Startup incorporation: Choosing the right corporate structure for tech and life sciences

As a startup founder, you will be faced with a multitude of important decisions. One of the first is to choose which legal structure is the best fit for your startup. This decision is particularly significant for tech and life sciences startups, as it can impact everything from your ability to raise capital to how you protect your IP.

There are multiple ways to incorporate, each with its advantages and disadvantages. Before deciding, you’ll need a basic understanding of the types of incorporation to consider. Let's explore the five main business structures available, and then we'll discuss which options are typically best suited for tech and life sciences startups.

Five types of corporations

There are five general types of corporations in the United States: a sole proprietorship, a general partnership, a Limited Liability Company (LLC), an S Corporation (S-Corp) and a C Corporation (C-Corp). Each structure has its own advantages and is suited to different business needs and goals, particularly for tech and life sciences startups.

1. Sole proprietorship
The simplest option for small business owners who are getting started without VC funding is to create a sole proprietorship. A sole proprietorship is an unincorporated business that is owned and operated by one person. 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. The DBA document reserves your rights to a particular company name. However, once you register a name for your business, it’s a hassle to change it.

Although simple, a sole proprietorship does have its downsides. For example, many commercial banks, including Silicon Valley Bank, won’t be able to open accounts for you. And 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?” Raynor warns. At this point it may be wise to consider a different type of legal entity. Likewise, if you decide to seek VC funding you’ll need to incorporate.

2. General partnership
All partners share equal responsibility for the business's debts and operations. 

• Limited Partnership (LP): Includes both general partners who manage the business and limited partners who are passive investors.
• Limited Liability Partnership (LLP): Offers some liability protection to all partners, often used by professional services firms.

Partnerships can be attractive for their simplicity and tax benefits, as the business itself doesn't pay taxes. Instead, profits and losses "pass through" to the partners' personal tax returns. However, for tech and life sciences startups, partnerships are less common due to limitations in raising capital and potential personal liability issues. For tech startups, a partnership might be suitable in the very early stages if two or more founders are working together before seeking significant funding. In life sciences, partnerships might be used for research collaborations but are rarely the final structure for a growth-oriented startup.

3. Limited Liability Company (LLC)
Another common company structure is an LLC, or Limited Liability Company. An LLC is advantageous for a few reasons:

• The cost is relatively low.
• You record the company’s financial results in your personal tax filing.
• Owners of an LLC are not personally liable for the company’s debts and legal obligations.  

There are a few drawbacks to LLCs:

• You’ll likely have to pay self-employment taxes.
• It will be harder to attract investors.
• It can dissolve if you lose a member.   

For tech startups, an LLC can be a good option if you're bootstrapping or running a lifestyle business. Life sciences startups might consider an LLC in the pre-funding or research phase. However, if you're planning to seek significant outside investment, an LLC may not be the best choice. 

4. S Corporation (S-Corp)
S-Corps are typically small businesses and give you the benefit of incorporation with the tax-exempt privileges of a partnership. Like an LLC, you can pass income directly to shareholders without paying federal corporate taxes. There are some limitations to an S-Corp: 

• It is limited to only 100 shareholders.
• It can only issue one class of stock.
• It is only open to shareholders who are US citizens or residents, specific trusts and estates, or certain tax-exempt organizations. 

While S-Corps can be suitable for small tech startups, they're often less ideal for high-growth tech companies or life sciences startups seeking substantial funding. The restrictions on shareholders and stock classes can limit flexibility and fundraising options. 

5. C Corporation (C-Corp)
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 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, a C-Corp is typically the right answer. It’s best to establish the C-Corp as early in your company’s life as possible. 

What are the best legal structures for tech and life sciences startups?
The choice often comes down to two main options: LLCs and C-Corps. While LLCs can be suitable in some cases, C-Corps are generally the preferred choice for startups seeking significant growth and outside investment. This is due to their flexibility in issuing stock, attracting venture capital and handling complex ownership structures. 

