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.  

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