The difference between incorporation and company formation

GIL SILBERMAN , Startup Lawyer

8 May 2017

Gust Launch starts with the incorporation and company formation processes—sets of legal documents approved, signed, and in some cases filed in a specific order, that take a team of founders from private individuals with an idea all the way to being CEO and Board of a brand new Delaware C-Corporation, ready to conquer the world.

For convenience, we discuss this experience as one process, because they go hand in hand: formation follows directly after incorporation. But when we say that Delaware C-Corps are the preferred entity of investors, that’s only half the story. The qualities that make Delaware C-Corps attractive to investors are mostly determined by the details of formation, not just incorporation.

What does “incorporation” really mean?

Incorporation refers to a charter granted by a governmental jurisdiction, in this case the State of Delaware, for a group of people to do business as a legal entity rather than as individuals. This involves filing a Certificate of Incorporation—picking a name, signing a document, and sending it to the office of Delaware’s Secretary of State. In Gust’s version of this filing, each company authorizes itself to issue 10,000,000 shares, each at a cost of at least $0.00001. Other incorporation processes may have different numbers in those spaces, but you can read more about why startups start with 10,000,000 authorized shares on Gust’s FAQ.

Gust Launch’s incorporation process also includes an SS-4, which is the application for an Employer Identification Number (EIN). This IRS-assigned ID number is used when paying taxes and otherwise identifying the company to the US government. It’s necessary for opening a company bank account, as well as for paying employees when the company is ready to hire.

The next steps are the part of the process that requires legal precision and startup expertise, which we refer to as “company formation.” It’s a series of decisions to make and documents and actions to adopt reflecting those decisions that ensure that the brand-new C-Corporation has the structure and traits that investors expect. Some online incorporation services either skip the formation step or simply send the founder general-purpose documents that aren’t appropriately customized for specific types of companies—a family-run retail store would have very different formation documents than a venture-funded startup. Often, a startup will bring in an experienced lawyer at this point. We’ll describe the Gust Launch approach, which takes the process step by step, using online documents specifically intended for startups.

How C-Corporation company formation works

STEP ONE: CORPORATE BYLAWS

Immediately after filing for incorporation, a company needs to draft and adopt its bylaws. These are operating rules to specify the organization, structure, and governance functions of the corporation. Some basic categories of bylaws are:

• Stockholders: people who own shares of the company have meetings and vote to elect Board members, among other things.
• Board of Directors: this section specifies the number of people on the Board, what their powers are, and the rules that apply to them.
• Officers: the organization’s top management, what they do for the organization, and how they will be appointed. In the beginning, this might mean co-founders as well as any advisors or investors the company has.
• Indemnification: the corporation accepts the responsibility to cover legal actions brought against certain people who act on its behalf. In other words, if a founder or officer is sued, the corporation will pay the attorney fees and any damages assessed, rather than leaving the founder on their own.
• Stock: how the company’s stock ownership is tracked, including how the company records ownership, rights to receive dividends from the stock, and other specifications.

There are a few other pieces to the bylaws. Many will be different for startups than for other kinds of companies. For example, startups can save countless time and money by including provisions in their bylaws to take advantage of new Delaware laws that allow for paperless stock records and online votes and notices. This is one of many reasons to hire a startup lawyer or use startup-oriented legal automation software, such as Gust Launch, that use documents appropriate to startups.

STEP TWO: MOVING FROM INCORPORATION TO OWNERSHIP

There are several ways to go about the next formation steps. Gust’s process is optimized for simplicity and speed of execution.

In the incorporation process, the person signing and filing the Certificate with the state of Delaware is known as the “Incorporator,” and has certain initial duties specified by the Certificate and by Delaware law. For convenience, Gust asks the primary founder to sign as Incorporator, and in that role to adopt the initial bylaws by signing an “Action of the Incorporator.” By that document, the Incorporator also appoints the first Board members—in this case, appointing themself to be the first member of the Board, and then resigns as Incorporator (because the position has no further duties).

The new Board is empowered by the bylaws to appoint officers of the company. The next step is for the Board’s newly appointed initial member to appoint the company’s first CEO (usually themselves), secretary, and treasurer (the three “statutory” officer positions required by Delaware and the bylaws), as well as any other initial officer positions they wish to set up initially. The co-founding team are now the officers and Board of the company, but they do not yet actually own the company. In fact, nobody does. That’s what shares of stock are for. The next step is to solve this problem.

STEP THREE: ISSUING STOCK

Per Delaware law, the Board directs the issuance of shares of company ownership. The Gust Launch Certificate of Incorporation provides for 10,000,000 authorized shares of the new company, which just means that the company can theoretically be divided in up to 10,000,000 equal pieces. To create actual ownership, stock will have to be “issued,” meaning that the company pushes out shares from being merely authorized to being actually outstanding, and then “granted,” meaning that the shares are sold to one or more people or business entities. The initial stock grants will likely make up a significant but not complete portion of the 10,000,000 authorized shares, split among the co-founding team and any other initial participants. For more background on how this all works, check out Gust’s guide to startup equity terms and principles.

Once the Board approves the initial stock grants, the CEO oversees and signs the issuance and grant of stock to each recipient, who will need to sign a package of stock grant documents and purchase the stock (at the nominal “par value” of $0.00001 per share specified in the Certificate of Incorporation) for the grant to be complete. Most companies with multiple founders and team members opt to make stock ownership subject to vesting. There is also a stockholder agreement to handle a myriad of terms that apply to stock ownership, like transferability of shares. This is the point at which the co-founders would file their 83(b) elections, which relate to taxation of future gains in value of vested stock.

At this point, the company has:

1. Obtained a charter by filing its Certificate with Delaware
2. Applied for and received an EIN from the IRS so that it can open a bank account, hire employees, and pay taxes
3. Adopted bylaws containing the rules and structure that investors expect, and set out its operations and powers
4. Elected a Board of Directors
5. Appointed the founder and others to be officers
6. Issued and sold stock to founders, giving them ownership of the company

Now the company is ready to go… save for one last thing. If the company is based outside of Delaware, it must file a “foreign qualification” in the home state where it will be doing business (foreign in this case means that the company is from a different state, not a different country). This informs the home state of the company’s existence, and gives that state the power to regulate and tax the company.

After the initial formation, Gust Launch can handle the ongoing governance and maintenance of the company: additional stock issuances and repurchases, further appointments and resignations of officers and Board members, and even more advanced things like adopting stock options and recording investments. Much of this process can be amended later on, from a legal standpoint. From a strategic standpoint, though, it’s not usually to a startup’s advantage to modify the bylaws or fundamental structures of the corporation—after all, these standards and industry-preferred forms are exactly why investors generally require their portfolio companies to be Delaware C-Corporations.

There will also be employment agreements to sign, agreements for other participants such as Board members, consultants, and advisors, intellectual property assignments, and many other routine agreements for the day-to-day management and governance of the new company. These are all post-formation startup documentation.

While all of this may sound complicated, and probably shouldn’t be attempted by non-lawyers without assistance, it’s a regular enough process that Gust has been able to automate it for new startups. Legal automation software couples a low risk of error with a sensitivity to the needs of each startup business, and puts the tools necessary to correctly adopt these documents into the hands of founders without legal training. The end result: a full-fledged Delaware C-Corporation, owned by the founder and co-founders, authorized to operate in its home state, optimized for investment and ready to take on the world.

Not sure if your startup should be a C-Corp? This quiz will help you pick the right company type for your startup.

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