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Incorporation

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What is business Incorporation?


A business typically exists as soon as the person engaging in the activity says it does. The label
“business” is simply a statement about intent: If you intend an activity to make money by providing
goods or services to customers then congratulations, that activity is a business.

A company, on the other hand, is a particular operating structure registered in some jurisdiction. They
come with substantial rights and responsibilities.

Incorporation refers to the legal process of turning a business into a company. Many entrepreneurs
wonder whether their businesses should become companies and, if so, when and what form of
company. We’ve written a quick guide to explain what it means to incorporate a business.

What is the alternative to incorporation?


By default, a business has no existence apart from its owners. This is called a sole proprietorship
(sometimes called a sole trader outside of the US) if it has only one owner or a partnership if it has
multiple owners.

Sole proprietorships are extremely common. At the time of this writing, the Internal Revenue Service
(the US taxation agency) is aware of approximately 27 million of these informally organized businesses
(compared to approximately 6 million formally incorporated businesses). This is broadly true across
most countries that have a distinction between sole proprietors and corporations.

What are the benefits of incorporating a business?


So why incorporate if 80%+ of entrepreneurs do not? To quote the Orrick Legal Guide for Stripe Atlas:


The primary reason for selecting a corporate form is for the limited liability and perpetual existence that
these organizations can provide, because once a company is formed, it is regarded as a separate legal
entity from its owners. Sole proprietors and partnerships are usually personally liable for the debts and
obligations of their businesses, and the businesses cease upon the death or departure of the principals.

Incorporation is primarily about risk reduction for all parties in an enterprise.

Incorporation clarifies the ownership interests of entrepreneurs, investors, and employees, giving
everyone confidence that they are receiving the deal for which they bargained their money or labor.


Incorporation moves liability for debts and business obligations from the entrepreneurs into the
company itself—since the law recognizes it as a separate entity from its owners.


Incorporation turns a business from a concept to a thing; that thing can be owned, bought, sold,
borrowed against, destroyed, etc., like any other property.


Incorporation sends a signal to customers, partners, and the rest of the world that the business intends
to operate in a professional manner.


The chief reason many entrepreneurs choose not to incorporate is that running a real business is
complicated and expensive. A sole proprietorship exists as soon as you say it does. It can stop existing
almost as quickly. A company, on the other hand, is like a puppy: Owning it obligates you to expensive
upkeep, even when you are tired of it chewing on the furniture.

When to incorporate?


Whether to incorporate one’s business or not is a decision to make carefully after talking to one’s
professional advisors, such as a lawyer or accountant. The following are common reasons to
incorporate:

Incorporate immediately if you’re told to by professional advisors.


Some businesses are, by their nature, so exposed to liability that they should almost always be operated
as an incorporated entity. Your lawyer or accountant can, given a brief description of your business,
likely give you their considered opinion on whether your industry or business model strongly warrants
incorporation.

Your lawyer or accountant might also advise incorporation as a proactive measure if you have
substantial assets outside of the business, such as other business interests or a house, which should be
protected from debts or liabilities attached to the business.

Incorporate if you want to share ownership with anyone else.

Unincorporated partnerships can exist. That said, they have some drawbacks compared with
incorporated partnership structures, like limited liability companies (LLCs). Most entrepreneurs with
partners choose to have an LLC or corporation.

Partnerships are extraordinarily customizable with regards to who is contributing what and who ends up
owning what as a result of the partnership. This customizability can be extremely complicated, and
making sure the agreement is fair to all parties (and appropriately de-risked) can run up a large tab for
professional services. It is possible you can economize on costs and complexity by adopting a variant of
an LLC or corporation.

An unfortunate fact of starting businesses is every relationship will eventually come to an end. LLCs and
corporations have well-established mechanisms for removing a partner or winding down entirely. Ad
hoc partnerships often don’t, adding additional headaches, expense, and legal risk to an outcome that is
likely already an unhappy one for all involved. You can avoid heartache during the dissolution of your ad
hoc partnership by formalizing the partnership early.

The legal name for an ownership interest in a company is equity, and there are a variety of ways to grant
it. These implicate an existing legal infrastructure that dates back hundreds of years. Holders of equity
have predictable rights, which they can reasonably assume will be enforced; this is part of what makes
equity in a successful business so valuable.

Most founders who want to share ownership of a business with employees or advisors (even if they’re
not full partners) choose to grant equity—via a well-defined instrument—in an entity rather than having
poorly specified, informal agreements that come back to bite you later.

Incorporate when you anticipate taking investment.


Sophisticated investors want to know that, in return for their investment, they will share in the
economic proceeds of the business as agreed. This is much easier to guarantee for corporate entities
than for unincorporated businesses. We have centuries of practice in accounting for how much money
companies make, apportioning varying amounts of control over their operations, and handling disputes
in interpretation regarding agreements made about them.

Most serious investors prefer to invest in a corporate entity rather than an unincorporated entity. The
exact timing of incorporation depends on the particular deal and investor; sometimes the deal is struck
in principle before incorporation and formalized with the newly incorporated company. Usually, the
company being formed is a prerequisite to having the deal.

Incorporate before hiring a full-time employee.


