- Incorporate as early as possible to minimize your exposure to liability and to protect your intellectual property
- For startups looking for outside funding, incorporating as a C-Corporation is usually the right decision
- Incorporating in Delaware is often a good choice because of its business-friendly environment
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.
Know the types of corporations
There are four general types of corporations in the United States: a sole proprietorship, a Limited Liability Company (LLC), an S-Corporation (S-Corp), and a C-Corporation (C-Corp). Each has its advantages and disadvantages, and you will need to choose which legal entity is best for your startup.
1. Sole proprietorship
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?” At this point it may be wise to consider a different type of legal entity. Likewise, if you decide to seek PC funding you’ll need to incorporate.
2. Limited Liability Company (LLC)
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 to take on.
The requirement of S-Corps and LLCs 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 more avenues for fundraising. For example, LLCs and S-Corps can’t have more than 100 shareholders and they must be US citizens or residents, shareholders, and they can’t take equity investments from other companies.
Founders need to incorporate as soon as possible...
When to incorporate a startup
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.
When you need flexibility
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.
When you need Investors
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.
When you own intellectual property
As you grow, you’ll begin to amass intellectual property (IP) like patents, copyrights, trademarks and trade secrets. These are valuable assets, and you need to make it clear as soon as possible that your corporation owns your IP. The chain of IP rights and titles cannot be broken. The easiest way to ensure this is through corporate ownership. If IP ownership is uncertain, it will impact investments, partnerships, and acquisitions.
When you need prestige
Corporations have greater credibility among investors, partners, and customers — particularly for startups.
…investors will likely insist that you incorporate in Delaware…
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. But for startups looking to secure outside funding, investors will likely insist that you incorporate in Delaware because of its favorable corporate climate.
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 as 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, 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 who 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 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 ten years,” says Drew Amerson, director of LexLab, an incubator at UC Hastings College of Law. 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, check with connections like your accountant or bank. SVB, for example, provides law firm referrals. Sites such as LawTrades and UpCounsel can also help you find an independent lawyer at a reasonable cost. If you want the handholding and fuller range of services from an established law 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. 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 and WilmerHale has Launch. 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.
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, in many states, the Bar Association 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.
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 — Use this document as a checklist of the things your board of directors needs to do during their first 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 intellectual property.
Founders Preferred Stock Purchase Agreement — Sometimes founders are sold stock that can be sold prior to an acquisition or IPO. This agreement confirms those transactions.
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 intellectual property.
Capitalization Table — Use this document to track each person’s stock holdings as well as the stock plan pool.
Which type of corporation is right for your business?
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.
Running a startup is hard. Visit our Startup Insights for more on what you need to know at different stages of your startup’s early life.