Startup Cheat-Sheet: How to Incorporate Your Company
So, you’re ready to setup the legal structure for your startup.
You’ll need to choose between entity types such as a C Corporation or LLC and select a jurisdiction such as your state of residence or Delaware. You’ll also need to think about how many shares to authorize in your new company, and how to split the initial equity among the founders. And then there’s the matter of actually generating all the documents and getting them filed, which may or may not involve lawyers.
As entrepreneurs we want to innovate, do things better and in new ways. But when it comes to forming your company, you want to be as plain-vanilla as possible. Don’t innovate your legal structure. Save your creativity for building your product and tackling your market.
Now comes the part where I remind you that I am in no way qualified to offer legal advice. And I’m not including that disclaimer just to be litigiously cautious — as a founder who’s been through the incorporation process before, I know just enough about such legal matters to get by. But as a founder yourself, that’s probably exactly what you’re looking for anyway. So, here’s a cheat-sheet for incorporating your company.
The first step towards company formation is to figure out which type of corporate entity is the best match for your needs. As a U.S.-based company, you have two main choices:
- LLC. The easiest of the three entities to setup is a Limited Liability Company. Unlike simpler entities such as a sole proprietorship or general partnership, the LLC personally shields you, the founders, from business liability that could be incurred. It also offers a pass-through taxation regime, meaning the company doesn’t pay corporate tax, but rather “passes through” profit to the owners. Most small businesses are setup this way. But it’s a bad structure for startups who may want to take on outside investment, because venture capitalists usually won’t (and can’t) invest in LLCs due to complications arising from pass-through taxation. (See Joe Wallin’s 12 Reasons For A Startup Not To Be An LLC.)
- C Corporation. While more cumbersome to setup and manage than LLCs, the C Corporation is the standard entity for startups because it can take you from conception to IPO, and is the entity of choice for venture capitalists. Unlike LLCs, C-Corps do have to pay corporation tax, but they are much more robust and scalable. Investors expect you to be a C-Corp. If you apply to a startup accelerator as an LLC, they’ll make you convert to a C-Corp before accepting you. You better have a really compelling reason NOT to choose a C-Corp.
When it comes to choosing an entity type for your company, 99% of U.S.-based startups should opt for a C-Corporation. The only exception to the rule is if you don’t plan to ever raise money from outside investors and don’t aspire to ever IPO, in which case the simpler LLC could still be an option.
Once you’ve chosen an entity type, you then need to consider where to register that entity. In the U.S., LLCs and Corporations can be registered in any of the 50 states plus the District of Columbia. You have three options:
- Home State. You might assume that registering your company in your state of residence would be the default option. And if you opt for a LLC, it probably is. But you should think twice before incorporating a C-Corp in your home state. Each state has slightly different laws, and some Secretaries of State are easier to work with than others. Plus, you’ll get a lot of raised eyebrows if you tell a California VC that you’re incorporated in Alabama (which happens to be my state of origin).
- Delaware. Most startups are incorporated in Delaware, and that’s where investors expect your company to be incorporated. Why? The tiny state has a long tradition of hosting major U.S. corporations, and has developed a well-defined body of law that’s business-friendly. But the simple reality that Delaware is what everyone (investors, lawyers, accelerators, etc.) is familiar with and expects is reason enough for me. (See Yokum’s What state should I incorporate in? for more.)
- Offshore. Attend a startup Q&A session about company formation and inevitably you’ll get some hotshot asking about setting up a holding company in the Caymans. Sure, the tax rate may be lower, but as an early-stage startup, tax rate should be the last thing on your mind. Right now you need to figure out how to build a product and generate revenue. Get to $1 billion first, then worry about tax optimization. An offshore entity almost never makes sense for a U.S.-based startup.
If you’re setting out to create a high-growth startup, you can’t go wrong with a Delaware C-Corporation.
Number of Shares to Authorize
Now that you’ve chosen an entity and jurisdiction, you next need to decide how many shares to authorize. It can be any number, but let me save you the hassle and tell you the best answer: 10 million. Why? Because that’s what everyone else does. (Are you noticing the pattern here?)
Beyond that simple reason, 10 million is an easily divisble number. It’s a big enough number that when you give an employee 10,000 stock options, it psychologically feels like a lot (even though it’s only 0.1% of the company). It’s also a convenient number for dealing with the price per share — if your company has a $10 million valuation, each share would be worth $1. But more than anything, authorize 10 million shares because that’s the norm for startups.
Number of Shares to Issue
It’s important to realize the difference between authorizing shares and issuing shares. Authorizing shares is simply deciding how many slices to cut in the pie. Issuing shares is when you actually hand out some of those pie slices. “Authorized but unissued shares” are then the pieces of the pie still on the table. Once you decide how many shares to authorize, the next step is to determine how many shares to issue to the founding team.
The advice out there on this particular topic is more divergent than the other aspects we’ve covered so far, but I suggest allocating roughly half of the authorized shares to you and your cofounders. This should give you enough headroom to make it through your Series A financing without having to authorize additional shares.
