the time of incorporation.

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5. Protect Your Personal Liability

Last but not least, as long as corporate formalities are adequately kept and the company is sufficiently capitalized, the shareholders’ personal assets are out of the reach of creditors should things take a turn for the worse.

 

If you sign contracts in your personal name before incorporation, you will likely remain personally on the hook even after forming the company.

It is far safer to enter into substantial contracts only after having incorporated your business.

Image | Shutterstock

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Take Away

Incorporating early is essential for a startup’s capacity to stomach deadly co-founders fights; buy equity at a nominal price; minimize adverse tax consequences; keep intellectual property safe; and avoid personal liability.

The early stage incorporation documents are the foundations that enable startups to withstand the inevitable twists and turns that are the pulse of startup life.

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