Reasons to Incorporate a Startup
Incorporating a business provides limited liability to the owner(s) and shareholder(s) of the business. Limited liability is the legal concept that the owners’ or shareholders’ financial liability for a company’s actions or debts is limited to their investment in the company.
Unincorporated businesses — sole proprietorships and partnerships — have unlimited liability. Should an unincorporated business be unable to pay its debts, the owner or partners may be held personally liable, and their personal assets may be at risk.
The limited liability provided by incorporation protects the owner’s personal assets from things like lawsuits and being held personally responsible for the company’s debts.
2. Separates Personal and Business Assets
Incorporating a startup (and establishing and maintaining the corporate veil) requires you to separate your personal affairs from your business affairs.
Separating your personal and business accounts will allow you to better track income and expenses and understand your startup’s financial performance and health.
Moreover, in order for a corporation or an LLC to be considered a separate legal entity, a separation must actually exist. When your personal and business accounts are mixed, your personal assets (including your home, your car, and other valuables) could be at risk in the event someone sues your business. In business law, this is referred to as piercing the corporate veil.
3. Avoid Ownership Disputes
Another reason you should incorporate your startup is if your startup has more than one founder. Incorporating your startup requires you and your co-founder(s) to agree on the distribution of ownership, shares, and vesting conditions. Accomplishing this early allows you to avoid any future misunderstandings or arguments over each founder's share of the venture.
When the company is incorporated, the division of startup equity is set in stone, and co-founders, employees, and other key stakeholders are granted shares of stock (and restricted shares subject to vesting) in the organization.
Another reason to incorporate is to allow and ease the transferability of ownership in the business. When it comes time to take on investment or sell your stake in the business, the transferability of ownership becomes extremely important.
LLCs may allow for some transferability. Although some states do not allow the sale or transfer of ownership in an LLC, many states allow ownership to be transferred without having to dissolve the business. However, there may be numerous restrictions in the transfer of ownership both by the state as well as in the LLCs operating agreement. For instance, LLC operating agreements may require the approval of the other members to transfer ownership before admitting a new member.
C corporations provide much greater ease in transferability of ownership. The shareholders in a C corporation can typically transfer shares to others with limited restrictions (unless the shareholder’s agreement specifically states otherwise). This is part of what makes C corporations the preferred choice of investors.
5. Attract Investors
If you are hoping to attract investors, you will likely need to be incorporated. Your investors will likely want — or rather demand — that you are incorporated. Most investors are not willing to invest without the personal liability protection, taxation advantages, and ease of transferability of shares provided by incorporating.
More specifically, most investors prefer that you are incorporated as a C corporation. C corporations provide the easiest transferability of ownership and are the only type of corporation that most angel and venture capital investors will invest in since non-human investors (e.g., angel funds, venture capital funds, etc.) can not invest in LLCs or S corporations. If you hope to raise money from angel funds or venture capital, a C corporation is likely your only choice.
6. Issue Stock
You will need to incorporate your startup if you wish to issue stock to investors. However, seeking investors isn’t the only reason that companies want to issue stock. In the early, cash-strapped days of new ventures, many startups compensate early employees, advisors, supplies, and vendors with shares of stock or stock options in the company.
It is important to note, LLCs do not issue stock and do not have stockholders or shareholders. In order to issue shares of stock or stock options in the company, your company needs to be incorporated as a corporation.
Another reason to incorporate your startup is that LLCs and corporations have perpetual existence beyond the life of their owner(s). In fact, corporations have unlimited lifespans.
In informal business structures (sole proprietorships and partnerships), the business is directly tied to its owner(s) and formally ends with the life of its owner(s). Incorporating, on the other hand, designates a business as a formal legal entity that is not tied directly to its owners. Even if the owners or shareholders of the business exit the business or pass away, the corporation will continue to exist.
8. Establish Credibility and Trust
Incorporating a business also builds credibility and trust. When you incorporate a business where you form an LLC or a corporation, you make it its own entity, showing that you are serious about your startup and are in it for the long haul.
Corporations extend beyond the life of their owner(s) and can continue indefinitely. This communicates a sense of stability for customers, employees, investors, and other stakeholders.
Moreover, corporate designations such as “limited liability company,” “company,” “corporation,” and “incorporated” (LLC, Co., Corp., and Inc., respectively) build the legitimacy and credibility of your startup. They make your startup seem more real and more professional.
9. Protect Intellectual Property
Another reason to incorporate your startup is to protect the intellectual property of the business (technology, software, applications, websites, or code).
The ownership of any intellectual property (IP) created before the company was incorporated belongs to the founders and creators of the IP. If any problems arise and a co-founder leaves the company, they can take their IP (and the rights to use their IP) with them.
However, as an independent entity, a corporation can own assets, including intellectual property. What’s more, any IP developed by employees of the company (including the founders) after the company is incorporated belongs to the company.
10. Choice of Tax Structure
Tax implications provide another reason to incorporate your startup. Both LLCs and corporations can choose their tax structures. By default, LLCs are taxed as a pass-through tax structure — either disregarded entities or partnerships. However, LLCs can also elect to be taxed as an S corporation or as a C corporation. Likewise, corporations can also choose between C corporation and S corporation tax statuses, providing flexibility in seeking the best tax structure for your startup.
11. Ability to Reinvest Earnings
Incorporating your startup as a C corporation also allows you to reinvest earnings back into the business without paying a tax on the profit first. In LLCs and S corporations, profits are passed through to the members or shareholders as income; however, in C corporations, shareholders only pay tax on dividends, making it easier to reinvest profits back into the corporation.
12. Personal Tax Advantages
Depending on your situation, there may be several tax advantages to incorporating your startup. Corporate tax structures provide flexibility for determining how your income from the business is paid and taxed.
In corporations and LLCs that choose C corporation and S corporation tax structures, after paying owners a fair salary, owners are compensated through dividends, distributions, retained earnings, and capital gains. In many cases, owners have the ability to defer tax on this portion of their income. Therefore, rather than having this portion of the income subject to employment or self-employment taxes, it is instead taxed at preferential tax rates.
How to Incorporate Your Startup
- Choose a Business Structure
- Determine a Location
- Establish Share Structure
- Split Equity Among Founders
- Hire a Professional Service or Incorporate Yourself By:
Interested in a different business structure or haven’t launched your small business or startup yet? Check out our other formation guides: