Incorporating a Startup
Incorporating your U.S.-based startup means creating the legal entity that will employ your employees, own the intellectual property you create and act as a counterparty to the customer and vendor interactions in which you engage. It is the first formal step you need to take in creating your business.
By incorporating you will answer some important questions about your company:
- How do I keep my personal liability as a founder separate from that of my company?
- Under which state laws will my company operate?
- How do I divide the ownership of my company?
Keeping Personal Liability Separate
The primary reason to incorporate your startup is to create a legal structure that isolates your personal finance and legal exposure from that of the company you are founding.
For the vast majority of startups, that means creating a C Corporation. C Corporations are the norm for most U.S. companies. They have Boards of Directors, can issue shares as they grow relatively easily and they must pay corporate taxes. They assume financial and legal liability separate from their founders and stockholders. Almost all venture capital investors and accelerators will require a corporate structure to be a C Corporation in order to invest.
Personal liability is an important concept, and shielding founders from it is a something that Brex addressed directly with its product. More information about how Brex eliminates founder liability from its product is here (https://www.brex.com/founderliability).
You may also choose to incorporate as Limited Liability Corporations(LLCs). This entity type does shield you from personal liability as a founder and it is also not subject to corporate taxes. Instead, the profits or losses earned by the company are “passed through” to the owners, even though the owners are shielded from the legal and financial exposure of the LLC. While great in theory, it is important to consider that LLCs are not particularly scalable. Pass through taxation makes sense for people who have large ownership stakes in the LLC (i.e. founders and early investors), but as you add investors and employees with smaller ownership stakes, it is impractical (and often impossible) for them to have the profits and losses of your LLC passed through to them. For example, imagine you have an employee who owns a small percentage of the company and the company makes a profit for the year. In an LLC structure, that employee would have to report this annual profit on their tax returns, and pay taxes on it, even if the profit was not distributed as a dividend to the employee.
Another choice, particularly mission-driven startups, is to pursue classification as a Benefit Corporation (or B Corporation). While these are often structurally similar to and taxes like C Corporations, they also make a formal commitment to corporate purpose, accountability, and transparency at the time of their charter. There is more information online about Benefit Corporations here (http://benefitcorp.net/).
Companies that have separate liability from their owners all obtain Employer Identification Numbers (EINs) from the Internal Revenue Service (IRS). This is in contrast to companies that maintain personal liability, known as Sole Proprietorships. Owners of sole proprietorships report their business activity on their tax returns using their personal Social Security Numbers.
Selecting a jurisdiction (state) in which to incorporate
The vast majority of startups incorporate in Delaware, even if they have no commercial operations there. Delaware has a well-defined set of corporate laws that have been formed over the years, particularly due to the reputation of its state court for being efficient and fair with regards to corporate legal matters. Delaware has many established precedents in corporate law and governance, such as protections from lawsuits for member of company Board of Directors. As more and more companies incorporate in Delaware, more and more business law cases are adjudicated in the state, and the set of standards becomes even more robust and more mainstream among U.S. corporations.
"The vast majority of startups incorporate in Delaware, even if they have no commercial operations there."
The other natural place to incorporate is the state where your company has its headquarters. This is less common, and most investors will want and expect you to incorporate in Delaware given the legal environment there, as described above.
One downside to incorporating in Delaware is the annual franchise tax requirement (https://corp.delaware.gov/frtax/). Some states won’t have this, but in general for most startups the franchise tax in the earlier years of startups (it’s based off either assets or number of shares) is small (under $1,000).
Dividing the ownership of the company
Ownership of a company is divided into units of ownership, known as shares of stock. At the time of incorporation, you will need to decide how many units of stock to create. This can be increased or decreased later.
Most startups choose to incorporate with an easily divisible number, such as 10,000,000. The reason to create 10,000,000 and not say, 1,000, is that it allows you to be more granular in the ownership that you offer future employees. Many tech employees are used to certain numbers, and when hiring, if you tell someone they are getting 1 share rather than 10,000, it may make the recruiting process more challenging, even if that 1 share represents the same ownership as 10,000.
At the time you create your company you are onlyauthorizingthe number of shares (meaning deciding how many you could one day give out). When you give out the shares, that is known as issuingthem. You may decide to issue some shares to yourself and any other members of the founding team, and then reserve other shares for an employee option pool.
When you issue founder shares, you also need to establish the vesting schedule, which is how you earn your shares based on your employment service to the company. Vesting schedules protect the company in the event a founder leaves early, so that the departing founder does not obtain all their issued equity before providing an adequate duration of service.
It is common for vesting schedules in startups to occur over four years. Some startups will elect monthly ratable vesting (1/48thper month over 48 months), while others will impose a cliff, which means that founders only vest into their shares after a designated point in time, typically a year. After that cliff, they earn the remainder of their shares ratably (i.e. after 12 months of service earn 1/4thof their shares, then 1/48thfor the remaining 36 months thereafter).
First Steps for Stock Options
- Decide how much stock you will create
- Determine to whom you will issue stock (founders / founding team and / or an employee option pool)
- Establish a vesting schedule for founder shares
During the early phases of a startup, often time founders want to establish ownership and a legal entity to begin to formalize their idea and their relationship with other co-founders. This makes sense, and in doing so founders often turn to incorporation services. Clerky is a Y-Combinator company that helps startups incorporate.
Late in their lifecycle, often when they raise their first round of capital, startups will turn to an outside law firm or lawyer for additional advice and guidance.
Brex followed the typical path as outlined above. Brex is a Delaware C Corporation and used Clerky to incorporate with 10,000,000 shares initially. Our Founder Shares have a standard four-year vesting period. After incorporating, we later hired a law firm, Wilson Sonsini, to help manage our Series A round.