Types of corporations and how to incorporate your startup
As a founder, you will be faced with a multitude of important decisions. One of the first is to choose which legal structure is the best fit for your startup. There are multiple ways to incorporate, each with its advantages and disadvantages. Before making a decision, you’ll need a basic understanding of the types of incorporation to consider.
Know the types of corporations
There are four general types of corporations in the United States: a sole proprietorship, a Limited Liability Company (LLC), an S-Corporation (S-Corp), and a C-Corporation (C-Corp).
1. Sole proprietorship
The simplest option for small business owners who are getting started without VC funding is to create a sole proprietorship. A sole proprietorship is an unincorporated business that is owned and operated by one person. There’s no registration process or application to fill out, although you may want to pay a small fee to get a DBA (“doing business as”) certificate. The DBA document reserves your rights to a particular company name. However, once you register a name for your business, it’s a hassle to change it.
Although simple, a sole proprietorship does have its downsides. For example, many commercial banks, including Silicon Valley Bank, won’t be able to open accounts for you. And if you’re working by yourself—say, coding prototypes—this is a fine option, says David Raynor, founder of Accelerate Legal, a San Francisco law firm that caters its services to tech startups. “But the minute you have two people, there are problems, like who owns the intellectual property?” Raynor warns. At this point it may be wise to consider a different type of legal entity. Likewise, if you decide to seek VC funding you’ll need to incorporate.
2. Limited Liability Company (LLC)
Another common company structure is an LLC, or Limited Liability Company. An LLC is advantageous for a few reasons:
- The cost is relatively low.
- You record the company’s financial results in your personal tax filing.
- Owners of an LLC are not personally liable for the company’s debts and legal obligations.
There are a few drawbacks to LLCs:
- You’ll likely have to pay self-employment taxes.
- It will be harder to attract investors.
- It can dissolve if you lose a member.
3. S Corporations (S corps)
S Corps are typically small businesses and give you the benefit of incorporation with the tax-exempt privileges of a partnership. Like an LLC, you can pass income directly to shareholders without paying federal corporate taxes. There are some limitations to S corps:
- Are limited to only 100 shareholders
- Can only issue one class of stock
- Are only open to shareholders who are US citizens or residents, specific trusts and estates, or certain tax-exempt organizations
4. C Corporations (C-corps)
Most startups incorporate as a C-Corp, the same structure used by Apple, Google and pretty much every large company in the United States. A C-Corp is a fully separate legal entity, responsible for paying corporate taxes and issuing annual reports. It must also appoint a board of directors. It will probably seem like more structure than you need when you’re just starting, but if you plan to raise money, a C-Corp is typically the right answer. It’s best to establish the C-corp as early in your company’s life as possible. “C Corporation … almost always the right choice for tech startups.”
The importance of timing to incorporate
1. When to incorporate a startup
Founders need to incorporate as soon as possible to protect against personal liability. When your business is a corporation, it assumes this risk so your personal finances will not, in most cases, be affected by third party claims.
2. When you need flexibility
Incorporation allows you to freely transfer shares without approval from other shareholders. Most startups, however, do restrict transfers to protect the corporation and shareholders. The right of first refusal, for example, gives the corporation a right to repurchase a departing founder’s shares.
3. When you need Investors
Prior to investing in your startup, investors at every stage of your startup — from angels to venture capitalists — will insist that you incorporate. Any investor funds you receive cannot be co-mingled with your personal funds. To prevent this, you need to incorporate so you can open a bank account in the company’s name, isolate company funds and maintain financial statements.
4. When you own intellectual property
As you grow, you’ll begin to amass intellectual property (IP) like patents, copyrights, trademarks and trade secrets. These are valuable assets, and you need to make it clear as soon as possible that your corporation owns your IP. The chain of IP rights and titles cannot be broken. The easiest way to ensure this is through corporate ownership. If IP ownership is uncertain, it will impact investments, partnerships, and acquisitions.
5. When you need prestige
Corporations have greater credibility among investors, partners and customers — particularly for startups.
How to incorporate your startup
For many businesses, it makes fiscal sense to incorporate in your home state or where you intend to do business. But for startups looking to secure outside funding, investors will likely insist that you incorporate in Delaware because of its favorable corporate climate.
“…investors will likely insist that you incorporate in Delaware…”
While Delaware is not a “tax haven,” there can be some tax advantages to being incorporated there. If your company doesn’t do business in Delaware, you won’t need to pay state corporate taxes. Similarly, equity owned by people who don’t reside in Delaware is not subject to state taxes. Since companies are still on the hook for taxes in the state where they are based, these advantages essentially eliminate double state taxation. Even so, Delaware companies are required to pay an annual franchise tax to Delaware. (And no, you don’t have to move your company to Delaware to incorporate there.)
