The following is an edited excerpt from the book Acceleration: What All Entrepreneurs Must Know about Startup Law by Ryan Roberts.
Picture this. Five former coworkers from a major tech company decided to break off and launch their own startup. They dreamed of creating the next Instagram or Twitter. Much to their delight, the five founders gained momentum.
“Maybe we should formally create a company. Who wants to take the lead on that?” a founder says.
Everyone demurs. People are too busy building and developing the product, finding customers, and trying to line up financing. “Let’s talk about it next month,” someone finally volunteers.
Next month turns into three months, which turns into six months. Finally, after nine months, the founders — which started as a group of five but is now a group of three — move to make their company official. They form a C corporation and file in Delaware. A year later, the company is really humming along with a financing deal in the works. For the deal to go through, the founders need all inventions assignments and other corporate documents signed and delivered.
There’s just one problem: the two original founders who left the company before the company became a legal entity refuse to sign the inventions assignments and other related documents. Without their signatures, the investor backs out. It’s too risky for them: there’s nothing to prevent the former founders from turning around and suing the company and winning a tidy sum, and whether or not they win, they can keep the company in litigation for years.
Now the startup is in a real bind, because no investor worth partnering with will open themselves or their investment to such risk (and more importantly, the investor does not want their investment to go toward funding such litigation). Short of getting the former founders to sign the paperwork, the startup’s ability to raise capital has been severely damaged.
The sad truth is that this situation is all too common while being very easy to avoid.
Some founders assume that the only reason to incorporate a business is for liability protection. If they were running a business with a physical storefront such as a restaurant or retail establishment, then yes, that would likely be the main reason. When you incorporate, the “corporate veil” protects the corporation’s owners (i.e., the shareholders) from personal liability such as if an employee or customer slips and falls or otherwise injures themselves on the job. If this happens and the injured employee or customer sues, then they sue the legal entity rather than the owner or other shareholders. Liability protection in the corporate context, thus, protects the shareholders’ personal assets.
Startups are a different type of business. Sure, liability protection is important to startups, but two other reasons to incorporate are more important:
- To ensure all founders are properly issued equity and with a vesting schedule in place.
- To formally transfer the relevant intellectual property (IP) from the founders to the company. (This is what handicapped our founders from the opening story.)
Founders exchange their time and IP for equity in the company in hopes that the equity received increases in value over time. The corporate structure provides the framework to administer the unique requirements of a startup including ownership tracking, centralized IP ownership, and yes, liability protection.
When To Incorporate?
You can look for inspiration and guidance from your favorite startups, but when it comes to the timing for your company’s incorporation, don’t try to emulate anyone else. The circumstances around when a company chooses to incorporate vary. However, there are a few signposts that can help you determine when it’s time to incorporate. One is when you’re ready to move whatever you’re doing from a hobby to an actual business. Another is when you have two or more people working together. Another one is when you begin contracting with third parties. When you find yourself in one or more of these situations, then it’s time to make the commitment, to spend the money, the time, and the effort to incorporate.
It is far simpler to incorporate your startup early, and do it the right way, in order to avoid costly mistakes that can derail the startup later. Plus, this is your chance to pick the right structure for the startup, a structure that will support growth.
Should You Have Cofounders Before You Incorporate?
There isn’t a right or wrong answer. I’ve worked with plenty of startups where one founder launches the company, incorporates it, and then forms an excellent cofounder team. I’ve also worked with startups where the founders connect first and then they get their paperwork in order. You can make this process work either way. If you’re on the hunt for a great cofounding team, or if you’re a little skeptical of your current one and want to know what traits make a cofounding team strong, then check out chapter 4, which is all about the cofounding team.
Which Is The Best Legal Entity For A Startup?
I’m just going to say it: the best legal entity for a high-growth startup — really, the only legal entity if you want to raise VC capital or other outside financing — is a C corporation.
Many founders walk into my office asking about an S corporation or a limited liability company (LLC). Both have their benefits for companies, just not as many benefits for startups looking to grow big in the technology space. LLCs are flexible, and theoretically, there’s less administrative burden than with a corporation, even though the administrative differences between an LLC and a corporation aren’t material. I’ve noticed that some founders mistakenly believe that if they choose to incorporate, then they will have to rent a conference room at the Marriott and invite their shareholders every year for a meeting. An LLC, by comparison, seems much easier to them. But annual meetings for the shareholders are not required for a privately held corporation — but something to look forward to if the startup has an initial public offering (IPO).
