The Exploratory Phase – When should you incorporate?

“When should we incorporate?”  It’s a question we startup attorneys hear all the time.   Everyone knows that you want to run your startup business through a corporation or LLC to have the limited liability protections afforded by those entities.   But before any business gets going there is always an exploratory phase.  During this period business plans are developed and tested, market research may be conducted, and software code might be written.

Many times it turns out the idea isn’t worth pursuing, so it doesn’t always make sense to incur the time and expense of incorporating, not to mention having to get a tax ID, a business license, and incurring reporting obligations with federal, state and local governments. On the other hand, problems result if you wait too long.  Software, the business plan, contact lists, perhaps trademarks – all of these things are or should be assets of the business.  If you don’t have agreements among your collaborators, there can be confusion or disagreement about the ownership of these assets when the business gets going.  Frequently collaborators haven’t decided yet or they don’t take time to work out the percentage ownership of the business.  Often emails or other writings are exchanged that may be ambiguous or contradictory.  I’ve seen at least one case where an early collaborator who did very little made a successful claim against the company when it had an exit a few years later.  She received a healthy, and unearned, portion of the company sale price.

Another very serious issue is your potential personal liability if you collaborate with others during the exploration phase.  In an adequately capitalized corporation or LLC, an entrepreneur’s risk is normally limited to the amount of his or her investment.  A creditor suing the company could not reach, for example, the entrepreneur’s personal assets such as car, home, or bank accounts.  That liability limitation does not apply for partnerships.  Partners are personally liable for the debts of the partnership.  See RCW 25.05.120.  And individual partners have the authority, absent an agreement otherwise, to incur debt and other obligations for the partnership.

Now take those two rules of law and couple it with a third principle – by just working on the project together you may have formed a de facto partnership.  The explicit rule for Washington can be found at RCW 25.05.055:

“The association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership.”

So, if you are not careful, you might think you are just helping out a friend on his business idea and later discover you formed a de facto partnership and are personally liable for a debt that one of your partners took on in behalf of the business.    

So the takeaway is don’t wait too long to incorporate.  You should definitely  incorporate before:

  • earning any revenues
  • entering into any material contracts
  • hiring any employees
  • receiving any funding

During the exploratory phase, if after considering the above factors you feel it is still early to incorporate, take precautions to maintain ownership of your business and assets.  Make sure that anyone who works creates or works with any of your intellectual property signs an intellectual property assignment agreement.  This includes volunteers and contractors, as well as all collaborators/partners.   If you decide to hold off on incorporating, it is a really good idea to put in place a simple agreement between you and your collaborators.  At a minimum this agreement should have the following elements:

  • statement of the partners’ percentage ownership
  • contributions of individuals, including time, money, and assets (e.g., software, equipment)
  • limitation on authority of partners to sign contracts or incur debt without approval of other partners
  • assignment of all related intellectual property
  • agreement as to what happens to IP and other assets if the partnership dissolves

You can find a simple template agreement  on my resource page that covers these elements.   It is no substitute for legal counsel and you use it at your own risk.  So please, before you or your collaborators have risked significant time or money, consult an attorney.  

Does an LLC that has elected to be taxed as a corporation need articles and bylaws?

This is kind of trick question, because LLCs don’t have articles of incorporation or bylaws, they have limited liability agreements, sometimes called operating agreements.  An LLC that has elected to be taxed as a corporation is a weird animal.  It’s a corporation for federal tax purposes but an LLC under state entity organization law.  Even though it is taxed as a corporation, its governing documents must comply with the LLC statute.  That means all of the rules that govern organization, issuance of units, relationship of owners, duties of management, requirements for distributions, dissolution and liquidation — they are still found in the LLC act, not the corporation act.  For Washington that would be RCW 25.15, rather than RCW 23B.  One of the most material differences is that the fiduciary duty of loyalty can be waived with LLCs, something that is sometimes desirable for real estate management firms but would generally not be recommended for a tech startup.

An LLC that has elected to be taxed as a corporation needs a limited liability company agreement designed for its situation.    If the company has made an S corp election, it is very important that the LLC agreement have  protective language in the document providing, among other things, that investors may not join who would blow the S-election because of their status (e.g., an entity or a foreign citizen).  Disclosure and communication to members is critical with this kind of entity, because the distinctions are not widely understood, and investors/members may have incorrect assumptions.

The take away for a startup company is that if you are an LLC and you are being advised to make an S election, or even a C corp election, understand that you will become kind of a hybrid entity that isn’t always well understood.  Also, once a corporate election is made, that is what you are in the eyes of the IRS.  You can’t switch back to being taxed as a partnership without consequences – you will be treated as liquidating the corporation for tax purposes and may have tax liability as a result.  

What type of entity should I choose, LLC, C corporation, or S corporation?

Deciding whether you should organize as a C corporation, S corporation or limited liability company can soak up a lot of time and resources.  Some founders may spend more time on this question than is warranted given the inability to know for sure how quickly your business will grow, how much and which type of outside investment will be required, whether cash will be reinvested or distributed to owners, or whether you will sell the Company or go public – all of which are part of the analysis.  Tax rules are the primary source of the complexity, although management and liability issues under state law also make a difference.  

