When Should You Incorporate?
Once you decided a corporation is right for your startup, you should consider whether it is the right time for you to incorporate. It costs time and money to create and maintain a corporation. Failure to do so may subject you to fines, suspension, and even personal liability, one of the primary purposes of establishing a corporation in the first place. As such, you may consider holding off on incorporating your company until your company will receive the benefits of incorporation, such as:
Protection against personal liability;
Formalizing your relationship with your co-founders;
Ensuring favorable tax treatment for receiving stock;
Creating a structure for IP ownership; and
Raising equity capital for your company
Protection Against Personal Liability
A corporation that is properly formed and maintained protects you against personal liability. For example, if your corporation incurs a business debt, it is the corporation that is responsible for paying off that debt, rather than you personally. If the corporation cannot pay the debt, it dissolves, but you do not have to pay it off with your life savings. However, lenders commonly require new startups to personally guarantee the loan, which means you are personally liable regardless of the status of your corporation.
Incorporation also protects your personal assets if you get sued, for example, by a disgruntled employee or customer. Thus, it may be a good idea to incorporate before you sell your products or services or hire your first employee. This may be particularly advisable for blockchain startups where the products or technology may not be well-understood, pose uncertain or unforeseeable risks, or where regulation is uncertain.
Formalizing your relationship with your co-founders
If you have a co-founder, incorporation helps you formalize your relationship, including how equity will be split and your roles and responsibilities. It is also a prime opportunity to discuss your goals, hash out a plan for the business, and to put your plan in writing. Although you may go into business with the best of intentions, documenting your relationship may prevent misunderstandings and contentious disputes down the road.
Tax advantages for co-founders receiving stock as compensation
Founders are often compensated with stock. This stock is taxed based on the value of the shares when received. Depending on where you incorporate, you will set the par value of your shares, which is the minimum value which your corporation can issue each share. The par value can be set at less than a fraction of a penny and has no relation to the market value of the stock. When you incorporate before you sell any stock to investors, you will acquire the stock at its par value, rather than its market value, meaning your tax-bill will be significantly lower than it would be if you acquire your shares after an investment in your company.
Ownership of IP
Any IP that you or your co-founders develop should be owned by the company, rather than the individuals. The founders can assign the IP to the company before founders shares are issued and assign any future IP to the company. If the IP isn’t assigned to the company, a departing founder can take his/her IP with him or her, potentially leaving the company without an important piece of technology or invention. Because IP is a valuable part of your company’s assets, investors may be reluctant to invest in your company unless your company owns the IP.
Raising Equity Capital
Finally, you should incorporate if you plan to raise equity capital. It is much more manageable to issue shares of a corporation rather than units of a LLC, particularly if you plan to sell shares to a large number of shareholders. Professional investors also often require that you are incorporated as a C-Corp before they will make any investment in your company.
This article is also posted on Medium.
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