Incorporating a Business: When’s the Right Time?

Small Business - September 24, 2020
Smiling male business owner and barista

Operating without a business entity may lead to problems

When it comes to incorporation, timing is everything. Incorporate too soon, and you may be stuck paying fees, taxes, filing unnecessary reports, and generally wasting time and money. Incorporate too late and you may face the loss of your property or work, unlimited liability, and higher taxes. Here are some factors to consider when talking with a lawyer about incorporation.

Multiple founders & business divorce

No matter how well a relationship with multiple founders may start, there is always the potential for disagreement and, worse yet, a business divorce or dissolution of the company due to a permanent rift. Incorporation may be a good option to manage any such problems. After incorporation, founders are issued shares in exchange for performing work and/or investment, and each founder’s ownership in the company is determined simply by the number of shares owned. Incorporating and having appropriate Articles of Incorporation will also allow the founders to transfer shares without the potential dissolution of the business.

If property (especially intellectual property, or IP) is part of a business, setting up an entity early and transferring is wise to maintain the company’s rights to that property over any individual founder. Provided that the founders assign their IP to the corporation and have appropriate agreements in place, issues with a co-founder departure should be lessened. If the founders retain the rights to the IP rather than the corporation, you risk having your entire business unravel in a long, protracted ownership fight.

Contract agreements with third parties & employees

Liability in the case of agreements with third parties depends on whether your business is incorporated or not. In the case of unincorporated businesses (also known as a sole proprietorship), any liability falls on the owners of the company, which leaves their personal assets at risk. For example, any agreement made with a third party for supplies before incorporation may leave owners personally liable for that agreement even if the business incorporates soon after the agreement is signed. So for the sake of protecting everyone’s personal assets and avoiding any undue liability, it’s wise to incorporate before entering into contracts or agreements. If you have started making agreements or otherwise operated without any entity, consult an attorney to help you remedy the situation.

Selling equity in your company

Plenty of founders choose to bootstrap and self-fund from the operations or personal money, but if you’re planning to seek funding for your business, you’ll want to form a corporation to aid with the process. Not only does a corporation offer a professional sheen to your fledgling business, but it also structures the company in a way that makes it easier to attract funding by allowing investors to buy a share of the company. Although popular, LLCs are more difficult to fund and in the case of a sole proprietorship, investors wouldn’t be able to buy a stake as no shares exist, and any money invested would be entangled in the owner’s personal finances.

Offering equity is also a way for companies still in the embryonic stage to attract talent to their startup. Potential employees may be willing to accept a lesser salary or longer hours in exchange for a share in the company that might be worth exponentially more in a few years’ time. To that end, companies looking to be acquired should look to incorporate early if they want to avail themselves of capital gains taxes on their stock rather than a higher personal income rate.

Of course, there are other factors that should be considered when deciding whether or not to incorporate versus creating an LLC. There are fees involved in incorporating, as well as annual costs and taxes and regulatory and reporting requirements that go with a corporation, all of which may be more than you want to deal with for a small side business that’s more a hobby than a career. But the general rule of thumb is that once your business idea is more than just a twinkle in your eye, you should start looking at entity options with an attorney to make the informed choice.

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