When to Incorporate

So you’ve decided to start a company. Now the question is when to incorporate? Most founders know that having a limited liability entity (like an LLC or Corporation) protects the founders from being personally liable for business debts and claims. But there are two other lesser-known factors that are important to think about when deciding when to incorporate that are particularly relevant for start-ups:

1. Co-development of IP

If you develop IP in collaboration with other people, controlling who can use the IP and how it can be used can become an issue. It is usually ideal for the company to own the IP rather than individuals and it is often easiest to assign IP to the company when issuing stock to co-founders. If the IP is jointly owned by multiple individuals, you may run into problems around lack of exclusivity and dealing with accounting requirements to co-owners. If a co-founder leaves and there is no legal entity to which all IP has been assigned, that co-founder may leave and take their IP with them.

2. Tax Value of Stock

A common assumption is that it makes sense to wait until you have investors lined up and are ready to receive funds before forming an entity. This can be problematic because investments are likely to influence the fair market value of the stock. Co-founders and anyone else receiving compensatory stock (stock for services) is likely to incur a higher tax liability than if they had formed the company well before receiving investment.

To explain, let’s take the optimal scenario first: a company is formed well in advance of receiving investment. At that time the company has no real value. Instead, a nominal value (typically a fraction of a cent per share) is assigned to the stock. Co-founders receiving stock grants are receiving an insignificant amount of taxable income.

If, however, the company is formed and co-founders receive their stock close to when the company receives outside investment, then the IRS can impute that the co-founders’ stock price should be influenced by the amount that investors paid for their shares. A founder holding a significant chunk of shares could have a very high tax liability, even though at that point, the founder holds nothing more than a piece of paper and may not even have enough cash on hand to cover the taxes. As a consequence, it can become problematic or even unfeasible for the company to receive investments, particular through investment instruments that involve pricing the stock.

Takeaway: you may want to consider incorporating sooner rather than later if you are co-developing IP or are looking to get outside funding.

Related Articles:
Incorporating in Delaware versus California
Incorporation Versus LLC
Considerations for Founder Vesting Stock
Why Startups Incorporate in Delaware
New Businesses - Choosing a Business Entity