“The only thing worse than starting something and failing… is not starting something.” —Seth Godin, Dotcom Business Executive, Author and Blogger
Even though you may still be in the idea stage and not yet sure whether the opportunity you have identified can be turned into a viable business, you should form a legal entity if you plan to pursue it. A legally formed company affords you and your idea protections that are not available to you as an individual. Most startup companies are corporations, not sole proprietorships. A corporation limits shareholder liability. It’s a repository for intellectual property and other assets. Perhaps most importantly, a corporate entity provides a vehicle for inbound investment.
The first thing to come to grips with is that YOU are not your company. Your company is a creature of the law. Your company has a life of its own. It wants to survive, and it wants to protect itself, even from you. What is best for your company is not necessarily best for you. The role you play determines your obligations and your liability. As an officer and/or director of your startup company, the law will hold you accountable. And the minute you hire someone, or take investment money from someone, or enter into a business contract with someone, your obligations and liabilities increase exponentially.
Things to Think About and Decide
First, think about the costs, advantages, disadvantages, and tax consequences of the different types of legal entities.
Second, decide which legal form your company should take:
- Common choice for growth
- No limitations on foreign or entity
- Ability to issue multiple classes and series of
- Earnings are subject to taxation at the corporate level and again by each stockholder
- Best choice for companies planning to raise money from institutional investors.
- Potentially beneficial to prefunded companies or bootstrapped companies.
- Profits and losses “pass through” to
- Ownership limitations prohibit non-U.S. shareholders and most entity shareholders.
- Multiple classes of stock are
- Potentially beneficial to startups in the idea validation and testing stage, when the likelihood of continuing to develop the product is uncertain.
- Profits and losses “pass through” to equity
- No restriction on foreign or entity
- Costly to implement multiple classes of
- Costly to implement equity incentive
- Lots of tax
- Most professional investors avoid
- Generally, not recommended for growth companies, but may be suitable for a startup, with a path to migrate to a “C” Corp if and when the business opportunity is proved
Third, decide on the jurisdiction to incorporate. Most “C” corps choose Delaware because it is familiar to investors nationwide, has well defined and tested corporate law, and is fast and efficient. The downside to incorporating in Delaware is a higher formation and maintenance expense and carries a potentially large annual franchise tax. If you need to start quickly and cost- effectively, forming an LLC in your state might be fine to secure immediate corporate benefits.
Things to Do and Avoid
Do not proceed to invest time, money, and other resources to develop a business as a sole proprietor. Invest in the appropriate legal structure if you plan to build a business that will have other founders, employees and/or investors.
Do, seek the advice of a good corporate attorney to decide which type of business entity you should form.
Do, when putting together your board of directors, make sure to have an odd number to avoid voting and policy stalemates.
Do, register for a fictitious name in your home state.
Do, file an annual corporate report and obtain the proper licenses for the type of business being operated, as required by your state.
Do, visit the Secretary of State website for a detailed list of applications, licensing, and compliance requirements.
Do, get an Employee Identification Number (EIN) from the IRS to open a bank account and to file your tax return each year — even if you have no revenues or do not plan to have a profit.
Do, set up a reminder system for all state and federal tax, licensing, reporting, filing and compliance requirements.
Recommended Readings and Resources
Steps to Starting a Small Business The Company Corporation
LegalZoom, Templates, services, and legal assistance for starting a company.
The Startup Company Lawyer by Yokum Taku
A leading database of resources regarding legal issues from finding lawyers to researching rules and finding legal forms.
Templates: Articles of Incorporation, Company By-Laws, and LLC Partnership Agreement, StartupBiz.com Templates.
Application for Employer Identification Number (EIN) Internal Revenue Service.
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