To C-Corp or not to C-Corp? That is the question.
A Rough Draft of the Legal Basics: Forming a Legal Entity
By: Josh Rottner & Pat Mitchell, Cooley LLP
This post is part of “A Rough Draft of the Legal Basics,” a series covering the legal basics every startup needs to cover.
As start-up lawyers, we spend our days working with talented, passionate and courageous entrepreneurs creating cool things. Our clients are on the cutting edge of software, social media, energy, ecommerce, robotics and space exploration.
As companies mature, they face a variety of legal issues depending on their industry, strategy and stage of development. But at the very beginning, almost all start-up clients have similar legal needs and tend to ask the same questions.
We have advised many companies (including some in the Rough Draft program) on these basic legal questions, and will be sharing our answers with the Rough Draft community in a series of posts on this site.
Let’s start at the beginning: the formation of a legal entity.
1. Do I need to form an entity?
This is a question that may be best answered with a question: are you serious about pursuing this business? If the answer is yes, then form an entity. The formation of a legal entity is a critical first step in the life of a new venture. Without an entity, there can be no stock ownership, no corporate bank account and no limitation of liability for the founders. An entity is also important in order to enter into contracts with third parties and to establish clear ownership of the intellectual property underlying the business. So form an entity. It’s easy and inexpensive. For related resources published by our colleagues at CooleyGo, please see Corporations: The Basics and Why Do I Need to Incorporate? (Video).
2. Where should I incorporate?
If your company plans to raise funds from institutional investors, we recommend incorporating in Delaware. Delaware law is the lingua franca of American corporate law: it is well established, benefits from a rich caselaw and is generally predictable and user friendly. If you choose to incorporate in a different state, your venture capital investors may require you to migrate to Delaware in connection with a round of financing. Better to skip that step and just start in Delaware. For more information at CooleyGo, please see Where Should You Incorporate?
3. What type of entity should I form?
Most companies that expect to raise venture capital are organized as C Corporations. The C Corporation is the preferred entity for businesses with this profile because many venture capital funds with tax exempt limited partners are not permitted to invest in “flow through” entities (e.g., LLC’s, S Corporations, or partnerships). Further, few venture-backed businesses generate taxable income for several years (if ever), so there may be no benefit to organizing as a “flow through” entity. Finally, corporations are just easier to maintain and manage than LLC’s and partnerships. Nevertheless, there may be some cases when a “flow through” entity is appropriate for an early stage company, and careful consideration should be given to the pros and cons of this form of entity. For more information at CooleyGo, please see Choosing the Correct Business Entity: The Basics and Comparison of C Corp, S Corp and LLC Entity Types
4. What is the process for naming my company?
You don’t need to settle on the perfect name before forming your company. You can start by filing your formation documents with a placeholder name and change it later. As we discuss in Choosing Your Corporate Name, there are several issues to consider when deciding on your company’s name, including marketing, the availability of relevant URLs, trademarking and the availability of the legal name in the jurisdiction of incorporation. Some companies are able to figure it out at the time of formation, but many companies form first with a working title and settle on the name later.
5. How long will this all take?
You can form a company in a day. The formation documents are simple and standardized. We recommend consulting with an experienced attorney or paralegal to assist in the filing process to ensure that the necessary steps are followed. For more resources, please see How to Incorporate in Delaware and California, Delaware Incorporation Package and All Documents.
Next up in our legal basic series: Issuing Equity.