Many founders also ask for the S corporation or an LLC structure because of the pass-through taxation. Pass-through taxation allows the owners — the S corporation’s shareholders or the LLC’s members — to deduct the losses of the business on their personal income tax, based on their percentage ownership of the entity. Alternatively, if the pass-through entity made a profit, each of the owners would then pay taxes on such profits via their personal income tax return, also based on their percentage ownership of the entity. But it’s rare that any of my firm’s startup clients actually have a meaningful deduction to take. We’ll go through a series of questions that usually reveal my clients have no income to take the deduction from, or that their income is so low that the financial benefit of the deduction isn’t enough to tip the scales in favor of forming an LLC or S corporation.
S corporations have their own drawbacks for startups, primarily due to restrictions on shareholders. With an S corporation, shareholders must be — for lack of a better word — human beings, or “natural persons.” (There are a few exceptions for trusts and trust vehicles.) But many startups take investor money from entities like other corporations or LLCs, so even if your startup began as an S corporation, it would automatically convert to a C corporation the minute you accepted money from an LLC or another corporation. Once your S corporation status is revoked, then you can’t be an S corporation for five years.
Technically, an S corporation is just a C corporation that has elected to be taxed as an S corporation under Section 1362(a) of the Internal Revenue Code by filing IRS Form 2553.
The ability to maneuver between S corporation and C corporation status can be an important tax-planning mechanism for some startups, so losing such a benefit for practically no useful reason early on could be frustrating and limiting.
Therefore, instead of starting out as an S corporation, I counsel my clients to start out as a C corporation and take a wait-and-see approach.
Finally, if your startup has already formed as something other than a Delaware corporation, but wants to change to a Delaware corporation, you have three main options: (1) convert the current entity to a Delaware corporation, (2) conduct a reincorporation merger with the Delaware corporation as the surviving entity, or (3) start a new Delaware corporation without linking the current legal entity.
Which option you choose will depend on your startup’s circumstances, but conversion is generally preferred to the reincorporation merger (but not all states permit conversions). Furthermore, if a startup has just started and hasn’t transacted any business, the founders may prefer to scrap the current entity (and terminate it by the end of the calendar year, they can avoid another year of filing franchise or federal taxes) and incorporate a new Delaware corporation.
What About Double Taxation?
“I read about double taxation on corporations, and I want to be an LLC and not a corporation to avoid it,” is a line that many founders have said to me. Double taxation just sounds bad, right? But this is a case of myth versus reality. Double taxation only comes into play if the corporation makes a profit (which is taxed at the corporate level) and then distributes some or all of the profits to the shareholders based on their percentages — in other words, a dividend. A dividend payment is also taxed (at the personal level), hence “double taxation” occurs on the same money.
However, most technology startups aren’t profitable at first. Even successful startups don’t necessarily pay dividends. Google has never issued a dividend. Amazon is another example of a successful startup that has yet to issue a dividend. Furthermore, a founder is not double taxed on any amount she receives as a salary, as a salary is a business expense for the corporation (i.e., a deduction from corporate taxes).
Emerging startups typically reinvest what would be profits back into the corporation rather than issue a dividend to shareholders, because they are more concerned about increasing the overall enterprise value than immediately paying shareholders back. A startup may be on pace to make $500,000 in profit but may decide to increase expenses and spend that money on a marketing campaign or on hiring a few more developers.
In short, don’t let the fear of double taxation stop you from choosing a C corporation structure. I regularly advise clients that if they are going to deviate from what a standard startup would do based on taxes, then they should work with their accountant or tax advisor to really “hard circle” what their expected tax savings would be by not creating a C corporation. A large majority of the time, they return wanting to form a Delaware C corporation.
Which State Should My Startup Incorporate In?
It may seem counterintuitive to incorporate anywhere other than the home state that your startup is located in, but Delaware is the place to be. Delaware’s corporation laws are flexible in terms of equity division, different classes of stock, various control rights, voting, and other stockholder rights. It also has broad privacy protections.
What’s the big deal if I incorporated in the state I live? I’m sure you’re asking. Here’s the big deal: you may lose a potential deal, or it may cost you significant time and money.
