A sharp, concise checklist put together by a talented startup lawyer - to which I would add a few observations:
1. A Delaware C-corp is often a fine choice for startups but be careful not to make it a fixed rule. Whatever you do must fit your circumstances and not be something you do simply because it is declared from on-high. You don't want to find yourself in the position of the young founder who ultimately said "why incorporating my startup [in Delaware] was my worst mistake" (see http://news.ycombinator.com/item?id=2399139). And, as tptacek points out variously on this thread, sometimes an LLC or an S-corp might be a better fit for you or your team - this choice is often tax-driven, though it can also tie to the less formal management structure and the often lower cost of an LLC (see my comments here on some pluses and minuses of LLCs in a startup context: http://news.ycombinator.com/item?id=1276724). My point: think it through before making this choice (on domicile, here are some thoughts on how local domicile might in some cases be better than Delaware: http://grellas.com/faq_business_startup_002.html).
2. C-corp is a particularly good choice for 2011 if you plan to hold the stock in your venture for more than 5 years with the hope that you can sell it free of any federal capital gains tax and also free of AMT. Not all stock grants will qualify, even in a C-corp, and so you should check with a good CPA (for some of the relevant factors, see my comments on so-called QSB stock: http://news.ycombinator.com/item?id=2018041).
3. Vesting for founders is a mix-and-match process and does not have to be uniform for all founders. Those who have not yet make significant contributions to a venture at the time of entity formation normally should take their interest subject to vesting - otherwise, they might walk away with a large piece of equity before having earned it. This wouldn't necessarily apply to all founders, however, and it is at times appropriate that one or more founders on a team get their stock (or at least a significant part of it) free and clear of vesting requirements. Otherwise, there is an unfair risk of forfeiture placed upon them. Also, the one-year cliff idea often doesn't fit with founders, in my experience; more typically, there is some sort of immediate pro-rata vesting (monthly, quarterly, etc.).
4. The "lock down the IP" point is often overlooked, especially by founders trying a DIY approach: make sure you have not only technology assignment agreements to capture all IP generated in the pre-formation stage but also invention assignment / work-for-hire agreements to make sure the company owns all IP generated by founders after they have their initial stock (the company does not automatically own it just because they are owners doing work on the venture). The idea of IP has its detractors today but your company will suffer in fund-raising and on exit if holes exist in these areas. All it takes is one bad episode - anything from a founder bolting to form a directly competitive venture using the same IP to an ex-founder filing suit to block further company development on IP that he claims he owns - to convince most founders that IP protection is in fact vital in the early-company stage for most ventures.
5. One other very important item: make sure to separate your founder grants from any large cash investments that are done for equity. If you don't, it will create tax risks because, if cash and services are contributed for stock at the same time and for the same type of equity, the service providers (i.e., those contributing the "sweat equity") can potentially be taxed on the value of the equity received as measured by what might be a high company valuation (e.g., you get 50% and an investor gets 50%, you contribute your talents and services and the investor puts in $200,000, all for common stock - result: you are at risk for having received up to $200,000 income item on which you must pay tax). Not a particular tax risk if investors use convertible notes (because the stock is not priced in that case) but a potentially serious one if investors get stock. The relevant planning tip: while you don't need to unduly front-load expenses, don't wait too long before setting up the entity either - you should generally do this before you have your investors lined up and about to sign.
Note that while these are probably the best practices for a company that knows it is immediately going to take funding, LLCs and S-Corps are valid choices for companies that aren't sure or that are going to be making money before they take funding.
The S-Corp in particular has some attractive features: it simplifies equity grants to employees compared to an LLC, and taxes are easier to deal with in a C-Corp (there's also a sort of notorious salary-vs.-distribution trick people place with S-Corps to reduce their taxable income).
The LLC is incredibly easy to set up; you can probably get one via 1-click on Amazon now.
In the only company I founded that took serious VC, I didn't handle any of the legal, but the sense I got was that legal for a real VC round is so innately expensive that the S-to-C conversion isn't a big deal by comparison. It's most convenient for everyone if you're not even incorporated, but that's their problem (it is dumb to do business without incorporating); if you're worth funding, nobody is not going to fund you because of the cost of converting to their preferred structure.
The #1 reason not to go the LLC route when you start is if you are not the solo founder. If you have co-founders, please, please, save yourself years of agony, start with a C-corp and proper vesting in place upfront.
If you're going to have employees and those employees are going to have formal equity as part of their compensation, the simplest structure to use seems to be the S-Corporation.
If you're not granting options to employees or you're just 3-4 founders, you can get the same effect as vesting with buy-sell agreements.
You can do vesting in LLCs (at least in most places, right?). You need a lawyer in any case.
