Why you should incorporate your business venture from the start

When starting a company, many entrepreneurs skip right over the formation process and jump straight into operations. But there are many benefits to incorporation that make the formation process worth getting right from the start.

What is the main benefit of incorporating?

Incorporation creates a “corporate veil,” which limits the personal individual liability of founders and other stakeholders.

Limited liability is vitally important if the company is sued. With the protection of the corporate veil, the assets of the corporation will be the only assets available to satisfy a claim.

If founders have not incorporated and they conduct startup business in their individual names, then their personal assets are at risk. These assets can be accessed to pay claims against the business.

What are the relative benefits of each type of entity?

There are various entity forms to consider when starting a company, including C corporations, S corporations, and limited liability companies (LLCs). Below, we discuss the differences between these options.

C corps have become the most popular entity in the high-growth startup ecosystem. C corps can easily issue stock and options to an unlimited number of employees and investors. They can issue multiple classes of stock, such as the preferred stock commonly issued to venture investors. There are no US residency restrictions on who can hold the company's stock. Investors are familiar with these benefits and expect their portfolio companies to be C corps, absent some very compelling reason to choose another form. If a company initially forms using another entity type, it may condition investment upon conversion to a C corp.

S corp is often an appropriate form for a closely held or family-owned business that will not seek external financing. S corps have no corporate-level tax, only a single level of taxation passed through to the stockholder level. That can result in tax savings for companies with income. However, S corps present some problematic limitations for startups in a high-growth, global mode. S corp entities can have a maximum of 100 stockholders and is prohibited from having non-US stockholders. It is not an ideal choice of entity for a company planning to grant employee equity incentives to a large workforce, hire outside the US, or raise funds with international investors. For many startups, though, the primary drawback for S corps may be that they cannot issue multiple classes of stock, such as preferred stock, which is the universally accepted investment security of the venture capital (VC) community.

LLCs are a hybrid form, with the dual benefits of pass-through taxation (like an S Corp or a partnership) and the limited liability of a corporation. LLCs work well for high cash flow businesses like consulting firms and construction firms, which might pay high income tax. But high-growth startups generally do not have significant profit in early stages, and LLCs have disadvantages within the traditional VC-backed, high-growth company startup model. Granting equity incentives to employees and issuing preferred stock to outside investors are more complex in an LLC, and taking an LLC public has unique issues, so this form is not popular among high-growth startups.

Why are most startups formed in Delaware?

While other jurisdictions have recently adopted changes to attract more company formations, Delaware has historically been the favored jurisdiction for corporations and LLCs. The state confers a number of benefits, among them:

1. Delaware entities are easy to form and manage.
2. The corporate laws and courts in Delaware are generally favorable to business.
3. There is an extensive body of existing Delaware court precedent, creating more certainty about the outcome of potential litigation.
4. Delaware's Secretary of State Office is customer friendly, with long working hours and quick turnaround times.
5. State franchise taxes and filing fees are fairly low.

If you have a startup business that will require third-party equity financing to get to scale, it is recommended to begin as a Delaware C corp. It is more expensive to change the entity form later and there are very few downsides to forming a Delaware C corp from the start. But please do not panic when you get your first Delaware franchise tax bill. The initial bill is almost always miscalculated at hundreds of times the actual cost (for instance, a bill for $50,000 versus the actual tax due of around $500). We are experienced in working with Delaware authorities to quickly correct any calculations.

For more information, please contact your DLA Piper attorney.