Early in my law practice, I was working on a VC transaction for a client who was formed as a Texas corporation. The VC fund was in Texas, too, and they were OK with my client remaining a Texas corporation. Unfortunately, the deal ran into problems. The VC’s counsel and our side had to jointly try to interpret what one of the Texas statutes meant because no case law on it existed. Case law shows how the courts interpret various issues that come up, so it is what guides lawyers in advising our clients. Without case law, we have no guidance, which is what I and the legal counsel for the VC were struggling to understand and, thus, give our clients effective representation. After both sides, my firm and the VC’s lawyer, spent hours researching the meaning of the statute, we finally figured out that we had to go back to a forty-year-old amendment to review what was deleted from it.
There is a reason why Delaware is the state for a startup to incorporate. Delaware General Corporation Law is well-thought out, and there is a pile of case law behind each statute making the laws clear. Texas, I thought, had well-established corporate case law, too, but after the fiasco of this deal, my firm and the VC’s counsel in the above story made a “pact” to never let our clients be or invest in Texas entities again. This isn’t a knock against Texas; I think this happens in a lot of states.
For founders aspiring for their startups to be corporations, Delaware is the place to be. Sure, we ultimately got the deal done with the company incorporated in Texas, but it took us much longer to complete and cost both sides more financially.
Another reason to incorporate in Delaware is that it’s considered the universal corporate law. A lot of lawyers — not just here in the United States but internationally, too — either know and understand Delaware law or just feel comfortable with Delaware being the state of incorporation. For this reason, incorporating in Delaware can keep transaction costs lower for startups and potentially help facilitate interstate or international deals.
There’s also the VC piece. VCs typically expect to see startups as Delaware C corporations. In fact, most of the standard documents that you see for seed and venture capital financings are based on Delaware law. I’ve worked with VCs who specifically tell me they refuse to work with a startup unless it is a Delaware C corporation. And those VCs meant that I shouldn’t even send a pitch deck or make an intro. Why waste their time, they reason, when the startup just doesn’t “get it?”
Running a startup is stressful enough for founders who face numerous decisions that they have to make quickly. Make your life a little easier and incorporate in Delaware as a C corporation.
The one exception to becoming a C corporation is if a client tells me that they don’t plan to raise VC money for their startup. If that’s the case, then I’m more comfortable recommending they form an S corporation or LLC, or incorporate in their home state such as Texas.
How To Incorporate?
When founders decide it is time to incorporate, they essentially have two choices to complete the incorporation process:
- Purchase a do-it-yourself (DIY) kit or use a Software as a Service (SaaS) platform.
- Hire a lawyer.
The DIY options include legal forms such as LegalZoom and Rocket Lawyer. A word of caution: DIY forms tend to be geared toward small businesses rather than startups. These forms won’t guide you on issuing shares or on any IP assignment issues. Neither do these forms tend to offer any of the documents related to share issuances or assigning the IP over to the company. Since issuing equity and transferring the IP are the two main reasons to incorporate a startup, these DIY legal form offerings probably aren’t the best fit.
SaaS platforms include services such as Clerky and Stripe Atlas™. These platforms are usually more robust than DIY offerings in terms of how much information the user can fill into the legal document. The platforms may also include additional relevant startup incorporation documents — such as a stock purchase agreement and an invention assignment — so they’re closer to what a startup needs. But like the DIY forms, SaaS tends to disclaim responsibility for any tax or legal advice.
Additionally, it’s hard to deviate from the forms and templates offered by SaaS. While you probably won’t have to deviate very much, every now and then a startup may have a compelling circumstance that makes the one-size-fits-all approach unworkable. Many founders like to get complicated with their vesting schedules, which can be hard to do with SaaS offerings. Another downside that I’ve noticed with SaaS is that many founders skip signing all the documents, or they get the numbers or vesting schedules wrong, or they make the wrong edits and there’s no one there to fix or review those documents for them. This makes the incorporation incomplete. As a firm, we’ve had to develop special “post-SaaS incorporation” incorporation packages.
I see these situations too often. Usually, a founder comes in telling me that six months ago, they used LegalZoom to form their entity. They show me their documents such as their certificate of incorporation and bylaws. I review everything, and almost without fail, I will ask, “Do you realize that the founders still own the intellectual property and the company doesn’t?” or “Do you realize the founders have not been issued shares?”
Usually, my clients freeze with this news. They’ve operated under the assumption that everything was taken care of. But the IP doesn’t get transferred out of thin air, and it’s vital that it gets done, otherwise the company doesn’t own it.
