On Incorporation - I Still Say Hold Off Until You Have The Cash To Spare

In my last post about startup cash management, smart people like Chris Dixon, Manu Kumar, George Grellas, and the Hacker News cabal all disagreed with my advice to put off incorporation until you absolutely have to. 

Every single benefit of incorporation cited by these people is correct.  However, I still caution against jumping right into incorporating from day one.  This is because when you incorporate, you should do it right and doing it right isn't a drop in the bucket.  Also, when you incorporate, you're subject to your state and federal taxes, Delaware franchise tax, foreign business license in the state where you're headquartered, and other administrivia hassles.  But keeping in line with the last post, I'll stick to the cash.

When I founded Dawdle, I engaged a local Chicago law firm that was well-regarded in the startup community to do a simple incorporation.  It ran us about $1,500.  I didn't want to use LegalZoom to do the simple incorporation because I wanted to develop a relationship with my lawyer that I could leverage to make introductions to local potential investors when the time was right.  

However, soon after incorporation, I realized we needed an option plan for a potential employee we were recruiting.  Because my lawyer had set us up as a subchapter-S Corporation, he was unfamiliar with how an option plan should be structured for an S-Corp and ended up having to do substantial research to get it done.  The option plan ended up costing us an additional $6,000.  There are additional pieces of advice that we got that was incorrect, the sum total of which ended up costing the company over $40,000 in additional, unnecessary legal expenses (hindsight is 20/20).

Based on this experience, I strongly believe that any company that may potentially seek institutional money should use a top-tier Silicon Valley partner at a top firm.  It doesn't matter where your company is; get a Valley partner.  Many of these top tier firms have "off the shelf" packages that include much more than incorporation - some include the option plan, convertible note template, NDA form, and other commonly used documents.  You can see a sample of the bare minimum set of incorporation documents at TheFunded.  If you hold off on incorporating yourself and you get into a top-tier accelerator such as YCombinator or TechStars, they will also incorporate the company, with the whole kit and kaboodle, for you.  YC even tells potential applicants to not incorporate "if you can avoid it".  You probably can avoid it.

If you aren't going the accelerator route, and you've decided the time is right to incorporate, you'll need to get a full incorporation package from one of these firms.  This package runs approximately $5,000 or so from a top-tier firm.  (Feel free to let me know if this has gone up since the last time I checked.)  Generally, a paralegal will just fill in the blanks and the partner you choose will do a cursory glance, but the partner is 1) the person who can answer your questions without any research, saving you money and 2) the person who will be making introductions to potential investors.  It's important to pick your partner carefully.  Thankfully, my ex-Broadview colleague Giff Constable has a great list of lawyers that do good work with internet startups.  If you want specific thoughts on how to pick a startup lawyer, read Mark Suster's post on the topic (even though he's in the "incorporate yesterday" camp, it's still a great post).  

My personal recommendation for startup incorporation and general corporate work is Yokum Taku of Wilson Sonsini.  In addition to being wicked smart and a straight shooter, Yokum's blog, Startup Company Lawyer, probably already answers the first five questions on the tip of your tongue.  Past that, any answer to something you can't find on the blog is going to be consistent with what he's already written, saving you from conflicting advice.  You can read my rambling notes from my conversation with Yokum about incorporation at my personal blog.

I also don't believe that you should take advantage of deferred legal fee loan programs offered by some Valley firms because you're locked into working with that firm until you've closed your Series A.  If the partner leaves, the firm overbills against the deferred fee loan amount (usually $25,000), or the relationship doesn't work out for some other reason, you don't want to be stuck.

Because "doing incorporation right" is a rather large expense, I don't believe that entrepreneurs should incorporate until they are playing with other people's money.  Solo entrepreneurs need to watch every dime and I firmly believe that small founding teams can set the parameters on a napkin when starting out, to be codified when the time demands it.  If you can't trust your co-founders to stick to a terms written on a napkin, you've got bigger problems to tackle.  Sure, all else being equal, you do want to incorporate as soon as you can to start the capital gains clock, minimize the value of founder shares, and all the other benefits or early incorporation.  But $5,000 is still $5,000 and cash is king.

 

12 responses
Perhaps your Dawdle experience left a bad after taste. If your team lacks traction or motivation to create, incorporation can provide the emotional tipping point for real production.
Great advice. I had a conversation with a Pasadena-based lawyer for VC's who recommended something along the same lines. Doing incorporation right is truly make-or-break - there is no do-over!

Enjoyed the post - and the brand name. Meat in the Sky. Wow. Just added you to my Google Reader! :D

Minimize the value of founder shares?
Thanks for the kind words. I'll buy you a meal the next time you're out here.
When starting a company, founders have a million things to worry about. Health care, offices, hiring, patents, taxes, the list goes on and on. I always tell people, don't worry about any of it until you have to. Wait until it's a problem that you HAVE to fix. Otherwise, focus on product and nothing else.

So in that sense, I agree that incorporating shouldn't be at the top of your list. I remember in college when my friends and I had a couple good ideas, and we considered incorporating. We hadn't even built anything yet. I laugh looking back at that.

On the other hand, I think incorporation is very important to protect yourself and the company.

1. You want to separate any legal liabilities of the company from you personally. This doesn't mean you incorporate when you come up with an idea, but in my opinion it does mean you incorporate before you launch any products or accept any revenue.

2. When multiple parties are starting a company, you need a clear understanding on what the corporate arrangement is. The longer this is delayed, the more conflict may arise.

Maybe we're agreeing here, don't run out and incorporate on day one. But I do think you should incorporate earlier rather than later. I guess I would say "do it once you are serious about the idea and team, but not while you are brainstorming"

"do it once you are serious about the idea and team, but not while you are brainstorming" -- yes, I think this is a clearer way of explaining it, and I totally agree with the statement. There's a lot you can skip while brainstorming, but as soon as you decide to start doing something seriously, you really want to deal with things like incorporation, founder shares & vesting, and IP agreements (even if just a simple "everyone licenses everything they contribute to the company" letter) right away. Cheers! -- Giff
In the netherland you need about $32.000 of funds when you start incorporating. this means most startups do without incorporating. Most of them do fine. In the US I think it is more difficult because of the legal culture (higher risk of legal liability's)
We just revamped FairSoftware to emphasize online pre-incorporation founder agreement. The beauty of it is that it covers most of what early incorporation provides, but essentially for free.

For those who don't know, I'm talking about a software license inspired by the GPL, but instead of contributing freely, you contribute to a "virtual startup" under the condition that if your IP is used, you will be rewarded by ownership (virtual shares) of the company.

Having done this twice, I agree with you, Sachin. If you raise money, everything will need to be redone. So just do the bare minimum - stock llc or scorp. make sure any contracts you sign use the resulting entities name and then when the time comes you contribute the entity into whatever new c-corp you create. Added benefit - if you funding the startup from other income, passthrough taxation makes it easier to take advantage of the losses earlier. The extra $$ helps a lot in the beginning.
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