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Startup FAQs

When should I incorporate?

Incorporating a business requires a commitment to the enterprise on psychological and financial levels. Once formed, a corporation doesn’t wither away on its own if the business is not a success. A corporation requires the payment of annual franchise taxes – $800 in California, in addition to certain administrative tasks known as corporate maintenance. Depending on your situation, winding down a corporation may be more complicated than forming it. So incorporating your business is not a step that should be taken lightly, nor, however, is it something that should be delayed indefinitely, provided that the founders are committed to the venture.

There are certain triggers that usually force founders to take the leap and incorporate their fledgling company. Some of the more common triggers are as follows:

  • The founders wish to allocate equity amongst themselves, including implementing a vesting schedule;
  • The founders wish to engage consultants or advisors and would like to offer equity incentives;
  • There are investors (either angel or VC) who are expressing interest in funding the venture;
  • The company has (or is close to having) revenues and needs to open a bank account; and
  • There are business and contractual relationships that the company needs to begin developing with third parties, and the founders wish to limit their liability (and increase the credibility of their company).

Prior to incorporation, co-founders working together on a venture, whether they expressly wish to do so or not, create and are operating under a common law partnership. Common law partners are jointly and severally liable for all liabilities of the partnership, whether incurred negligently, recklessly, or intentionally by one of the partners. In plain English, that means that if one of the partners incurs a liability and cannot pay, the other partners are on the hook for this liability. For example, imagine that one of the co-founders hits a pedestrian on his way to a company meeting. He and all the other partners are all liable for the thousands or even millions of dollars of treatment that will be required and that insurance does not cover. That’s a rather dire example, no doubt. But the take-away should be this: if you are working with other people (whether they are your co-founders, customers, or third parties with whom you have entered into contracts), the relationship may be exposing you to liability. Once you are committed to the business and are acting like a company, it is a very good idea to incorporate (and purchase business insurance!).

Where should I incorporate?

That depends, among other things, on whether your business is a “startup” or a “small business.” You might wonder what the difference is. There is no bright line rule and certain ventures fit into both categories or morph from one into another over time. But to provide you with some guidance, I would say that if you are providing personal consulting services, like IT or accounting, you have a small business. If both in the short- and in the long- term you are not counting on equity funding to jump-start your business, but will instead be bootstrapping via credit cards and maybe a line of credit secured by your personal assets, you have a small business. On the other hand, if you are talking to prospective hires about their equity stake in the company, creating a profile on AngelList, and preparing an executive summary to email to a VC, you have a startup.

Generally speaking, if you have a small business, you should keep things simple and incorporate in the state where you are doing business. If you are working on a startup, however, I would say, incorporate in Delaware. Do you have to incorporate in Delaware? No. You can incorporate in California, save a little on franchise taxes annually, and accept the headache of dealing with California Secretary of State every time you need to get something done. On balance, I think Delaware makes life easier for startups on several fronts, and I am happy to have this discussion with you if you are at that juncture. But if you already incorporated your business in California, or if you are going to incorporate in California, it’s a defensible decision, though, I would argue, not an optimal one.

What form of entity should I choose?

I have seen many long discussions about the right choice of entity, and most of them are more confusing than enlightening. Of course, there is no answer that will hold true for everyone. And, of course, reasonable minds may differ on their general approach to this question and on its application to your specific situation. But without making this a long treatise on the advantages and disadvantages of each entity form, I will try to offer some useful guidance.

Once again, your decision will depend on what you are trying to do and on the kind of enterprise that you have, a startup or a small business. The choice for most companies is going to be between an LLC and a corporation, so those will be the forms of entities that I will focus on.

LLCs are all the rage with some attorneys and with many business owners. Note, these are, generally speaking, not attorneys who specialize on working with startups and, for the most part, not business owners who have founded startups. There are many enterprises, primarily the ones that we have classified here as “small businesses,” where the simplified corporate formalities and pass-through tax treatment of an LLC are just what the doctor ordered. But, if you are in a universe where you are interviewing engineers and enticing them with stock options, or if you are planning on taking outside investment, especially from the venture capital community, you are better off with a corporation.

When should I retain legal counsel?

You should start talking to an attorney early, very early. If you are finding yourself at a crossroads, having to make a decision on anything remotely legal, it’s time to talk to a startup attorney. This doesn’t mean that you are going to have to pay thousands of dollars per month in legal fees. But it does mean that you are going to have someone on your speed-dial who knows what you are doing and can help you navigate around the pitfalls. Attorneys who specialize in startup work are very efficient because they run into the same questions that you have day in and day out. Remember, it’s always cheaper to do it right the first time than to fix it later!

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White Summers provides practical and cost-effective approaches to startup legal matters. From our Redwood City, California office, we serve individuals and businesses throughout the San Mateo, Santa Clara and San Francisco Counties, including Palo Alto, Menlo Park, Woodside, Atherton, Los Altos, Mountain View, Sunnyvale, Cupertino, Santa Clara, San Jose, Saratoga, Redwood City, Redwood Shores, Foster City, Burlingame, Brisbane, Daly City, and the City of San Francisco.

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