More times than not, when a client attempts to incorporate on their own, there are items handled incorrectly like the story above. It isn’t because founders are dumb — they’re not. In fact, startup founders tend to be very smart, so there’s a tendency for founders to feel like they can handle the incorporation process themselves. There’s a potential for founders to think that at this early stage and with no customers, the incorporation paperwork is simple. It’s not.
If your options are between a DIY or a SaaS platform, go with SaaS. But if you can, I strongly advise a second option and that’s working with a lawyer.
Without coming off too much like a sales pitch for lawyers, I will say that many of us have handled hundreds, if not thousands, of incorporations. That translates into saving you time from having to spend hours on the web scouring through documents and trying to wade through contradictory answers to your questions. Lawyers can also address your startup’s specific needs and then tailor the incorporation papers accordingly, something that is difficult to do if you opt for DIY or SaaS. We also, usually, have a handle on all the paperwork and filing that you need to complete to protect the founders and the company.
To their credit, the SaaS platforms usually recommend that you use a lawyer when you use their services. But let’s be honest, founders are using SaaS platforms to avoid having to pay for a lawyer.
Although a startup starts small, these incorporations are typically more sophisticated than even a $50 million real estate deal. There are tax issues to consider and the vesting of shares to plan for. Even the stock purchase agreement tends to be complex and often includes items such as 83(b) election forms if a founder’s shares are subject to vesting. The IP assignments must be handled correctly. You get the idea. Incorporating a startup involves a lot of essential documents and moving parts that should be prepared at the outset.
If you decide to go with a lawyer, you’ll want to be sure that you hire someone well versed in startups. If a law firm or lawyer says they work with startups, then check to see whether the majority of their practice is in the startup world. If they have a laundry list of practice areas (and don’t have hundreds of lawyers), then you may want to consider another lawyer. Important issues crop up in the startup world, and it can be easy for an inexperienced lawyer to make a mistake, either by giving you the wrong set of documents or setting you up in the wrong legal entity.
If you’re worried about costs, I get it. As soon as we hear the word lawyer, most of us have visions of exorbitant per-hour fees. Before the money fear drives you to the DIY and SaaS options, consider this: I frequently see incoming clients mess up their incorporation process even with the SaaS platforms, which then costs them more money to have me fix the documents and they have lost critical time repeating the process (or maybe still have a lost founder, etc.).
So choosing a startup lawyer to help you incorporate doesn’t mean it will cost you significantly more money. In fact, startup lawyers don’t have to reinvent the wheel on what the document set should look like for a startup, and as such, many of us typically offer a nice flat-fee package for a thorough startup incorporation. Plus, you can rest assured that the incorporation process will be done right. In reality, incorporations are not a profit center for startup lawyers. We just want to see you do this right because it can derail many important milestones and growth opportunities for the startup if you get this wrong.
What Documents Are Included In The Incorporation Process For A “True” Startup?
The main incorporation documents for a startup that becomes a corporation include:
- Certificate of incorporation. The certificate of incorporation is the official filing with the applicable Secretary of State, which typically sets forth the name of the company, authorized number of shares, and par value of the shares. Frankly, a startup’s certificate of incorporation is somewhat basic and usually no more than two pages long.
- Action of incorporator. The action of incorporator is a document signed by the “incorporator” (usually a founder or the lawyer incorporating the startup) that adopts the bylaws and appoints the initial board of directors.
- The bylaws. The bylaws are a legal document that determines the corporate governance of the startup and include the rules and regulations for the startup’s internal administration and management.
- The stock purchase agreements for each of the founders. The stock purchase agreements are the documents that perfect the issuance of the startup’s shares to the founders and typically contain vesting provisions.
- Technology assignment agreements. A technology assignment agreement typically captures the IP that’s been developed before the incorporation date (more on this below).
- Confidential Information and Inventions Assignment Agreement (CIIAA) for each of the founders. The CIIAA (also sometimes termed a proprietary information agreement) is probably the most overlooked item that doesn’t get accomplished at incorporation or just doesn’t get accomplished at all. A good CIIAA contains nondisclosure obligations and nonsolicit obligations. The CIIAA also assigns related patents, domain names, business plans, and so on to the startup. It’s the work product related to the project or venture. A lot of founders will ask, “Does this mean I’m assigning everything I’ve ever invented?” The answer is no. The CIIAA broadly covers everything related to the project or venture, but the assignment should be confined to the project or venture. Some startup incorporations may not include technology assignment agreements, but all should include CIIAAs (more on this in chapter 2).