Do you need a lawyer to register your startup?
Setting up a C-corp used to require an experienced lawyer, and many entrepreneurs still choose to retain one for various reasons, but it is no longer required. “There’s been a dramatic shift in the last 10 years,” says Amerson. You can pick from a bevy of online services that walk you through the paperwork and provide basic guidance at a lower cost.
“…try to negotiate a deferred fee arrangement…”
If you want to have a lawyer from the get-go, check with connections like your accountant or bank. SVB, for example, provides law firm referrals. Sites such as LawTrades and UpCounsel can also help you find an independent lawyer. If you want the handholding and fuller range of services from an established law firm, try to negotiate a deferred fee arrangement, Amerson suggests. Typically, the firm agrees to provide some free hours with the understanding that it won’t be paid unless your company reaches some milestone — say, funding of more than $1 million.
Incorporating online: Sorting through the options
There’s also an increasing number of self-help options, which tend to fall into a few different categories.
General-purpose legal services sites like LegalZoom and RocketLawyer offer basic, one-size-fits-all tools for a monthly subscription, including premium packages with online or live access to lawyers. The tools are designed to satisfy the broadest range of companies possible, which means they aren’t as focused on the specific needs of technology startups as other alternatives.
Some newer services are targeted specifically at tech companies. Clerky, which was founded by former startup lawyers, offers tools to help with hiring and fundraising, and can forward your incorporation documents to a lawyer for review. Stripe-Atlas is an increasingly popular option that, for a low fee, helps you incorporate your company, set up a bank account, issue founders shares, and sets you up to receive credit card payments online.
Many leading Silicon Valley law firms have also created sites featuring advice, documents and other services, for a variety of needs, such as the need to raise a seed round. Cooley LLC has CooleyGo and WilmerHale has Launch. These resources are usually free.
And for dedicated DIYers, Docracy is essentially an open-source library of legal documents—a sort of GitHub of legal forms.
If you want a lawyer to give you a one-time read-through of your final paperwork or spend an hour advising you about the pluses and minuses of your situation, in many states, the Bar Association offers limited pro bono (free) appointments with expert lawyers.
Documents you need to incorporate
The forms you’ll need are all available online. However, if you’ve decided to use an attorney to help you incorporate, it’s still wise to have a working knowledge of the documents you’ll need to form your corporation.
Certificate of Incorporation — This is your initial charter that is filed with the Secretary of State. The charter requires some basic background info, sets out legal requirements and the general purpose of your company.
Action by Sole Incorporator — This is a procedural document that appoints you, the founder, as the initial director of the company.
Board Action by Unanimous Written Consent in Lieu of Organizational Meeting — Use this document as a checklist of the things your board of directors needs to do during their first meeting.
Bylaws — These establish the framework for how your company’s board, officers, and stockholders should perform duties and operations.
Founder Common Stock Purchase Agreement (SPA) — Use this to validate the sale of common stock from the corporation to the founders. Stock is usually sold at a nominal price and is paid for in cash or intellectual property.
Founders Preferred Stock Purchase Agreement — Sometimes founders are sold stock that can be sold prior to an acquisition or IPO. This agreement confirms those transactions.
83(b) Elections — Use this tax document to enable founders to pay taxes on their unvested shares immediately rather than waiting until shares vest and are worth significantly more.
Proprietary Information and Inventions Agreement (PIIA) — This document confirms the corporate ownership of founders’ and employee’s intellectual property.
Capitalization Table — Use this document to track each person’s stock holdings as well as the stock plan pool.
Why investors favor C-corps
There’s one big reason why nearly every venture-backed company registers as a C-corp: Your investors are likely to demand it. That’s because the “pass-through” tax status of an LLC or an S corp means the investors would have to pay taxes on their share of your company’s profits. That’s an administrative headache most investors won’t want.
The fact that S corps and LLCs require each owner to file a separate tax form that documents the income realized from the company is “a huge turn-off for venture capitalists,” says Drew Amerson, director of LexLab, an incubator at UC Hastings College of Law.
Simply put, becoming a C-corp can open more avenues for fundraising.
With the countless decisions you’ll need to make as a first-time founder, how to incorporate should be near the top of the list. Fully vet your options and get as much help as you need with the paperwork. It will be worth it sooner than you think.
Running a startup is hard. Visit our Startup Insights for more on what you need to know at different stages of your startup’s early life. And, for the latest trends in the innovation economy, check out our State of the Markets report.