A question we often hear from entrepreneurs and founders of startup companies is, “When should I incorporate?” In typical lawyerly fashion, the answer is, “It depends.” While there is no perfect answer that applies to every situation out there, we generally counsel people to incorporate when: 1) they are ready to get serious about the business; 2) they have multiple business parters; or 3) they are ready to contract with an outside party. For a more detailed discussion, below are some additional factors that should also be taken into account when deciding when to incorporate. If you are in a situation where one or more of these conditions exists with your business, then you should seriously consider incorporating sooner rather than later so that you can get the ball rolling and save yourself time and money in the long run.

1. Multiple Business Partners. With multiple business partners or founders, the greater the necessity of getting a written agreement in place that outlines the rights and obligations each has to the other, and how much of the company each founder owns. Incorporating and issuing founders’ shares according to a vesting schedule will help prevent the misunderstandings common among founders when it comes to ownership splits. Trying to clean up pre-incorporation promises to ownership in a startup company is a difficult, time consuming and expensive task, especially if one or more founders leaves before formal documentation is in place.

For more information see our post on splitting up founder equity.

Please be aware that the documents from do-it-yourself online incorporation services do not contain founders restricted stock purchase agreements with vesting.

2. Product or Service Launch. Often the main reason cited for incorporation is to protect founders and other shareholders from personal liability for debts of the company. Therefore, we often counsel people to incorporate prior to launching a product or a service due to potential liability issues, as the potential for liability increases with customers or users, and the amount of liability depends upon the nature of the product or service.

3. Intellectual Property Creation and Holdings. IP needs to be owned by the company and not the individuals working for the company. Before IP is created by an employee or founder, the appropriate IP assignment agreements need to be in place so that upon creation of the IP, the ownership of that IP is automatically transferred to the company. Incorporating creates the place where all of the IP is then transferred, especially important when you have employees or multiple founders. You can run into problems if a founder or employee leaves the business before incorporation and the IP has not been assigned to the other founder or the entity. Subsequent use of IP created by the former founder may be problematic, potentially resulting in costly litigation or expensive assignment negotiations with the departing founder.

Examples of IP created in startups include program or website code, company or product names, trademarks and slogans, trade secrets, patentable products, and copyrights in code or marketing materials.

Again, please be aware that the documents from do-it-yourself online incorporation services do not contain IP assignment provisions for founders or employees.

4. Raising Money. If outside investors such as venture capitalists or angel investors want to invest in your company, you will need an entity to accept the investment and issue securities. In our experience, we consider it a best practice to incorporate early and then immediately issue shares to the founders at the lowest justifiable price (par value, if done immediately). The greater the separation in time between the issuance of founders’ shares and the first round of financing, the easier it is to justify the price difference between the founders’ common stock (ex: $0.001 per share) and the Series A preferred stock (ex: $1.00 per share).

5. Hiring Employees or Independent Contractors. Most founders will need to incorporate if they intend to hire employees or engage independent contractors. It generally makes sense to incorporate so that the employee or contractor enters into an agreement with the company instead of an individual founder. In addition, as discussed above, any IP created by the employee or contractor can be assigned to the company instead of an individual founder. This also has the added benefit of freeing up the individual founder for any personal liability incurred that is owed to the contractor.

Once again, please be aware that the documents from do-it-yourself online incorporation services do not contain IP assignment provisions and do not adequately deal with this situation.

6. Issuing Stock Options. Many startups do not have the cash to pay contractors or service providers and therefore may agree to fully or partially compensate the other parties by granting stock options or giving them the opportunity to purchase shares at highly discounted price. Although it is possible to have pre-incorporation agreements to grant equity upon incorporation, it is easier to incorporate and then grant the stock options or equity to satisfy these promises.

Once again, please be aware that the documents from do-it-yourself online incorporation services do not deal with this situation.

7. Obtaining Visas. If a foreign founder intends to work in the U.S. on a startup project, then the founder should work with an immigration attorney on a strategy to legally work in the U.S. Incorporating a company and demonstrating that it is a “real” business with sufficient capital is typically a prerequisite to a visa application.

8. Favorable Tax Treatment. If a founder sells stock of a company in a taxable transaction and it is held for more than a year, then the capital gains tax rate is 15% for founders in the 25% tax bracket and higher. If the stock was not held for a year, or if no company has been formed and only the assets are sold, the seller’s proceeds will most likely be taxed at the ordinary income tax level, which in the example above would be 25% instead of the 15% long term capital gains rate, an additional tax of 10% on the transaction.

Incorporation is not something to take lightly, as it is a serious step that results in out of pocket costs and ongoing tax and other filing obligations, and therefore we recommend it only when you are serious about your business or one or more of the above factors applies. Before deciding to incorporate, please seek the advice and counsel of an attorney with startup experience, as other factors may impact whether or not you can or should incorporate, such as if one of the founders is still employed by another company. In this case, the founder will need to have his employment documents carefully reviewed in order to determine if there are any issues with non-compete, non-solicitation, or confidentiality.