- Board consent. The initial board consent will approve the issuance of the shares to founders and other matters such as appointing the officers of the startup.
- If you are thinking about purchasing a corporate kit and/or corporate seal for your startup, don’t. These items are never used; your corporate books will likely be scanned or otherwise will be electronic.
Naming The Corporation
Before incorporating your startup with the Secretary of State, make sure the corporation name is available at the state level and potentially as a trademark.
Don’t assume you can register your corporate name with the Secretary of State even if you don’t see your desired name registered. Some states have very strict naming conventions and will reject your corporate name if there is a similar name already registered. Sometimes you can get a consent from the other company with the similar name, but this can be awkward to request, especially if you’re in a similar industry.
Some founders incorrectly assume that the Secretary of State conducts a trademark search, or that by registering a corporate name that it means their startup is shielded from trademark infringement lawsuits, or that they automatically then have the US or worldwide rights to such name. This is not the case.
Trademarking a name is a separate process typically handled through the US Patent and Trademark Office (USPTO). A full trademark search is typically performed by a third-party search firm. If you don’t want to go down that somewhat expensive road, founders can usually do online searches and web domain searches to see what’s available. From a branding perspective, you’ll definitely want to see what names are available. A lot of my clients actually register their web domain names first, then incorporate their startup with the Secretary of State.
If you want to change your startup’s name, you will need to file a certificate of amendment (to the certificate of incorporation) with the Secretary of State. Many founders incorrectly assume filing an “assumed name certificate” (a DBA) takes care of that, but the official name is what you register with the Secretary of State.
Finally, your startup’s corporate name does not have to be the name of your startup’s product. While it can be beneficial from a marketing standpoint to have the same corporate and product name, it’s not required. Some startups have more than one product. You could incorporate your startup’s name, and then likely seek trademark registration for both the startup and product’s name.
What Is A Registered Agent?
A registered agent is someone, either a company or an individual that a corporation appoints to receive service of process and other official notices such as state franchise tax notices. Service of process is how a third party gives your company notice of a pending legal matter, which allows your company to respond accordingly.
A corporation’s registered agent must be located within the relevant state. For example, if your Texas company is incorporated in Delaware, your company will need to hire a registered agent in Delaware. If your Texas company is incorporated in Texas, you or another shareholder or officer could be the Texas registered agent (assuming each resides in Texas).
The registered agent must be available during normal business hours and supply a physical address in the relevant state — no PO boxes or private mailboxes. Since this address is public record, some people opt to hire registered agents to maintain privacy, even if they are in the applicable state and could be their company’s registered agent.
The most common mistake startup companies make is failure to update the name and/or the address of the startup’s registered agent. For example, if you fail to update registered agent information with the Secretary of State, your company could be sued — and lose — without your knowledge. If you fail to have a registered agent (such as because the registered agent resigns for lack of payment), the ultimate result could be a forfeiture of your company. You may be able to “revive” your startup in this case, but it would come with some additional fees.
Rates for registered agents tend to range between $50 to $360 per year.
What Is A Foreign Registration?
While most startups are incorporated in Delaware, most Delaware corporations are not physically located in Delaware. If your startup is “doing business” in another state than Delaware, it will have to file what’s known as a foreign registration in such state. Each state will have its own definition or criteria for what is “doing business” in such state. A general rule is that if your company has a physical footprint and/or has employees in a state, then it is doing business in that state. Each such state will likely require a one-time filing fee, usually in the $50 to $1,000 range depending on the state. Additionally, your startup will then be responsible for applicable franchise taxes in such state.
Failure to register as a foreign corporation in a state can lead to adverse consequences to your startup, usually in the form of monetary penalties, not being allowed to bring lawsuit(s) in such state’s courts, and/or in the worst-case scenario, personal liability for the company’s directors or officers with respect to certain matters. The foreign registration does not have to be done simultaneously with the startup’s Delaware incorporation, but it should be made timely upon “doing business” in such state.
Note that this additional layer of potential franchise taxes and filing should not be a compelling enough reason to avoid Delaware as a destination for your startup.
This is just a cost of doing business as a startup.
To keep reading, pick up Acceleration: What All Entrepreneurs Must Know about Startup Law by Ryan Roberts.