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WHEN TO INCORPORATE
This chapter discusses an entrepreneur’s timing considerations for when to incorporate her startup venture. I use the terms incorporate and incorporation generally to refer to the decision to form a separate entity (other than a sole proprietorship or GP) for the business activity. Entrepreneurs may put off incorporating until business operations are established or there is adequate capital in place. Below are some considerations or factors to use when determining when to incorporate.
How can incorporating early help avoid disputes with other founders?
An important point that the world learned from Mark Zuckerberg regards the value of formally establishing roles and ownership interests early in the life of a business. You may recall that the Winklevoss brothers sued Zuckerberg in a highly publicized trial to determine their ownership interest in the business organization. The brothers claimed an ownership interest in Facebook, Inc., based upon their alleged contributions to the venture early in its formation. This scenario goes to show that, as a general rule, a startup should incorporate when there is more than one founder. Part of the problem results from the fact that founders are renowned for making loose promises of equity ownership to those assisting in the early stages of the business. These promises often result in later disputes and lawsuits. Incorporating forces (or at least encourages) the founders to formally establish the authority and ownership interest of each founder.
• Note: Stock distribution agreements with founders and early employees should always include repurchase rights for vested shares and forfeiture of unvested shares.
When should I incorporate to limit personal liability?
As previously discussed, incorporating protects individuals from personal liability for the debts of the corporation. Carrying out business operations necessarily entails entering into contractual agreements with third parties. Failure to comply with any of these agreements can lead to liability for the parties. Incorporating allows the founders to enter into agreements in the name of the corporation, rather than their names. Founders must take care to maintain corporate formalities in order avoid the loss of liability protection.
• Note: When entering into agreements prior to incorporating a business entity, founders should identify themselves in the role of incorporator.
Should I incorporate before hiring employees?
As discussed in prior chapters, an employee is an agent of the business. Carrying on any sort of business activity prior to incorporating defaults into a sole proprietorship or GP. Therefore, an employee of the business activity subjects the founder(s) to personal liability for her tortious actions within the scope of employment. Incorporating before hiring employees eases the process. The business can file for an EIN and state taxpayer identification number and set up withholding and deposit requirements. Lastly, incorporating allows the issuance of equity to founders, employees, investors, etc. Recall that founder and early-employee, stock agreements will often be subject to a vesting schedule or include restricted stock options.
• Note: Early in the life of a business, compensating individuals with stock options is a common manner of acquiring talent without sufficient capital to pay a salary.
How does timing affect business intellectual property?
The early creation of intellectual property by founders is a huge issue. If the business activity involves intellectual property, the founders should incorporate as soon as possible and transfer ownership in the intellectual property to the business. Any improvements or modifications to the intellectual property will therefore inhere in the business. Failure to do so could give rise to disputes between the parties regarding the ownership of the property if one party leaves the business at a later date. In any event, business owners should use work-for-hire agreements to make certain that the work and creations of employees and contractors are the legal property of the business.
• Example: Jake and Elise work together to create a new design for a robot. Early in in the process, Jake breaks away form the partnership and attends college. Elise continues to work on the robot. She incorporates the business and assembles a research and development team. Years later, Elise and her team are successful in selling the robotics technology to a large corporation. Jake sues Elise and the corporation to obtain a portion of the sales proceeds. The court will have to determine the extent of Jake’s interest in the business venture at the time of dissolution of the partnership. Failure by the parties to have a formal agreement regarding intellectual property rights has caused considerable controversy over who has ownership rights in the technology.
• Note: It is important to have comprehensive intellectual property transfer agreements that transfer all existing intellectual property rights to the corporation at or near the time of formation.
How does timing affect the tax basis for founder ownership interest?
A successful business will typically become more valuable over time as it grows. Incorporating early and transferring assets to the business creates a basis in the common shares. Stock option plans with vesting periods are used to compensate early employees. These individuals will want to establish an early basis in the stock 9when the price is lower) and pay taxes on the shares at that time. The IRS allows an employee or founder to make an IRC Section 83(b) election preserving the basis at the time of award of the stock or stock option. When the stock later vests it maintains the early basis and the employee is not taxed at the higher valuation. The shareholder pays taxes on the value of the stock options when granted. The stock will be taxed on the increased value at the time of sale. If the holding period is longer than one year, the long-term capital gain tax rate will apply, rather than the ordinary income rate.
• Note: Failing to make the IRC Section 83(b) election means that the shareholder will pay ordinary income taxes on the receipt of stock options at the time of vesting. If the value of the options increases from the time of granting, the holder of the option will pay higher taxes. All parties who intend to sell their interest in the business will want to take advantage of the long-term capital gain rate. Incorporating early and vesting shares in founders will begin the holding period.
• Example: Darlene and Wallis found a new technology startup. They immediately form a corporation and distribute 1,000 shares of founder’s stock to each founder. The founder’s basis in the stock will be the value of the company at the time of issuance. At this early stage of the business, the founder’s basis is very low. If the founders wait until the technology assets have substantial value, then the value of shares in the company will be much higher.
How does incorporating early in the life of the startup facilitate equity financing?
As discussed in prior chapters, investors in the corporation generally require preferred shares in exchange for their investment capital. Incorporating early will signal to potential investors that the business is established and open to outside funding. Further, it makes it easier for the investors to carry out due diligence and reduces the costs associated with reforming the entity at the time of equity investment.
• Note: Reducing equity funding costs is a concern for the business, as the costs of funding (the investor and the corporation’s attorney) are generally paid by the business. The amount is taken directly from the funds injected by the investor.
What other considerations on timing are important when incorporating?
Incorporating a business triggers all of the maintenance requirements, discussed previously. Founders should be prepared to comply with all corporate formalities. Further, if a founder is employed elsewhere, make certain that there are anti-compete clauses that would be triggered by incorporating the business. Likewise, if an employee is subject to work-for-hire provisions in an employment contract, make certain that there will not be any disputes over the ownership of intellectual property between the businesses.
• Note: Employees and directors (particularly those in small to medium-size businesses) are bound by a duty of loyalty to their employer. They cannot usurp a business deal for their personal interest that originates as a result of their status as employees or directors. Creating a formal business entity may expose a potential conflict of interest in dual employment status or situations where a director is also affiliated in another business in a similar industry.