Incorporation Flashcards
What if one or more founders are currently working at another job?
Sometimes the best course is still to incorporate now, sometimes it makes sense to wait until you depart your other job to incorporate. This is a critical and fact-specific decision that should be made with the guidance of an experienced intellectual property attorney.
What if I’m a solo founder? When should I incorporate?
The analysis is substantially the same as the standard case. With a solo founder there is little risk of intellectual property misappropriation or a disagreement over equity allocation, but a corporate entity is still a requirement for many important steps that come after ideation (e.g., entering into contracts with customers).
Aren’t LLCs tax-advantaged?
What people are referring to is the “double-taxation” of corporations, where the corporation pays entity-level taxes, and then owners pay individual taxes on distributed profits. An LLC does not pay tax at the entity level, it passes profits through to the owners. This can be more efficient when the business is profitable and wants to distribute those profits to the owners, because taxes will only be paid on those profits once. But this is a red herring, because the tax efficiencies gained are…
irrelevant because profits are usually non-existent. High-growth companies are usually not profitable for several years, or reinvest all profits in growth, so extra taxes on distributed profits are a moot issue.
…made less significant because of tax loss carry-forwards: Even if a Delaware corporation shows a profit in the medium term, this profit is usually offset in whole or part by the tax loss carry-forwards from prior unprofitable years.
…not worth the reporting: founders & investors do not want to prepare or receive K-1s for various reasons.
In summary, there are many advantages to the Delaware C Corporation, and LLC’s advantages are either small or not relevant to the venture-backed startup world.
When should I incorporate?
From a legal perspective, a corporate entity is necessary for: (1) capturing intellectual property developed by the team, (2) issuing equity to stakeholders, (3) receiving investment, (4) entering into contracts, and (5) limiting liability. You may also want to incorporate if you (i) have more than one founder in order to finalize equity splits (procrastinating on this increases the chances of conflict), (ii) are hiring third party contractors or employees, or (iii) need to obtain visas for employees.
From a personal/psychological perspective, incorporation is a step that signals to yourself and others that you are seriously pursuing the venture and is an important milestone in founding a company.
There are additional equity-related benefits to incorporating and issuing stock ASAP. First, it enables founders to begin their vesting schedules. Second, stock ownership starts the clock on the holding periods for long-term capital gains treatment (1 year) and Qualified Small Business Stock (5 years).
Incorporation timing is usually driven by the factors above. To offer some specific rules of thumb, you should strongly consider incorporating before the first lines of code are written, as soon as the co-founding team wants to formalize equity splits, prior to approaching investors for fundraising, prior to signing a customer to a pilot agreement, etc.
Why does incorporation matter?
Legal & Business
Intellectual property: The corporation creates a legal container into which stakeholders assign their intellectual property, ensuring that the corporation owns all developed IP.
Issue equity to early team: A corporation may issue stock & stock options to the early team. This is particularly important to do early on to avoid adverse tax consequences from founder equity issuance after other major economic milestones (e.g., fundraising). Prompt issuance also starts the clock on long-term capital gains and Qualified Small Business Stock tax treatment. Equity is also critical compensation, as most early contributors will not earn a salary for a period of time and beginning to vest in equity is needed as incentive.
Bank account: The company cannot open a business bank account without a certificate of incorporation.
Limit liability: A corporate entity creates a liability shield between owners/managers and potential claimants. The longer the enterprise operates informally and without a corporate entity, the greater the risk is that a claim may be made against the founders as individuals.
Enter into contracts: With users (including privacy policies and terms of service), customers, investors, and more.
Fundraise: A corporate entity and bank account are needed to sell securities and receive funds.
Psychological
Incorporation is an important step in formalizing the startup and it forces the founders (and others) to take things more seriously. There’s equity “skin in the game,” and a path to raising outside capital and growing the team. It’s no longer just a casual side project.
C Corp vs. LLC: Which entity is “better”?
If the company will raise multiple rounds of outside venture capital, compensate many employees with stock & stock options, and exit via M&A or IPO, the Delaware C Corporation is the clear choice.
Employee equity: Unlike LLCs, Delaware C Corporations can issue stock options, which are advantageous to employees because they do not require up-front payment for the equity, and taxes are delayed until gains are realized following exercise & sale.
Preferred stock: Delaware C Corporations can issue multiple classes of preferred stock with different rights & preferences, enabling the traditional Series Seed, A, B, C, etc. fundraising framework.
VC fund requirements: Many VC funds restrict investment to Delaware C Corporations; the partnership agreements prohibit investments in LLCs.
How much does incorporation cost?
Initial Setup
Delaware filing fees: ~$500 +
Cost to register a Delaware entity in California (if operating in CA): $150 +
Document drafting via software startup tool: $500 OR
Document drafting by lawyer: $1,500 - $3,000 (billing often deferred until financing)
= ~$1,000 - $3,500
Ongoing Annual Fees & Franchise Taxes
Delaware Registered Agent fee is $120/year
Delaware minimum annual franchise tax in DE is $800/year
California minimum franchise tax in CA (if operating in CA and registered as a foreign corporation) ~$800/year
Other fees if applicable (e.g., city business license) - variable
= ~$2,000/year
Where should I incorporate? (Why Delaware?)