Founders tend to fall into two categories when dealing with this issue – those that , with their lawyers and accountants, carefully analyze the various tax rules against their expected growth and exit strategy and try to make the best decision under uncertainty  – and those that punt, opting to stick with the format used by most VC-backed technology companies  (C corporation) and spend their time and energy on growing their business.  

One reason venture capital firms generally will only invest in corporations because they usually have tax exempt investors who do not want to subject to unrelated business income tax (UBIT), which would be an issue with an LLC.  Moreover, VC members may not want to file state tax returns, or, in the case of foreign investors, federal tax returns.   VCs like some of the other advantages to C-corporations discussed below.   

For those that want to dive into the analysis, I discuss the major differences between C corporations, limited liability companies, and S corporations in the second half of this article.   Perhaps the best place to start the  analysis is to understand why most tech startups are corporations, and to consider what makes your company different, if anything.  If not, you may want to follow that model.   Since the C corporation is the predominant entity form for tech startups, documentation has become fairly standardized for corporate governance, rights among shareholders, equity compensation, and capital raises. 

The top level questions that will affect your choice of entity are these:

  1. Do you expect to take money from a Venture Capital firm or an institutional investor.   In this case, you will need to be a C corporation, although you may be able to start life with an S election while you bootstrap and only convert if it becomes necessary.
  2. Will you be a typical technology company that will want to issue stock options to employees, raise capital through preferred stock, and expect a typical technology company life-cycle in which all surplus will be reinvested into the company (no distributions to owners) which is grown until the company is acquired or goes public, These factors would push you toward the C corporation form.
  3. Alternatively, will your company be operated for its cash flows over a long period of time, not necessarily managed for a public exit.   In this case, a pass through entity such as an LLC or an S corporation may be preferable.

Those are the primary considerations.  For those that want to dig deeper into the minutiae, what follows is a more detailed discussion of the differences between C corporations, S corporations, and LLCs (taxed as partnerships). 

C Corporations.  The biggest downside of corporations is that they are subject to double taxation.  (The corporation itself is taxed on its profits, and shareholders are taxed when earnings are distributed to them.)   However, the downside is diminished if the company intends to reinvest most of its surplus cash for growth.  Moreover,  the C corporation can accumulate net operating losses, which may offset profits in the future or have value to an acquiring corporation.  C corporations can qualify for Section 1202 qualified small business stock, and for Section 368 tax-free reorganizations.

Limited Liability Companies.  Technically, LLCs are disregarded entities in the eyes of the IRS.  Under the Code, LLCs may elect to be taxed as a partnership, as a C corporation, or as an S corporation.  When people refer to the tax treatment of LLCs, they usually mean an LLC that has elected to be taxed as a partnership.  Taxed as a partnership, the LLC is a “pass-through entity” that is not taxed.  The members are taxed according to the amount of profits that are allocated to them per the terms of the operating agreement.  Allocations of profits and losses need not necessarily follow ownership percentages, they can be specially allocated per the terms of the operating agreement, although accounting and compliance gets more complicated when it does not.  Investors can offset their other income from their share of LLC losses.  Another advantage of partnership taxation is that appreciated assets  can generally be distributed to partners/members tax free.  (This can allow tax-free spin-offs of subsidiaries and other assets to the members.)  Appreciated property (such as developed software, for instance) can be contributed to the LLC tax-free (without a  “control requirement”).  Lastly, redemptions of membership interests are a deductible expense to the LLC.

S-Corporations.   Technically an S corporation is an election filed with the IRS, not a form of entity.  LLCs, as well as corporations can be taxed as an “S corporation”.  An LLC that makes an S election will be an S corporation in the eyes of the SEC, but it’s corporate governance matters will still be controlled by state law and the LLC operating agreement.  Like an LLC taxed as a partnership, an S corporation is a flow though entity with a single layer of tax.  S corporations convert easily to a C corporation.  (Actually they convert automatically to a corporation if the company does anything to blow its S election, such as exceed 100 shareholders, accept a foreign shareholder, or issue preferred stock.)  As with C corporations, Section 368 tax-free reorganizations are available. 

 An S corporation structure may result in the reduction in the overall employment tax burden.  One difference between S corporation taxation and partnership taxation is that owners of LLCs can not be employees of the company.   All member draws are subject to self-employment tax.  With S corporations, owners may be reduce employment taxes by taking part of their income in salary (and paying employment taxes on that) and taking the rest of their income as a distribution.  S corporation shareholders who are employees are taxed as employees and receive a Form W-2, not a Form K-1.   As long as the salary is reasonable in the eyes of the IRS, the income taken as a distribution is not be subject to employment tax withholding. 

Traditional stock options are available for S corporations, as long as the exercise price is a fair market value and doesn’t have any unusual terms that would cause it to be characterized as a another class of stock. 

