As a founder, you will be faced with a multitude of important decisions. The first is to choose which legal structure is the best fit for your startup.
There are multiple ways to incorporate, each with its advantages and disadvantages. There’s one business type, though, a C-Corporation, that’s almost always the right choice for tech startups. It’s best to establish the C-Corp as early in your company’s life as possible. And while setting it up can seem complicated, there are lots of resources that can help.
Which option is right for you?
The simplest option for business owners who are getting started is to create a sole proprietorship. There’s no registration process or application to fill out, although you may want to pay a small fee to get a DBA (“doing business as”) certificate, which reserves the rights to a particular company name. (Note that once you register a name for your business, it’s a hassle to change it.)
If you’re working by yourself—say, coding prototypes—this is a fine option, says David Raynor, founder of Accelerate Legal, a San Francisco law-firm that caters its services to tech startups. “But the minute you have two people, there are problems, like who owns the intellectual property?”
Another common company structure is an LLC, or Limited Liability Company. An LLC is advantageous for several reasons: The cost is relatively low, you record the company’s financial results in your personal tax filing, and, as the name suggests, owners of an LLC are not personally liable for the company’s debts and legal obligations. The same is true for an S Corporation, or S-Corp.
“Most startups incorporate as a C-Corp”
And yet, most startups incorporate as a C-Corp, the same structure used by Apple, Google and pretty much every large company in the United States. A C-Corp is a fully separate legal entity, responsible for paying corporate taxes and for issuing annual reports. It must also appoint a board of directors. It will probably seem like more structure than you need when you’re just starting. But if you plan to raise money, as is likely, a C-Corp is the only right answer.
Why investors favor C-Corporations
There’s one big reason why nearly every venture-backed company registers as a C-Corp: Your investors are likely to demand it. That’s because the “pass-through” tax status of an LLC or an S-Corp means they would have to pay taxes on their share of your company’s profits. That’s an administrative headache most investors won’t want to take on.
The S-Corp’s and LLC’s requirement that each owner file a separate tax form that documents the income realized from the company is “a huge turn-off for venture capitalists,” says Drew Amerson, director of LexLab, an incubator at UC Hastings College of Law.
“Becoming a C-Corp also opens up more avenues for fundraising”
Becoming a C-Corp also opens up more avenues for fundraising. For example, LLCs and S-Corps can’t have more than 100 shareholders or any foreign shareholders, and they can’t take equity investments from other companies.
The benefits of incorporating in Delaware
As a separate legal entity with many of the legal rights of a person, a C-Corp can also choose to incorporate in Delaware. More than 66% of Fortune 500 companies have chosen to incorporate there, because of the various advantages the state offers.
For starters, business disputes involving a Delaware C-Corp are handled in a separate Chancery Court, where cases are handled exclusively by judges, rather than juries. The judges are experts in corporate law and typically rule on cases faster and more efficiently than elsewhere. What’s more, Delaware’s state laws are business-friendly and flexible. (One small example: Delaware companies can have as many directors on their board they’d like, whether it’s one, two or forty, says Raynor. Compare that to California law, for example, which requires a company with two shareholders to have at least two directors and a company with three or more shareholders to have at least three.)
“Elements of Delaware business law have been adopted throughout the world”
Elements of Delaware business law have been adopted throughout the world, and many foreign companies have chosen to incorporate there. As a result, corporate lawyers virtually everywhere will know the law well.
While Delaware is not a “tax haven,” there can be some tax advantages to being incorporated there. If your company doesn’t do business in Delaware, you won’t need to pay state corporate taxes. Similarly, equity owned by people that don’t reside in Delaware is not subject to state taxes. Since companies are still on the hook for taxes in the state where they are based, these advantages essentially eliminate double state taxation. Even so, Delaware companies are required to pay an annual franchise tax to Delaware.
(And no, you don’t have to move your company to Delaware to incorporate there.)
Do you need a lawyer?
Setting up a C-Corp used to require an experienced lawyer, and many entrepreneurs still choose to retain one for various reasons, but it is no longer required. “There’s been a dramatic shift in the last ten years,” says Amerson. You can pick from a bevy of online services that walk you through the paperwork and provide basic guidance at a lower cost.
If you do want to have a lawyer from the get-go, sites such as LawTrades and UpCounsel will help you find an independent lawyer at a reasonable cost. If you want the handholding and fuller range of services from an established firm, try to negotiate a deferred fee arrangement, Amerson suggests. Typically, the firm agrees to provide some free hours with the understanding that it won’t be paid unless your company reaches some milestone—say, funding of more than $1 million.
Incorporating online: Sorting through the options
There’s also an increasing number of self-help options, which tend to fall into a few different categories.
General-purpose legal-services sites like LegalZoom and RocketLawyer offer basic, one-size-fits-all tools for a monthly subscription, including premium packages with online or live access to lawyers. The tools are designed to satisfy the broadest range of companies possible, which means they aren’t as focused on the specific needs of technology startups as other alternatives.
“Some newer services are targeted specifically at tech companies”
Some newer services are targeted specifically at tech companies. Clerky, which was founded by former startup lawyers, offers tools to help with hiring and fundraising, and can forward your incorporation documents to a lawyer for review. Stripe-Atlas is an increasingly popular option that, for a low fee, helps you incorporate your company, set up a bank account, issue founders shares, and sets you up to receive credit card payments online.
Many leading Silicon Valley law firms have also created sites featuring advice, documents and other services, for a variety of needs, such as the need to raise a seed round. Cooley LLC has CooleyGo, WilmerHale has Launch and Wilson Sonsini Goodrich Rosati has Whiteboard. These resources are usually free.
And for dedicated DIYers, Docracy is essentially an open-source library of legal documents—a sort of GitHub of legal forms.
“In many states, the Bar Association offers limited free appointments with expert lawyers”
If you want a lawyer to give you a one-time read through of your final paperwork or spend an hour advising you about the pluses and minuses of your particular situation, in many states, the Bar Association offers limited pro bono (free) appointments with expert lawyers.
With the countless decisions you’ll need to make as a first-time founder, how to incorporate should be one of the easier ones. Register as a C-Corp and get as much help as you need with the paperwork. It will be worth it sooner than you think.
For many founders, the only thing worse than paperwork is paperwork they don’t understand. Figuring out how to incorporate is the quintessential example: There are lots of structures to choose from, forms to file with regulators and distinctions that are hard for a non-lawyer to parse.
It isn’t as complex as it might seem. Most founders and their tech startups should follow the same playbook. And increasingly, there are online services and low-cost options to help. Here’s what you need to get started.
Visit Startup Insights for more on what you need to know at each stage of your startup’s early life: