Pre-Incorporation Startup Law

This post collects useful reading on pre-incorporation cofounder agreements and selecting a corporate entity. This can be a simple process. Don't overlawyer it.

Contents:

I try to collect useful startup guidance from around the internet.¹ This post discusses pre-incorporation founders agreements and the entity formation process.

Pre-Incorporation

Founders can collaborate on a project before dealing with the expense of formal incorporation. They should agree to a simple written collaboration letter. A verbal agreement is a recipe for disputes. Above all, remember that incorporation shields your personal assets from the startup’s losses or liabilities. Don’t put off incorporation for too long.

• “Vesting” - Discuss how long cofounders will need to stick with the project to earn their ownership share. Assume that a cofounder will drift off to different project, and define what will happen to her pre-incorporation ownership stake. Put it in writing. A reasonable pre-incorporation “vesting” schedule might be “if you leave before we incorporate, you lose all ownership interest.”

• Breaking Up Prior to Incorporation. Zach Shulman, (2011). “Founder L is not pulling his weight; he is happy to talk strategy and suggest tasks for others, but is not willing to get his hands too dirty.” Fucking Founder L.

• Startup Founder Agreements. Simeon Simeonov, 2010. The founding team should create a simple written agreement outlining IP ownership, equity ownership, vesting, etc.

• When Do I Need to Incorporate a Company? Yokum Taku, 2009. Startups should incorporate before they start to generate revenue, create serious intellectual property, hire employees or contractors, issue stock options, or get visas.

• Why Incorporating My Startup was My Worst Mistake. Hacker News, 2011. Grellas: “Corporations are not particularly hard or expensive to start, maintain, or dissolve - but you need to be at a stage of life where a thousand dollars here or there is not a major burden.” The original link is broken, but the HN comments are more interesting anyway.

Formation: Use Clerky

• Clerky - A spin-off from the law firm Orrick, Clerky helps you generate founders’ arrangements for a VC-backable DE corporation.

• The Deflation of Startup Law Continues: Clerky. Jose Ancer, 2013. Clerky is “LegalZoom prices, but for premium, startup-focused documents.”

• Hacker News Conversation on Clerky. 2013. From Grellas: “The beauty of Clerky, as I see it, is that the founders, having worked extensively as superb startup lawyers in their own right, have a keen sense of how all this works and are aiming to develop a service that truly deals with the issues that have burdened clients and lawyers alike.”

LLC or S Corp or C Corp?

If you need venture capital, form a Delaware C-Corp. If your business will never need VC style investors, form an LLC.

Note that only a C-Corp can qualify for “Qualified Small Business Stock”. This is a potentially huge tax savings when you sell your company.

Here’s a high-level summary:

The difference between an “S Corp” and a “C Corp” is just a tax election. A “C Corp” gets double-taxed, but allows multiple classes of stockholders (which VCs will demand). An “S Corp” avoids double taxation, but imposes several restrictions on the company and its owners. “Double taxation” isn’t as bad as it sounds. Accountants can often reduce or eliminate the extra tax.

• What Type of Entity Should I Form? Yokum Taku, 2009. If you want to raise venture capital, form a Delaware C Corp.

• Startup Company Form: LLC or S-Corp? Paul Graham in HN Comments, 2007. “Ordinarily a startup should be a C corp. It’s cheaper to be an LLC, but if you plan to succeed, you may as well do things right from the start.”

• Corporate Entities. Fred Wilson, 2010. “When you start a business, it is important to recognize that it will eventually be something entirely different than you. You won’t own all of it. You won’t want to be liable for everything that the company does. And you won’t want to pay taxes on its profits.”

• B-Corp: Companies with Benefits. James Surowiecki, 2014. “Becoming a B corp raises the reputational cost of abandoning your social goals. It’s what behavioral economists call a ‘commitment device’—a way of insuring that you’ll live up to your promises.”

Where to Incorporate? Delaware? NY? CA?

Delaware offers the strongest corporate laws and many investors will expect a Delaware corporation. The downside is that incorporating in Delaware will add some extra paperwork and a Delaware “franchise tax” of about $350/year for a pre-revenue startup.

• What State Should I Incorporate In? Yokum Taku, 2009. Incorporate in Delaware (probably).

• How To Calculate Delaware Franchise Tax. Yokum Taku, 2008. Startups that incorporate in Delaware need to pay an annual “franchise tax.” Its about $350/yr for a pre-revenue company.

• When Do I “really” Need to Qualify My Delaware-Formed Startup in Texas? Jose Ancer, 2013. Delaware companies generally also need to “qualify” in the states where they “conduct business.” For example, if your office is in New York and you incorporate in Delaware, you also need to “qualify” in NY by filling out a form and paying a fee.

Cofounders

Finding Cofounders

Where do I Find a Technical Cofounder? Devin Hunt, 2015. “Cofounders are not found; they are grown.”

Founder Agreements