In summary , here are reasons you may choose one entity form over another:

 C corporation because:

  • Predominant model for tech start-ups (equity offerings and IPOs)
  • VCs usually won’t invest in LLCs
  • You will have foreign, corporate, or non-profit investors
  • Retention of earnings/reinvestment of capital
  • Qualified small business stock (Section 1202)
  • Section 368 tax free reorganizations available

LLC (taxed as partnership) because:

  • Single level of tax
  • Flow through entity that allows: multiple classes of units, foreign members, over 100 members
  • Investors can use operating losses
  • Business will be operated for cash flows
  • Tax-free distributions of appreciated assets
  • Tax-free contribution of appreciated property without “control requirement”
  • Special allocation of tax attributes (such as specific gain, loss, income or deductions)
  • Redemption of partnership interests are deductible expenses of the LLC

S corporation because:

  • Simple flow through entity with single level of tax
  • Easy to convert to C Corporation
  • Can minimize employment taxes
  • Investors can use operating losses
  • Business will be operated for cash flows
  • Traditional stock options are available (as long as exercise price is at market value)
  • Section 368 reorganizations available

But, S corporations are limited to 100, domestic, non-corporate shareholders, one class of stock.  Shareholder redemptions are not deductible.  Lack of ability to allocate profits, losses, attributes other than pro rata.

 

What legal documents are necessary to start a company?

One can form a new corporation in minutes on the Secretary of State website, but much more documentation is required to establish rights and protocols with respect to ownership and management of the corporation.

To do it right, all of the documents listed below would be necessary in a corporation that is preparing to grow without legal hiccups.  Fortunately, over the years, this documentation has become fairly standardized, and is not expensive to prepare.

 
Formation of Corporation:
 
Master Business License Required by the State of Washington.
Local Business License May be required by your local city or county.
Articles of incorporation This is the foundational legal document of the corporation.  It is required by statute.  It establishes the classes and number of authorized shares, the rights and preferences of the stock, fiduciary and liability standards for board members, any special voting requirements, and other fundamental corporate matters.
Bylaws The Bylaws establish rules regarding the board of directors, shareholder meetings, and other matters.  Sometimes they contain indemnification rights for officers and directors.
Organizational resolutions These first resolutions of the board of directors authorizes the first issuance of stock, appoints officers, establishes authority to open bank accounts, and other matters
Subscription Agreement   This is the agreement between the company and a purchaser of stock.  Depending on choices they make, founders may have a simple subscription agreement, or they may have extensive documentation for restricted stock.
Stock Certificates The document that certifies to a shareholder’s ownership of shares.
Stock Ledger Ledger that shows the history of all issuances, transfers, and cancellations of stock.
Cap Table The Capitalization Table is derived from the Stock Ledger.  It shows the current ownership of the company, amounts paid and percentage interests.  It includes options, warrants, convertible notes, and other rights to purchase or be issued stock of the company.
Shareholder Agreement This sets forth agreements among the shareholders.  Common terms are rights of first refusal and co-sale rights with respect to proposed transfers of shares, rights to approve certain major corporate actions, protocols if someone dies or gets divorced, and composition of the board members.
Asset Assignments Usually the founders have created some IP before the company is incorporated.  IP could include software, a patent application, a business plan, a potential customer list.  All of these things should be assigned to the company when it is formed.  There may be other assets, such as contracts or office equipment, that need to be assigned to the company.
S Election For an S Corporation only, a document filed with the IRS that establishes the company’s election.
   
Limited Liability Agreement For a limited liability company, the Limited Liability Company Agreement (sometimes called an Operating Agreement) will replace the Articles of Incorporation, Bylaws and Shareholder Agreement.
   
Equity Compensation:
 
Founder Restricted Stock Agreement Founders often impose buy-back restrictions on their stock that incentivize founders to stay with the company.  See my post on the subject. 
83B Election If the founders take restricted stock, the 83B election is a necessary form to file with the IRS to obtain the desired tax treatment.
Stock Option Plan To issue stock options qualified for certain tax treatment, the options must be issued persuant to a written plan approved by the board of directors and the shareholders.
Employee Stock Option Agreement This document contains the Grant Notice, which sets forth the number, type, exercise price, and other terms of the the options.  The Stock Option Agreement, together with the Stock Option Plan and other incorporated documents, establishes and governs the employees rights with respect to the granted options.  
Authorizing Resolutions The board of directors and shareholders must approve the stock option plan, including the amount of shares set aside for the plan.
   
Human Resource:
 
Employee Offer Letter For the general employee, this agreement will document employment-at-will status and clarify compensation and benefits.
Form Independent Contractor Agreement Most startup companies find it necessary or beneficial to hire consultants or other independent contractors.  A well drafted Independent Contractor agreement will provide for important terms such as the nature of the relationship (not an employee), scope of work, payment terms, and most importantly, ownership of intellectual property created under the contract.
Worker Intellectual Assignment Agreement The company should have a form confidentiality and intellectual property assignment agreement for employees and for independent contractors.
   
Other Agreements
In addition to the above, a company may have supply agreements, customer agreements, distributor agreements, service contracts, agreements with advisors, and promissory notes from founders or other supporters to the company.