Before a technology startup becomes a company, it spends a period of time as simply a project. The founding team is usually one or two individuals building and testing products as they try to validate a demand for them in the market. At some point, founders ask themselves: when is it time to turn this project into a company?
This article tackles that question with respect to a particular type of business venture, which is a growth-oriented tech startup. By this, we mean an organization whose products incorporate intellectual property (I.P.) and which seeks to scale quickly after confirming product-market fit.
First, a note on terminology: for convenience, this article uses “formation” to refer to the creation of either a limited liability company (LLC) or a corporation, the two most common U.S. company types. As a founder, it is good to understand that “incorporation” specifically refers to the formation of a corporation while “organization” or “formation” usually refers to the formation of an LLC. Founders form both LLCs and corporations by filing documents with a state government.
Form a company when the business presents significant risks
All business models carry some risk. Some are less risky than others. Consider mobile app developers, of which there are now more than 20 million in the iOS App Store alone. The typical mobile developer has just one product: a free app with fairly few users, most of whom will delete the app within minutes of installing it. Most such developers have little legal need to form a company, especially if the app is a game or other product that is unlikely to harm users. Users are not likely to sue a provider of a free app, and regulators are unlikely to sue their developers for legal missteps.
Other tech businesses carry more risk, however, and this is when forming a company becomes important. A person who does business without forming a company (a “sole proprietor”) risks her personal assets to the extent of that business’s risks. If the business owes $50,000 to a lender, or to an injured customer who has won a lawsuit against the business, then the lender or injured customer is legally entitled to $50,000 of the owner’s personal assets.
Doing business through a company, on the other hand, generally confines business risks to the assets held by that company. In the example above, a $50,000 jury verdict against a company with $10,000 in total assets would bankrupt the company, but the owners’ personal assets would not be at risk to satisfy the $40,000 balance. Forming a company therefore reduces risks to owners’ personal assets, provided that the company follows corporate governance rules.
A startup should usually form a company when any of the following is true:
- The number of customers or users is large. More customers means more users who might sue. Developers often make inadvertent legal missteps in their product design; deceptive-advertising and privacy laws are common traps. A single poor design choice can create real risk when repeated across large numbers of users.
- The product generates significant revenue. A business can face risk from a small number of customers who each pay it significant revenue. Not all tech startups make free mobile games. One might make small numbers of expensive machines on which customers depend to run their own businesses. Another might publish Software-as-a-Service for which banks pay hundreds of thousands of dollars annually. A problem with any one customer can become expensive quickly.
- The nature of the product causes harm if it fails. A hospital may license software and hardware from dozens of providers, to power anything from life-support machines to restroom soap dispensers. Failures of some of these products cause problems more deadly than failures of others. Mission-critical products should be sold by companies and not individuals.
- The product’s users or customers present risks. U.S. federal and state laws provide special protections for certain industries and consumer types. Software used in education, health care and financial services faces unique risks because of privacy laws in those sectors. Technology designed for use by minors carries additional risk because of the laws protecting children’s privacy. Violations of these laws by businesses are usually inadvertent but can be costly.
A company should usually be formed when the venture will give equity to multiple people
Early-stage startups usually lack cash to pay market-rate salaries to their workers. The founders typically take no cash compensation, expecting instead to receive equity in the company once it is formed. (“Equity” means an ownership stake in the company – usually stock or stock options in the case of a corporation or “membership interests” in an LLC). The founders may also offer equity to freelancers or other outside service providers.
A solo founder can delay forming a company for some time because there is only one person who will receive the company’s equity – the single founder. If the startup will give equity to several people, then it is far more important to form the company earlier. This is because the details of equity with multiple recipients have a different magnitude of complexity. For example, will the equity vest over time, as is often recommended, or be granted all at once? Does the equity come with voting rights or only economic rights? May the equity holder avoid dilution by putting in cash when investors do?
These questions are most easily answered by simply forming the company and addressing them in the formation documents. Once the company is formed, it can distribute equity through frameworks that are well understood by founders and other workers, accountants and attorneys.
Forming a company is usually advisable when multiple people will contribute intellectual property
Most tech products include I.P. developed by multiple individuals. Front-end designers create the software interface, engineers create the database structures, graphic designers make the product logos, and so on. All of that I.P. must be aggregated into one place before it can be presented to customers. The simplest course of action is to form a company and have all founders, employees and contractors enter into written agreements (“I.P. assignments”) giving the company the necessary rights to their respective I.P.
This approach converts all of the various pieces of I.P. into a single package that the company can efficiently offer to customers. Committing these assignments to writing early also prevents I.P. disputes later. Most I.P. contributors will not remain with the venture for more than a few years. If they leave before giving the venture the I.P. that it needs to license to customers, then they are in a position to charge a high price to assign it after the fact (and if their departure was not friendly, they often will charge it).
Form a company well before the startup begins seeking outside investment
A startup that plans to seek investment in the near term should typically form a company immediately. It is easy to inadvertently violate securities laws, the state and federal rules protecting investors, when offering equity in a company that does not yet exist. Securities violations can entitle investors to the return of their invested funds and doom a startup’s chances of secure funding in the future.
A solo founder may be tempted to delay forming a company until a potential investor seems ready to sign a deal. That approach is risky. Forming a company suitable for outside investment takes some time, even when it has just one owner. The process takes far longer with multiple founders, as they negotiate titles, ownership percentages, board seats and other variables. These are not delays that startups want to face when an investor stands ready to wire funds.
Form the company early to reduce founders’ tax liabilities
Company equity is property that can be taxable when transferred to the startup’s founders or other recipients. A person receiving equity for services (i.e., most tech startup founders and workers) must generally include the fair market value of that equity in her gross income reported to the tax authorities.
In a startup’s earliest days, when it is pre-revenue and often pre-product, it is easier to make the case to tax authorities that the equity has no value. After all, that equity is just a piece of a company that has no contracts, no income and nothing else that looks valuable. As the venture begins to generate revenue, name recognition and other valuable assets, its value increases. So too does the value of its equity. Receiving equity in that company before it has real value can therefore keep the recipient’s tax liabilities low. This is why many tech startups are able to value their company stock at rock-bottom levels (often $0.0001 per share) at day one. All else equal, tax considerations tip toward early company formation.
Conclusion
The costs of company formation are trivial in the course of a business that intends to grow. And those costs are usually lower when incurred earlier. Each startup must make its own decision as to when to become a company, but the principles described in this article apply to most tech startups with whom we have worked.
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