How does a C-Corp structure benefit tech startups seeking venture capital?
C-Corp offers several advantages for tech startups seeking venture capital:

• It allows for multiple classes of stock, which is attractive to investors.
• Stock options can be easily issued to employees, a common practice in tech startups.
• There's no limit on the number of shareholders, allowing for multiple funding rounds.
• The corporate structure is familiar to investors, making due diligence smoother.

The importance of timing to incorporate

Deciding when to incorporate your startup is crucial. While it's generally advisable to incorporate as early as possible, certain milestones in your business journey may signal that it's time to take this important step. Let's explore the key scenarios that often prompt founders to incorporate:

• Protecting personal assets: Founders need to incorporate as soon as possible to protect against personal liability. When your business is a corporation, it assumes this risk so your personal finances will not, in most cases, be affected by third party claims.
• Facilitating share transfers: Incorporation allows you to freely transfer shares without approval from other shareholders. Most startups, however, do restrict transfers to protect the corporation and shareholders. The right of first refusal, for example, gives the corporation a right to repurchase a departing founder’s shares.
• Preparing for investment: Prior to investing in your startup, investors at every stage of your startup — from angels to venture capitalists — will insist that you incorporate. Any investor funds you receive cannot be co-mingled with your personal funds. To prevent this, you need to incorporate so you can open a bank account in the company’s name, isolate company funds and maintain financial statements.
• Safeguarding IP: As you grow, you’ll begin to amass IP like patents, copyrights, trademarks and trade secrets. Incorporating helps establish clear ownership of these assets under the company name which is critical for future investments, partnerships and acquisitions. The chain of IP rights and titles must remain unbroken, and corporate ownership is the most straightforward way to ensure this. 

How do I protect my tech startup's IP during incorporation?
Protecting your tech startup's IP during incorporation involves several key steps:

1. Ensure all founders sign proper IP assignment agreements, transferring their rights to the company. 
2. Include confidentiality clauses in all employee and contractor agreements.
3. Consider filing provisional patents for key innovations before discussing them publicly.
4. Implement a clear policy for open-source software usage to avoid licensing issues.
5. Register trademarks for your company name and key product names. 

Special consideration for life sciences and healthcare
When incorporating a life sciences or healthcare startup, navigating regulatory compliance is crucial. This may include FDA approvals, HIPAA compliance and other industry-specific regulations. It's highly recommended to seek legal counsel specializing in life sciences to ensure proper compliance from the outset. 

Boosting credibility
Incorporation lends greater credibility to your startup in the eyes of investors, partners and customers. This enhanced prestige can be particularly beneficial for startups looking to establish themselves in competitive markets.

How to incorporate your startup

For many businesses, it makes fiscal sense to incorporate in your home state or where you intend to do business. However, startups seeking outside funding often favor Delaware.

Why do startups incorporate in Delaware?
Delaware incorporation offers several advantages, making it a popular choice for both tech and life sciences startups:

• Established legal framework: Delaware boasts a well-developed body of corporate law, providing predictability and stability for businesses. This is particularly attractive to investors.
• Specialized courts: The Delaware Court of Chancery is renowned for its expertise in corporate law, providing efficient and knowledgeable handling of disputes, including those common in the tech and life sciences industries.
• Tax benefits: While not a tax haven, Delaware offers potential tax advantages, including:
  • No state corporate income tax for companies not operating in Delaware.
  • No state tax on equity held by non-residents.
  • R&D tax credits for tech companies, which can be significant for those investing heavily in innovation. 
• Investor preference: Many investors prefer Delaware incorporation due to its familiar legal framework and established precedents.
• Flexible equity structures: Delaware law is well-suited to the complex equity structures often used in venture capital financing, which is especially relevant for tech startups. 

