What Startup Founders Should Know About Compliance and Self-Protection

David S. Rose , Founder and CEO , GUST INC.

5 Sep 2018

In order to facilitate fundraising, easily reward shareholders, and protect themselves from legal liability, most sophisticated founders of high-growth startups incorporate their businesses as Delaware C-Corporations. That’s a great first step, but what many founders fail to realize is that it’s only the first one. Right after incorporating, there are several additional steps and ongoing responsibilities that they must take to both realize the full advantage of corporate benefits and to avoid potential fines and violations.

Staying in good standing with Delaware and the other states in which your venture operates isn’t much of a headache, but failing to do so can lead to legal bills, fines, or worse. Because it’s easy to miss the crucial compliance and self-protection steps, services like Gust Launch help founders take the actions needed for their brand new Delaware C-Corporations that will keep them fully compliant and give them the best chance to succeed.

Using the Delaware C-Corporation’s advantages

From a legal standpoint, there are two essential attributes that make a fully-formed C-Corporation the ideal entity for high-growth startups:

1. Stock divides ownership into equity shares
2. Limited liability protects shareholders

However, neither of these attributes come with the C-Corporation structure right out of the box. To enjoy liability protection as shareholders, the shareholders must actually have ownership of the business, and to create ownership, the company must issue stock.

Once the company has issued stock (and assuming that the corporation is compliant with all appropriate statutes, court rulings, and regulations), its shareholders’ personal assets are not at risk if the company faces a lawsuit or goes bankrupt. Provided the corporation is compliant, its owners can freely invest their time, capital, and energy into the venture without risking their non-business related personal assets, such as their house, car, or personal bank accounts.

To establish a corporation, the first step is to file a Certificate of Incorporation, wherein the person filing the certificate (the “incorporator”) picks a name and authorizes the division of the new corporation’s ownership into a number of equal equity shares. The state then reviews the filing and, assuming it approves the certificate, grants the company a charter to conduct business as a legal entity. The charter gives the company the ability to do many of the same things a regular person can do, such as buying and selling goods, entering into contracts, and owning property.

While the corporate charter by itself may seem to provide sufficient permission for a business to operate, there are a number of other things that the founder must address in order for the corporation to comply with the law and do business while protecting the founders’ personal assets.

The importance of creating ownership

A corporation is designed to protect its shareholders’ personal assets from liability, but to do so, it must issue stock. Without a stock issuance, the company has no shareholders, which presents problems if a startup runs into legal troubles because Delaware corporate law and legal precedent assume that a company has distributed ownership. Failing to immediately issue stock will therefore put the startup into unclear legal territory and dramatically increase a court’s likelihood to “pierce the corporate veil” (which means “hold the business’s operators personally liable”) if the company ends up in litigation.

To create ownership, stock needs to be issued by the company to a grantee, usually in exchange for money. According to Delaware law, the company’s board of directors is in charge of administering stock issuances.

Founders should purchase their own shares as early as possible. Remember, if you don’t issue stock, you don’t get the liability protection! A newly incorporated startup is generally worth so close to nothing that the purchase price of each share (what is known as its “par value”) is very low, and the company’s common stock price is theoretically at its cheapest. If the founders wait to purchase until the company is arguably worth something, such as if they raise a funding round at a higher price-per-share with investors, not only will they not have had the liability limitation protection, but they will then have to buy shares at a much higher valuation!

Ensuring operational compliance

Startup founders must also remember that they have a duty to comply with state laws and regulations. When a startup receives a Delaware corporate charter, no other state is aware of the entity’s existence. But unless you are running your company out of actual, physical offices in the state of Delaware, you will need to ensure that it is compliant with the laws, regulations, and tax requirements of the state in which you are actually operating.

Step one to address this situation is filing a foreign qualification. “Foreign” in this sense doesn’t mean another country, it just means another state. Foreign qualification registers a company in the state within which it operates, and failing to do so can bring serious consequences. For example, an unqualified company may be restricted from using its home state’s court system, should an intellectual property dispute or other legal issue occur. Depending on the state, the company may also be subject to fines, back taxes, or other penalties that will greatly exceed the cost of filing for foreign qualification in the first place.

These potential risks make the timely filing of a foreign qualification a critical step in setting up a business. The filing process, however, is usually relatively simple: submitting documents and paying a fee with varying requirements depending on individual states’ specifications.

After foreign qualifying, each state has additional requirements that require ongoing attention. Annual franchise taxes (sort of a “permission to do business in our state” fee) are levied by most states, and the way those taxes are calculated vary from state to state. Each state will explain their method of calculation along with your annual bill.

So, to recap, here’s what is required to correctly incorporate your high-growth startup and maintain it in good standing, all of which can be facilitated by Gust Launch:

SET UP

1. File your Certificate of Incorporation with Delaware, authorizing your stock
2. Appoint a registered agent in the State of Delaware
3. Adopt your corporation’s bylaws and establish your board of directors
4. Issue your stock to founders, and accept the issued stock (note that if you are married, your spouse will also need to sign)
5. File for foreign qualification in your home state, and pay their fees

ONGOING

1. Pay your annual franchise tax in Delaware
2. Pay your annual equivalent tax in your home state
3. Continue to issue common stock to your co-founders and perhaps early advisors

EVENTUALLY

When you are finally ready to hire employees, you’ll be taking a serious leap forward that requires many more things. These include establishing an equity incentive plan so that you can provide them with stock options, having a specific type of independent valuation of the company prepared so that you can issue your options at fair market value, establishing vesting schedules for the stock options you will be granting, issuing the option grants to employees and collecting their spousal consents, managing the company’s capitalization table so that it is always up to date, filing appropriate payroll forms with the IRS, withholding cash from each paycheck, and much more. But the good news is that all of this is (a) further down the road, (b) the subject of another blog, and (c) facilitated for you by services like Gust Launch.

Good luck with your new venture, and remember: start smart and keep compliant!

Gust Launch can set your startup right so its investment ready.

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