There are many ways that businesses are regulated. One of the most detailed and complicated ways is in
their interactions with employees, due to the social importance of the employment relationship.
Accordingly, bringing on your first employee causes a quantum leap in the level of sophistication that
you have to bring to running your business and to the potential downside risk of being noncompliant.

Additionally, your business may be responsible in some circumstances for that employee’s actions. If
you have not incorporated, the business does not have a separate identity than you personally, so you
personally might be forced to pay for their mistakes.

Incorporate as your business approaches material size or complexity.


As businesses grow, they tend to get more complicated and accumulate more sources of risk. You’re
shipping more products to more customers. Your services start getting sold to more sophisticated
customers, who have more to lose if you break things and more propensity to sue when things get
broken. You attract the attention of bad actors.

Incorporation can help limit your personal exposure to risks that might properly belong to the business
you’re running.

What “material size” means to you is a great question to run by your accountant, but as a guideline, in
the United States, many businesses with revenue above $100,000 choose to incorporate.

What types of companies are there?


Companies, in the United States, are regulated at the state level, not at the federal (national
government) level. The laws of the 50 states generally provide for limited liability companies (LLCs),
corporations (generally referred to as “C corps”), and a few more exotic options that are not relevant to
most people running internet companies.

Should I have a C corporation?


Most companies that seek to raise investment from investors in the United States choose to have a C
corporation, specifically, a Delaware C corporation. It is the overwhelming choice of technology
companies and their investors—over 90% of IPOs in the US from 2007 through 2014 were of Delaware C
corporations (see here, page 8). If you have another type of business entity, your investors may ask you
to dissolve it or convert it into a Delaware C corporation as a condition of, or prerequisite to, investing,
which can be needlessly costly.

Why do venture capital investors overwhelmingly prefer to invest in Delaware C corporations?
Quoting the Orrick Legal Guide for Stripe Atlas:

Forming your company in Delaware is the easiest and most efficient. Delaware is the state of
incorporation for more than 60% of Fortune 500 companies. Delaware has an established body of laws
governing corporations: It’s the only state to have a separate business court system (the Court of
Chancery). This is meaningful to entrepreneurs for two reasons. First, there is a long-established body of
laws relevant to corporations that has been tested in the Delaware courts over many years. In the event
of any legal action, therefore, there is a high degree of predictability. Second, Delaware has a long
record of pro-management decisions. Venture capitalists (VCs) feel more at ease when they see that a
company is incorporated in Delaware because it is familiar to them.

Should I have an LLC?


LLCs have a few advantages over C corporations:

 

  1. They cost less to incorporate.

  2. They’re generally easier to incorporate and administer in an ongoing fashion.

  3. They offer pass-through taxation, which may be more tax efficient in some circumstances, particularly for smaller firms.

  4. They provide limited liability protection; owners’ personal assets are protected from being liable for the debts and obligations of the LLC.

 

 

Many solo entrepreneurs, consultants, or folks doing freelance work choose LLCs for these reasons. It is
far less common to see high-growth technology companies choose to organize as LLCs—those
companies usually choose to take investment, at which point they typically will be forced by investors to
become C corporations.

Learn more about the differences between an LLC and C corporation and find additional resources for
incorporating your startup with Stripe Atlas. Stripe Atlas helps guide entrepreneurs through the
incorporation process by removing lengthy paperwork and legal complexity.

Is one type of corporation more of a “real business” than the other?


This is an excellent question for many of our international entrepreneurs, because in some countries,
some classes of corporation are treated as second-class corporate citizens. This is not widely true in the
United States. Companies are happy to deal with both C corporations and LLCs. Individual consumers
largely do not particularly understand the difference. Both are well-understood, supported options for
interacting with the government.

I’ve heard of S corporations, what does the S corporations look like?


An S corporation is not a separate type of company. It is a particular way to elect (i.e., ask the IRS for)
the pass-through tax treatment of LLCs with the corporate form of a C corporation. The IRS covers the
topic in more detail here. We’ll cover S corporations in more detail at a later date. However, the S
corporation cannot be held by the foreign stockholders, and the stockholders’ number shall not exceed
100 people.

Who can incorporate companies?


Substantially, anyone can incorporate a US company and own all of its equity interests. You do not have
to be a US resident or US citizen. A foreign company can incorporate and wholly own a US company.
Misconceptions about this are common, but the Orrick Legal Guide for Stripe Atlas is clear:

There is no US federal or state laws that require a stockholder or LLC member to be a US citizen or
permanent resident to form a US company. Non-US nationals can own all of the shares of a US
corporation or be the sole members of a US LLC. Nor must a member of the corporation’s board of
directors or corporate officers own any shares (like “directors’ qualifying shares”). Similarly, all of the
members of the US corporation’s board of directors and all of its officers can, if so desired, be non-US
nationals and US nonresidents.

Millions of US corporations exist that are directly controlled by people outside the United States,
including many people or corporations who are not US citizens. This is considered a normal business
practice. The United States does an incredible amount of business internationally, which requires
foreigners to be able to transact business in the United States, and when they do so, it is often most
convenient for them to transact as US entities. People routinely incorporate US companies for projects
as simple as owning a flat or a condominium.

 

Notes: Corporations owned by foreign residents or noncitizens are still corporations.

We are here to help.

To learn more about your potential legal options, have questions or to schedule a consultations contact us today – it’s free and strictly confidential.

(770) 936-3991
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