When to Incorporate a Startup
If you fall into one or more of these situations, it is time to strongly consider incorporating your startup. Here are the top eight reasons you need to start thinking about incorporating:
Recommended: Hiring a professional service will help simplify the incorporation process for you. Check out our review of the best online incorporation services for startups!
You Want Personal Liability Protection
One of the key reasons that many founders incorporate their business is for personal liability protection. Prior to incorporating, you are operating, entering contracts, and taking on loans as individuals and are personally liable for the company's actions and commitments.
Incorporating your startup establishes your startup as a separate legal entity from its owners, providing liability protection for the owners of the company.
In other words, the “corporate veil” protects the owners from the debts and liabilities of the company. So, for instance, if your company would be sued in court, fails to honor a contract, or defaults on a loan, you — as the owners — would not be personally liable for the company’s liabilities or debts.
Many founders wait to incorporate until they hit a stage where their liability increases, such as hiring an employee or launching a product, service, software, or application. However, as you will see, there are many more reasons for a startup to incorporate early.
Your Startup Has More Than One Founder
If your startup has more than one founder, you should consider incorporating as soon as possible. Incorporating your startup will require 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.
You Need Intellectual Property Protection
If your startup is developing or relying on any type of intellectual property you have created (technology, software, applications, websites, or code), you should consider incorporating your startup as early in the development process as possible. This is because 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.
Since it is ideal for the company to control any intellectual property it relies on to operate if you and your co-founder(s) have already started developing IP prior to incorporation — and most founders do – you (and your co-founders) should assign any rights to the IP over to the organization at the time of incorporation.
You Want to Establish Credibility and Trust
Incorporating a business is also a way to build credibility and trust. When you incorporate a business, making it its own entity, it shows 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, for employees, for investors, and for other stakeholders. While sole proprietorships and partnerships end with the death of their owner(s), corporate entities continue on.
Moreover, corporate designations such as Company, Corporation, and Incorporated (Co., Corp., and Inc., respectively) build the legitimacy and credibility of your startup. They make your startup seem more real and more professional.
You Are Seeking Investment
If you are seeking an investment, it is likely that your investors will 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 a C corporation.
LLCs, S corporations, and C corporations each have differing rules for investors and treat taxation differently. While many founders and co-founders prefer the simpler pass-through taxation structure found in LLCs and S corporations, investors typically prefer the corporation to be taxed, and they themselves report and pay tax on the capital gains only when the gains are realized.
And, because non-human investors (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.
Recommended: Read our guide on Why Investors Prefer C Corps to learn more about why the type of corporation you choose matters to investors.
You Want to Issue Stock
Seeking investors isn’t the only reason that companies want to issue stock. In the early, cash-strapped days of new ventures, many entrepreneurs and their startups compensate early employees, advisors, and even vendors with shares of stock or stock options in the company.
However, in order to issue shares of stock or stock options in the company, your company needs to be incorporated.
This is also another instance for why you should incorporate your startup as early as possible. Stock options give their holders — your cofounders, employees, and key stakeholders — the option of buying stock in the future at the price of the stock when the options were granted. Incorporating and granting stock options earlier gives your stakeholders the opportunity to make a significant profit as the startup scales and grows, and the value of the stock goes up.
You Want to Build Business Credit
Just like personal credit scores, businesses also earn their own credit score. The first step to begin building business credit is to establish yourself as a formal legal entity (i.e., you will need to form an LLC or incorporate your startup).
Prior to incorporation, all liabilities and debts are the responsibility of the sole proprietor or partners of the startup. Forming an LLC or incorporating your startup designates your company as a separate legal entity that is able to enter into contracts and take out credit cards, lines of credit, and business loans in the company’s name. Thus, to begin building business credit, you need to incorporate and register your startup as a formal legal entity.
Recommended: Read our guide on how to build business credit to learn more about what you need to do to start building business credit.
You Want to Avoid Unfavorable Tax Situations
You also may want to consider incorporating your startup to avoid unfavorable tax situations. In fact, there are several reasons why incorporating as early as possible can help you to avoid costly tax consequences.
In many early-stage ventures, co-founders, advisors, and employees receive stock compensation or stock options as part of their compensation for their early work in a new venture. This is often referred to as “sweat equity.” Depending on how this compensation is structured, the recipients of stock compensation or stock options will need to realize this value on their personal taxes either now or later.
When you incorporate early, the taxable value of this compensation is often small. However, if you wait to incorporate until you gain traction or secure an investment, the taxable value of this compensation can increase substantially — potentially causing significant tax burdens for you and your key stakeholders.
Another tax consequence of waiting to incorporate occurs if you are or want to be acquired within the next year or two. The IRS provides favorable tax treatment to long-term capital gains (assets you have held for at least one year). If you wait to incorporate and issue yourself stock in the year before you are acquired, you may be subject to short-term capital gains rules at a much higher tax rate.
How to Incorporate Your Startup
- Choose a business entity type
- Choose a tax structure
- Determine a location
- Create a founders’ agreement
- Hire a professional service or incorporate yourself by following our guides on LLC formation or corporation formation
- Maintain your corporate veil
Interested in a different business structure? Haven’t launched your small business or startup yet? Check out our other formation guides: