Incorporation can be both expensive and confusing, which are a few reasons that many founders delay the process. So when exactly should you incorporate your startup? The short answer is: as early as possible.
Specifically, you’ll want to be incorporated as soon as (or before) you have any of the following:
- A partner
- An employee
- An investor
- A customer
- A grant
- A need for a bank account
- Any intellectual property (including trademarks or computer code)
- Any potential liability
- Any assets
These things will happen quickly, and they’ll signal a need for incorporation for one a few basic reasons.
Protecting personal liability
Corporations are meaningfully distinct entities from the people who own them, but can mostly do the same things (like enter into contracts or buy and sell products). But while a person who is doing business activities as herself is personally liable for them (and their effects), members of a corporation are not personally liable for the activities and agreements made by the corporation.
So, if a court judges against your startup for some reason in a suit, or if you find yourself unable to fulfill contracts—whether they’re with employees, contractors, suppliers, or customers—the courts or the other party in the contract won’t come after you and your personal assets. Instead, the corporation is responsible for bearing any penalty.
Assets and intellectual property
Like liability, many of the benefits of incorporation are tied to the company’s status as an independent entity. This entity can own assets like capital, equipment, and intellectual property (IP). All of these increase your company’s value, especially from the perspective of future investors and existing shareholders.
For example, if you do not protect your IP early then you’ll introduce downstream risks on future financings and/or in the market through competition. Keeping that IP within the walls of an incorporated entity reduce risks if done properly, and they can benefit from corporate laws that have already been built around scenarios like this.
This is part of what makes startups so exciting. The division of startup equity, which is a process of granting shares to co-founders or other key stakeholders, enables the company to track exactly who owns what in the company. This is especially critical for future liquidity events, like when you’re acquired or you take your company public through an IPO. You can also create equity incentive programs (the most common form being an option pool), which sets aside a slice of the company to offer to future employees and advisors as part of their compensation package.
Ownership distribution varies by the type of startup legal entity you select. We’ve given a full account of the reasons startups should incorporate as Delaware C-Corporations before, just know that when it comes time to fundraise that professional investors will almost always expect startups to be structured as C-Corporations. It simplifies ownership, and they’re more familiar working with laws that govern C-Corporation.
The sooner you become incorporated, the easier it will be on you and your employees’ personal tax returns. There is a cost of ownership—your company has a value, and anyone who owns part of it must recognize that value on their taxes (now, or later depending on how ownership was distributed and certain elections of the recipient).
Before you have traction or investment, your company valuation will be small. The impact on your taxes is trivial in the early days, but increases over time. As Keyvan Firouzi, CFA, Principal of Preferred Return here at Gust explains, “Incorporating as soon as possible means there is no question that the company is giving shares of little value—the sooner you do it, the easier it is to argue that you’re ‘worthless,’ which minimizes your tax liability.”
That’s also something to keep in mind if you choose an LLC over a C-Corporation, as any conversion process to a C-Corp also means working with lawyers and accounts to try and work around taxable events. You’re typically doing this when fundraising, and considering tax implications adds another level of cost and complexity that you’re going to wish you avoided.
In short, incorporating early is something your startup should consider and these are a few of the primary reasons that we require it as the first step for founders on Gust Launch.
Gust Launch can help you move your venture forward.
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.