Delaware has made a huge industry out of being a friendly home to corporations.
Below are key reasons why Delaware is the dominant choice for corporate domicile:
Legal Certainty. There is greater legal certainty in Delaware.
Chancery Courts. Delaware has special Chancery Courts that are subject-matter experts in corporate and business law.
More precedent. Because there are more corporations in Delaware, there is more litigation, therefore more case law, therefore a better understanding of how particular issues will be resolved.
Global standard. Because so many founders, investors, and lawyers do business with Delaware entities, everyone knows the rules.
Efficiency.
Form documents are drafted by law firms with Delaware in mind. It can be extremely inefficient and costly to use another jurisdiction, as these contracts will require bespoke changes.
The Delaware Secretary of State has well-established processes & timelines for all corporate matters, and is often more efficient and easier to work with than other states.
A note on Web3: With the new opportunity presented by Web3, some jurisdictions, including Wyoming, have positioned themselves to be the domicile of choice. If you are founding a Web3 company, you should consult with an experienced Web3 startup attorney.
Can I change entity type if I change my mind?
Yes, you can change entity types. It costs several hundred dollars in filing fees, and anywhere from $500 - $5,000 (or more) in attorney time depending on company stage and complexity. It is worth noting that while changing from an LLC to a C Corp is not a taxable event, changing from a C Corp to an LLC is, near-term tax strategy should be discussed with an experienced corporate accountant.
Common vs. Preferred Stock
In the startup and venture capital world, preferred stock almost always refers to stock purchased by venture capital investors. It comes with special rights and preferences, which are typically grouped into “control rights” and “economic rights.”
Control rights often include electing a member of the board of directors, as well as certain protective provisions or “veto rights” enabling the preferred stock to block certain company transactions. For example, the Series A Preferred Stock likely has the right to elect a Series A Director. The Series A also likely has the right to veto any proposed sale of the company, or future fundraises. These veto rights give the investor significant power. Sometimes the preferred stock votes as a class with regard to veto rights, but more often each series of preferred stock will have a separate veto right. So, a sale of the company might require a majority of all stock and a majority of each class of stock (Series A, Series B, Series C…).
As for economic rights, in any liquidation event (e.g., sale of the company), the preferred stock typically has the right to be repaid 100% of their investment prior to any payment to the common stock (a “1x liquidation preference”). This protects the investors’ downside in the event the company is sold at a low price. The preferred stock also has the right to convert into common stock, so, in the case of M&A, if the company is being sold for a good price, such that the venture investor is receiving more than 100% of their money back, they would opt to simply convert to common. The preferred stock also typically has anti-dilution provisions, meaning that if the company sells preferred stock in the future at a lower price (a “down round”), the current preferred stockholders will receive additional shares as an adjustment to protect against the dilutive effects of the down round.
These control rights and economic rights are what make the preferred stock much more valuable than the common stock early on in a company’s life, which explains the disparity between the price per share paid by a venture capital investor and the value of common stock (as determined by a 409A valuation firm). Often the price disparity is 5-10x, for example, a Series A investor may purchase Series A Preferred Stock at $1.00 per share, and, after a financing, the common stock might receive a 409A valuation of $0.15 per share.
What is a registered agent for service of process?
An “agent for service of process,” also called a “registered agent,” is either an individual or a corporation that is designated by a business entity to receive official legal documents, such as service of process in the case of a lawsuit. Use of a registered agent is common in the case of a company incorporated in Delaware but headquartered elsewhere. There are several companies in Delaware that perform this service for a low annual fee.
Delaware C Corp vs. Delaware Public Benefit Corporation?
A Delaware C Corporation (C Corp) is the entity of choice for venture-backed startups, although a relatively new entity, the Delaware Public Benefit Corporation (PBC), is becoming a popular choice for mission-oriented founders.
PBCs are exactly like C Corps, except that in their certificate of incorporation, PBCs are obligated to include at least one specific public benefit as their stated purpose. PBCs must provide to their stockholders, at least every other year, a report assessing the PBC’s success in fulfilling its purposes, the related standards established by the board, and evidence relating to the attainment of those standards and objectives.
The major concern founders have in making this decision is whether or not it is more difficult to fundraise with a PBC. The short answer is “probably.” There is no doubt that most investors are used to investing in C Corps, and that they might view the PBC as an unknown or riskier investment, or a signal that a founder is more focused on mission than profit (which is a “bad” thing from the perspective of many traditional investors). However, a sizable and growing pool of impact-focused investments funds, foundations, and family offices have a specific mandate of backing mission-driven organizations, and when approaching those firms the PBC may in fact be a competitive advantage. For a mission-driven founder who likely wants to partner with like-minded investors, using a PBC is an excellent way to align values and objectives toward impact beyond profit.
Keep in mind that it is always possible to amend the company’s certificate of incorporation, so a founder can start as a C Corp and become a PBC, or vice versa. Before deciding on C Corp vs. PBC, we recommend seeking the counsel of an experienced corporate startup attorney, as well as another attorney that has experience with mission-driven or impact structures.
