Chief Everything Officer (aka Startup CEO): Incorporation

Posted on Posted in Chief Everything Officer, operational finance

The revelation moment has come and now you have a great idea for a product or service. If you plan on keeping your idea just as an abstract concept, then there is absolutely no need to incorporate. Yet, as soon as you are ready to take next steps and turn your idea into a business, you should consider incorporation.

Incorporation of a business offers a number of practical and financial benefits, and should be one of the first steps that founders ought to take when launching a startup venture. STARTUP FINANCE MADE EASY by oleksiy nesterenko provides an overview of the key reasons to incorporate your business:

  1. Protect yourself against personal liability: an official legal structure, such as LLC, S-Corp, or C-Corp., effectively puts a “wall” between the owners and the business. Thus, your personal assets will be protected from the company’s creditors or court judgments (as long as all of the required corporate formalities are adequately kept). That is the main reason why most of the founders choose to incorporate (or form an LLC) before their product or service launches to the market.
  2. Establish ownership structure and appropriate co-founder agreements: regardless of how much you trust each other, word of mouth agreements between co-founders are not sufficient. Whenever a company with more than one founder begins operating, but has not yet been incorporated, it exposes itself to a number of potential problems. How should the equity be divided? What if one of the co-founders decides to leave the company before incorporation? How should IP rights be assigned to the multiple founders? And worst of all, what if a dispute arises? How will it be handled? All of these issues can be resolved by having an incorporated entity in place along with appropriate agreements.
  3. Keep your venture’s intellectual property safe: patents, copyrights, trademarks, and trade secrets are largely what investors/acquirers pay for, when they invest in a company. Value of a company’s IP portfolio often has a significant impact on the company’s valuation as a whole. If a business’ IP was developed prior to incorporation without taking the necessary steps to assign the IP to the corporation, then the company may not end up owning the IP in full, thus resulting in a break in the chain of title. Break in the chain of IP rights and title surely will adversely affect future investments, partnerships, and acquisitions at the due diligence stages. Always remember to protect your IP in the company’s name as early as possible.
  4. Create your own currency: practically all of the startups are short on cash when they start out. Yet, you still need to pay your employees, contractors, vendors. Incorporation of your business provides an elegant solution to this riddle: granting stock options as a means of compensation. While it is possible to create a pre-incorporation agreement promising an equity stake in a company, such promises are inherently uncertain and difficult to enforce. Thus, if you want to offer “sweat equity” to your employees, you should incorporate.
  5. Avoid adverse tax consequences: VCs and angels invest only in incorporate entities. However, if you delay incorporation until you find investors, you might run into valuation problems triggering unnecessary personal tax hit. If you incorporate right before receiving $250,000 in seed funding while granting stocks to founders at $1,000 valuation, IRS might surprise you with a hefty tax bill (Section 409A of the of the Internal Revenue Code)

Thus, as you can see incorporating or forming an LLC is a major step and provides a number of big benefits. At the same it is also a big responsibility, and you need to keep in mind that once you create a formal business structure you will be responsible for keeping up with recurring administrative obligations each year.