Does my startup have to be incorporated in order to go out and begin raising funds?

QUESTION:

Does my startup have to be incorporated in order to go out and begin raising funds? I’m a solo operation, and I’m looking for angel funding, but I haven’t incorporated yet. I figured I’d see what the potential is before taking this step. Is this fairly typical?

ANSWER:

by Ethan Stone, Stone Business Law

First, a quick but important clarification: I’m not your lawyer and this answer doesn’t establish a lawyer-client relationship. I’m giving a generic answer to a generic question to educate the users of this site. The information below is general in nature and should not be understood as a substitute for personal legal advice.

It isn’t hard or expensive to form a company. An experienced lawyer will charge you a small fee and a few hundred dollars in filing expenses to do the basic work. You may owe some minimal taxes ($800 per year in California). Beyond that, there’s not much to it. So think about how much you care. If you don’t care much, it’s better to form a company and turn your attention back to building your business. That said, the lawyers’ fees, state filing fees and minimum taxes can seem like a lot of money, especially if you’re not sure you’re going to move forward. So I’ll discuss why you might or might not want to do it.

Experienced lawyers and seasoned business people generally advise tech entrepreneurs to form a company before doing much else. For example, take a look at this post by Mark Suster: http://www.bothsidesofthetable.com/2009/08/17/most-common-early-start-up-mistakes.

There are several reasons for this advice.

First, forming a company formalizes ownership arrangements between co-founders. That is not an issue for the solo entrepreneur.

Second, forming a corporation allows the founder to grant stock options to early non-founding team members at very low valuations. Once a round of outside investment is on the horizon, tax rules will require a higher valuation of the common stock and, consequently, a higher strike price for employee options. For a bit more information on this topic, you might look at Fred Wilson’s discussion here: http://www.avc.com/a_vc/2010/11/employee-equity-the-option-strike-price.html. If no one is getting equity before the first investment comes in, this is also not a concern.

Finally, forming a company is important because it creates a repository for IP rights that the founder and any employees, contractors or consultants create for the business. This is particularly important if there are multiple founders, since bitter, business-crippling fights can break out over who came up with what. It is also an issue, however, if employees, contractors or consultants will be developing any IP, including logos, graphics and websites.

Most of these problems can be solved by forming a company before starting serious development. On forming the company, the co-founders formally agree (in writing) to contribute whatever IP they have to the corporation at the outset and formally agree (in writing) to an IP assignment/”work for hire” agreement to make sure everything they develop, going forward, belongs to the company. Everyone else who develops IP (including contractors and consultants) signs similar written agreements. The result: When you go to investors for financing, their lawyers can quickly determine that the company they’re investing in has clear title to the IP. That’s important because doubts about who owns the IP can slow down the investment process, make it more expensive (the legal fees build up as your lawyers have long discussions with the investors’ lawyers) and lower the valuation. In extreme cases, IP ownership can make it impractical to finance an otherwise attractive business.

Whether this concern applies to a solo entrepreneur depends on how solo the entrepreneur really is. If you’re planning to hire employees, consultants or contractors to help develop parts of the business, you no longer have a one-person operation and it would be unwise to put off forming a company.

If you decide to put off forming a company you have to be extremely sensitive to any changes that might raise one of these three concerns. For that reason, it is important to be very realistic about your own personality and habits in deciding not to incorporate immediately. Some entrepreneurs are consistently meticulous, methodical and cautious. Many others have a tendency to get enthusiastic as new opportunities come up, focusing on the business and forgetting or putting off the “legal niceties.” Remember that fixing mistakes in this area (if they can be fixed) can take a lot of time, money and effort. Don’t choose a path that you’re not sure you can follow.

Also, if you’re going to form the company and take your stock close to the time of the initial round of funding, make sure your lawyer is thinking about the tax treatment of your investment. You should be able to avoid adverse tax consequences fairly easily, but you need to think it through before you act.

Good luck! I hope the first round comes quickly.

Founders Tip: Consider using a filing service such as Legal Zoom where they file all the documents with the state, get your record book, and more.