Indeed, the author notes in another post (http://startuplawyer.com/incorporation/accountants-heart-llc...) that the LLC is a fine choice except in situations when you expect to "(i) raise capital, and/or (ii) issue incentive equity compensation". Most posters here are probably thinking about that kind of start up, but not every new venture needs to worry about raising outside capital.
Because when you sign any contract with a commitment in it and you're not incorporated, the liability attaches to you personally. This may sound natural but it is not the natural order of things for businesses. You should not be at risk of losing your house simply because you can't pay your bandwidth or office bills.
Agreed. The primary issue with an S-to-C conversion is that any assets with built-in-gain (i.e., worth more now than when they were acquired) may result in "immediate" income to the corporation. This is not an issue for most startups, unless they start off spending lots of money (i.e., Color). (Also, "immediate" in tax world really just means they'll be part of that year's income.) The conversion itself is otherwise tax-free at the federal level, and in most (but not all) states.
LLCs, however, are a frigging nightmare. They're the most difficult form of business entity to set up (except for non-profit 501(c)(3)'s). Accounting for LLCs will require an experienced (expensive) accountant. Plus, state laws on LLCs aren't uniform in the states that matter.
That hasn't been my experience with LLCs. If you're making money and you're a founder, you need an accountant full stop. But having said that: you make distributions, and the principals pay self employment tax. Where's the big deal?
Here's where I get jumpy on this stuff:
S- and C- corporations are complex enough to put people off until they get a lawyer. Most startup founders probably don't have a lawyer when they start.
When you say "LLCs are a nightmare", besides the fact that they're aren't for most people (they aren't even notably complicated for most people; that's the point), and that it's not that hard to switch out of an LLC when things get complicated (by that point, you have a lawyer)...
... besides those things, you're also probably effectively talking people out of incorporating at all. That's more than suboptimal; it's dangerous. It creates situations where you can be personally liable for all sorts of company expenses. We've had HN posts from people who were told by cofounders and business partners that they were personally liable for huge expenses, and had those same people discovered they owed zero because they were incorporated.
Don't do business as a sole proprietor. Get a structure with limited liability as soon as you can. If it's between an LLC now and an S-Corp "maybe 6 months from now, maybe earlier if we can find a good lawyer and we're making money" --- do the LLC.
You're the expert here. Where am I wrong in this analysis?
LLCs, however, are a frigging nightmare. They're the most difficult form of business entity to set up (except for non-profit 501(c)(3)'s). Accounting for LLCs will require an experienced (expensive) accountant. Plus, state laws on LLCs aren't uniform in the states that matter.
Funny, setting up our LLC took about 20 minutes of filling out forms and mailing them in. I've heard it's different state-to-state, but in the state we set up in (Virginia) it was not terribly harder than buying a new cell phone...and less money.
I wonder why would somebody go with S-corp instead of C-corp if they plan to be big (meaning raise money)? Majority of startups will not have enough of profit to pay founders at the beginning, so tax advantage does not look very appealing.
Can't resist giving a shout-out to the sole proprietorship without outside funding. It's pretty amazing how much cheaper it has gotten to start a whole range of software businesses in the last three years.
Can you get insurance? Have you had trouble invoicing people without them withholding taxes on your behalf? Is your company liable for your bandwidth, hosting, and office expenses, or is your mortgage?
Lots of smart people seem to use sole proprietorships, but I don't understand why. I mean that seriously, not rhetorically: this is something I don't understand. LLCs are comically easy to set up.
I told myself I would set up an LLC as soon as it had some practical benefit to me, and five years later...
I don't mean that to be flippant. I can see many good arguments for it, including the ones you list, but in my specific circumstances (no clients to invoice, clear line between personal and business expenses) it has been simpler to remain a sole proprietor.
That said, what I wanted to stress was the idea of not taking outside funding, however you choose to structure things.
We are very much on the same page regarding funding, which is one of the things militating my LLC advocacy. If you think you can just get starting without goofing around with admin details and funding pitches, LLCs are great.
Please talk to the layer to understand liability for your particular business. As a officer of a company you are still personally liable for some things and D&O will not cover it. In other words, don't think incorporation will make your private assets 100% safe.
You are particularly exposed when it comes to torts you personally have a hand in, and possibly for contracts where it can be entered in bad faith.
That said: I'd be very surprised to hear a lawyer say that incorporation makes you more exposed. You make a good point, but I'm still pretty sure the default should be "incorporate somehow".
This sounds totally reasonable since you've thought it through, and you can always get an LLC before you do any kind of business that would change that calculation.
I just want to advocate for the stance that, if you're not sure, you should err on the side of having limited liability. Your business is probably going to fold, and when it does, it's probably going to have liabilities.
Even though it's completely hypocritical I wholeheartedly join you in your LLC cheerleading. Fast, easy, not expensive.
What I've found by far the hardest as a one-person business is finding a lawyer and an accountant. It's hard to know where to start looking, and there's so much startup money sloshing around that it crowds out smaller fish like me.