Here’s an example scenario. Let’s say we issued 4 million shares to the founding team, and set aside 1 million shares into an option pool for future hires. We’ve now carved out 5 million shares. In order to get to a Series A funding round, many startups are now raising at least two prior rounds (call it pre-seed and seed), and a rule of thumb is that we’ll need to give away 20%-30% of our company each round. So if we start out with 5 million shares and are diluted 25% over three consecutive funding rounds, we’re still within our 10 million authorized shares:
5,000,000 × 1.25 = 6,250,000
6,250,000 × 1.25 = 7,812,500
7,812,500 × 1.25 = 9,765,625
Splitting Equity Among Cofounders
At this point, you’re probably planning to authorize 10 million shares and issue a total of 4 to 5 million shares to you and your cofounders. However you decide to split it up between you, there is one very important consideration: vesting periods.
It is highly recommended that you and your cofounders all agree on a vesting schedule for your founders stock. Recommended terms are:
- 4-year vesting schedule. Your equity vests in 1/48 chuncks every month for 48 months.
- 1-year cliff. If you leave the company within the first year, you don’t take any equity with you. Instead the first 1/4 of your equity vests on the 1-year anniversary.
- Single-trigger acceleration. In the event of a company sale, all your unvested equity vests immediately, even if the full four years has not ellapsed.
Why would you, a founder, put such restrictions on yourself? To protect your cofounders and — since they’ll be signing the same agreement — to protect you in case one of them leaves the company early. At this point your cofounders are probably close friends, but four years is a long time and startups are stressful. Cofounders leave. The last thing you want is to fall out with a cofounder a month after the company is formed and have them walk away with half of the company. A huge number of company blowups are the result of cofounder fights. Protect yourself. See Cooley Go’s Founder Basics for more on this.
(If you do opt for a vesting period, there’s a document called the Section 83(b) election that you really, really need to file with the IRS within 30 days to avoid being potential hit with a sizeable tax bill later. It’s a hard deadline — so do it right away before you forget.)
Making it Happen
Entity, jurisdiction, shares to authorize, shares to issue, founder vesting schedules. Those are the main parameters you need to think about when it comes to incorporating your startup. With those in mind, how do you actually go about incorporating? You have a few options:
1. Hire an attorney
In the past most startups have hired a lawyer to handle the incorporation process for them. A good attorney will first walk through the types of decisions we’ve covered above, generate the relevant documents (Certificate of Incorporation, Bylaws, Initial Board Consent, stock purchase agreements, and others), and file your Certificate of Incorporation with Delaware (or other jurisdiction), and often help with other details such as getting an Federal Employer Identification Number (EIN) and arranging a registered agent (a third-party registered within the state who receives correspondence from the state on your behalf).
I recommend using UpCounsel to hire an attorney to help you with company formation, where you can expect to pay $1,00o to $2,000. Higher-end law firms often charge north of $5,000 for formation.
2. Do It Yourslef
If you don’t want to spend a couple grand on attorneys and are willing to roll up your sleeves, it is entirely possible to incorporate on your own. I managed to. But a word of caution: if you screw up your incorporation, it could lead to big problems down the road, or at the very least make you look amateurish, so be extremely careful. Here’s how I did it:
- First, apply for your Federal Employer Identification Number (EIN). Easy.
- Second, arrange a mandatory “registered agent.” One of the common ones is Harvard Business Services and will cost you $50 per year. They don’t do anything special and are more or less all the same but you’re requried to have one.
- Here’s the magical part. You can use Cooley Go’s Delaware Incorporation Generator to create all the documents, free. Cooley is a well-recognized international law firm with a healthy startup practice, so I put alot more faith in their templates than, say, LegalZoom.
- Then, you need to file the Certificate of Incorporation (generated by Cooley Go) along with a Filing Memo and fax it to the Delaware Division of Corporations at the number included in the memo. It will cost you $89.
So for $139 and a bit of DIY elbow grease, you’re now a Delaware C-Corporation. However, before you actually file with Delaware, I recommend that you get someone—an advisor, another founder, an attorney—to help you double check that everything is as it should be.
3. Stripe Atlas
If you don’t want to spend $1,000+ on legal fees, but don’t have the wherewithal to DIY, a great third option sprung up just last year: Stripe Atlas. For just $500, Stripe will incorporate your company, arrange the registered agent, create your federal EIN, and even open a bank account for you. It doesn’t get any easier than that. If I were starting a new company today, I would use Stripe Atlas in a heartbeat.
Parting Tip: Get a Mail Service
Prior to incorporating I recommend signing up for a mail service that gives you a dedicated address and scans your mail for you. Why? Over the past 2 years at Crema we have moved offices 4 times. It is a royal pain if you have to update your business address with state and federal governments, banks, etc., each time you move to a different office building. Get a dedicated address right at the beginning and save yourself the trouble (plus having everything scanned rather than cluttering up your desk is a big bonus). I use EarthClassMail and have a San Francisco address.
Congrats, You’re Legit
Now that you know what a “plain vanilla” legal structure looks like and how to pull it off, you’re ready to become a going concern as a Delaware C-Corporation. Onward and upwards!
Other Startup Cheat-Sheets
This is the first post in my Startup Cheat-Sheet series. Here are the others:
- How to Incorporate Your Company
- How to Close Your First Investor
- How to Create a Winning Pitch Deck
- How to Hire Employees & Advisors
- How to Get Into an Accelerator
- How to Run a Crowdfunding Campaign
- How to Track the Right Metrics
- How to do Cohort Analysis
- How to do Inbound Marketing
- How to do Outbound Marketing