These advantages essentially eliminate double state taxation, as companies still pay taxes in their home state where they are based. Investors will likely insist that you incorporate in Delaware because of its favorable tax climate. However, Delaware companies are required to pay annual franchise tax. 

It is important to note you don’t have to move your company to Delaware to incorporate there. The state's benefits make it an attractive option for startups seeking growth and outside investment, regardless of where they physically operate.

Do you need a lawyer to register your startup?

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 15 years,” says Drew Amerson, Director of LexLab, an incubator at UC Hastings College of Law. For example, 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 want to have a lawyer from the get-go, check with connections like your accountant or bank. SVB, for example, provides law firm referrals. Legal sites, such as LawTrades and UpCounsel, can also help you find an independent lawyer. “If you want the handholding and fuller range of services from an established law firm, try to negotiate a deferred fee arrangement,” says Amerson. 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 $1M.

How do I prepare my tech startup for seed funding after incorporation?
Preparing your tech startup for seed funding involves several crucial steps:

• Ensure all corporate documents are in order and up-to-date.
• Develop a compelling pitch deck that clearly articulates your value proposition.
• Create a detailed financial model and forecast.
• Be prepared to discuss your IP strategy.
• Build a strong team or have a plan to attract key talent.
• Consider creating a prototype or MVP to demonstrate your concept.
• Research potential investors and tailor your approach to their interests and portfolio.

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. 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 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 and WilmerHale has Launch. These resources are usually free.

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 situation, the Bar Association in many states offers limited pro bono (free) appointments with expert lawyers.

Documents you need to incorporate

The forms you’ll need are all available online. However, if you’ve decided to use an attorney to help you incorporate, it’s still wise to have a working knowledge of the documents you’ll need to form your corporation. Here’s a list of legal documents you should be aware of:

• Certificate of incorporation — This is your initial charter that is filed with the Secretary of State. The charter requires some basic background info, sets out legal requirements and the general purpose of your company.
• Action by sole incorporator — This is a procedural document that appoints you, the founder, as the initial director of the company.
• Board action by unanimous written consent in lieu of organizational meeting — This is a legal process where all board members can approve a decision in writing, rather than a formal meeting. Especially when there is unanimous agreement with board members, this document can be used without an in-person meeting.
• Bylaws — These establish the framework for how your company’s board, officers and stockholders should perform duties and operations.
• Founder common stock purchase agreement (SPA) — Use this to validate the sale of common stock from the corporation to the founders. Stock is usually sold at a nominal price and is paid for in cash or IP.
• Founders preferred stock purchase agreement — This is a contract where founders can purchase a special class of stock that converts to preferred stock when sold to investors during a funding round, an acquisition or IPO. This allows founders to achieve liquidity without selling common stock, which could impact valuation.
• 83(b) elections — Use this tax document to enable founders to pay taxes on their unvested shares immediately rather than waiting until shares vest and are worth significantly more.
• Proprietary information and inventions agreement (PIIA) — This document confirms the corporate ownership of founders’ and employee’s IP.
• Capitalization table — Use this document to track each person’s or investor’s stock holdings in your company, as well as the stock plan pool.

Final thoughts

Why investors favor C-Corps
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 the investors would have to pay taxes on their share of your company’s profits. That’s an administrative headache most investors won’t want.

The fact that S-Corps and LLCs require each owner to file a separate tax form that documents the income realized from the company is “a huge turn-off for venture capitalists,” says Amerson.

Simply put, becoming a C-Corp can open more avenues for fundraising.

Prepare for funding
For tech startups preparing for seed funding after incorporation, focus on creating a compelling pitch deck and ensuring all corporate documents are prepared for due diligence. Life sciences startups should also prepare for potential grant applications, as well as venture capital pitches. Both sectors should be ready to clearly articulate their IP strategy and market potential.

With the countless decisions you’ll need to make as a first-time founder, how to incorporate should be near the top of the list. Fully vet your options and get as much help as you need with the paperwork. It will be worth it sooner than you think.