Sounds like hours of pondering about international tax issues would follow this decision?
I have a sole proprietorship in Finland. Sometimes I've given thought to having this type of standard corp in US, as if I have another hit Facebook app or whatever it seems like it would make me an easier entity for others to deal with.
Apart from the tax issues, I worry about having to pay an US lawyer high US wages for advice / set up fees. Maybe I'm starting to believe all the news stories too much, but doesn't being incorporated in US also make you much more likely to be the target of some frivolous patent / other lawsuit?
I'm currently in the process of setting up a web start-up in Germany. I therefore know it from my own experience that - especially from a legal perspective - there are big differences between setting up a start-up in the US or in Germany. And trust me, this how-to list is not 1-to-1 applicable to how it's done in Germany.
There has been coverage about German business clones of successful US start-ups. Also there have been complaints that some start-ups "don't think big" and expand their market coverage only in regional boundaries (airbnb vs. wimdu/9flats). Probably they would do better overseas if from early on such lists wouldn't be so focused.
These are great points for someone like me who knows only programming. I would say this is a good list to look at 'when the time comes'.
EDIT: More clarity in line 1
The one non-negligible issue I had with the tips was the "vesting over time" approach recommended in the article. I prefer to setup vesting to milestones, such as "x contracted clients", or "delivered first MVP (minimum valuable product, as defined by a list of mutually-accepted user stories)", etc. IOW, I prefer vesting to some sort of deliverable, not just time.
These are the things he would do in the beginning?! What about the part where you create something of value? I guess this is the explanation why lawyers don't launch startups.
1. A Delaware C-corp is often a fine choice for startups but be careful not to make it a fixed rule. Whatever you do must fit your circumstances and not be something you do simply because it is declared from on-high. You don't want to find yourself in the position of the young founder who ultimately said "why incorporating my startup [in Delaware] was my worst mistake" (see http://news.ycombinator.com/item?id=2399139). And, as tptacek points out variously on this thread, sometimes an LLC or an S-corp might be a better fit for you or your team - this choice is often tax-driven, though it can also tie to the less formal management structure and the often lower cost of an LLC (see my comments here on some pluses and minuses of LLCs in a startup context: http://news.ycombinator.com/item?id=1276724). My point: think it through before making this choice (on domicile, here are some thoughts on how local domicile might in some cases be better than Delaware: http://grellas.com/faq_business_startup_002.html).
2. C-corp is a particularly good choice for 2011 if you plan to hold the stock in your venture for more than 5 years with the hope that you can sell it free of any federal capital gains tax and also free of AMT. Not all stock grants will qualify, even in a C-corp, and so you should check with a good CPA (for some of the relevant factors, see my comments on so-called QSB stock: http://news.ycombinator.com/item?id=2018041).
3. Vesting for founders is a mix-and-match process and does not have to be uniform for all founders. Those who have not yet make significant contributions to a venture at the time of entity formation normally should take their interest subject to vesting - otherwise, they might walk away with a large piece of equity before having earned it. This wouldn't necessarily apply to all founders, however, and it is at times appropriate that one or more founders on a team get their stock (or at least a significant part of it) free and clear of vesting requirements. Otherwise, there is an unfair risk of forfeiture placed upon them. Also, the one-year cliff idea often doesn't fit with founders, in my experience; more typically, there is some sort of immediate pro-rata vesting (monthly, quarterly, etc.).
4. The "lock down the IP" point is often overlooked, especially by founders trying a DIY approach: make sure you have not only technology assignment agreements to capture all IP generated in the pre-formation stage but also invention assignment / work-for-hire agreements to make sure the company owns all IP generated by founders after they have their initial stock (the company does not automatically own it just because they are owners doing work on the venture). The idea of IP has its detractors today but your company will suffer in fund-raising and on exit if holes exist in these areas. All it takes is one bad episode - anything from a founder bolting to form a directly competitive venture using the same IP to an ex-founder filing suit to block further company development on IP that he claims he owns - to convince most founders that IP protection is in fact vital in the early-company stage for most ventures.
5. One other very important item: make sure to separate your founder grants from any large cash investments that are done for equity. If you don't, it will create tax risks because, if cash and services are contributed for stock at the same time and for the same type of equity, the service providers (i.e., those contributing the "sweat equity") can potentially be taxed on the value of the equity received as measured by what might be a high company valuation (e.g., you get 50% and an investor gets 50%, you contribute your talents and services and the investor puts in $200,000, all for common stock - result: you are at risk for having received up to $200,000 income item on which you must pay tax). Not a particular tax risk if investors use convertible notes (because the stock is not priced in that case) but a potentially serious one if investors get stock. The relevant planning tip: while you don't need to unduly front-load expenses, don't wait too long before setting up the entity either - you should generally do this before you have your investors lined up and about to sign.