- November 21, 2010
- Posted by: Seth Heyman
- Category: Business Law
Many small entrepreneurial ventures are started on a shoestring budget, and some develop into multi-million dollar operations relatively quickly. “Social Network,” the recent film covering the phenomenal growth of Facebook, highlighted the bitter infighting and expensive legal battles engendered not by Facebook’s growth, but in large part by a failure to clearly set forth the rights, duties, obligations, and expectations of the founders.
One way to avoid (or at least minimize) such issues is to incorporate your startup before it launches. However, this involves additional costs, which a shoestring budget may not be able to bear, and it could be money better spent on ensuring the company’s success. After all, an ironclad agreement securing your position in a startup won’t do you much good if it goes under. Another downside is the possibility of generating ownership issues that lead to infighting before there’s anything to fight about. In addition, many states begin taxing a corporate entity immediately after it’s formed, regardless of whether the company generates any income.
That being said, most lawyers agree that the benefits of incorporating early largely outweigh the burdens, especially when one considers the consequences of incorporating too late.
Incorporating early in the process helps clarify what the founders envision for the company’s growth and direction. It helps further develop the brand and the product line, and if bitterness or acrimony comes out when the distribution of interests is addressed, it’s considerably easier to resolve the matter before millions of dollars are at stake. In addition, if the business does go under shortly after incorporation and the issuance of shares, the shareholders will be better protected against any personal liability that may be associated with the now-defunct enterprise.
Here’s an effective way to address the timing issue: As soon as the founders agree to partner up, they should enter into a pre-incorporation agreement setting forth their respective rights, duties, and obligations relating to the company that they later intend to create. Doing so makes later incorporation a smoother process, because the consequences of failing to deliver money or services have already been addressed. In my opinion, a good time to consider incorporation is whenever the company enters into a contract that will generate revenue sufficient to pay the cost of incorporating (around $1,500 to $2,500 depending upon the complexities involved), and in any event before the company enters into any contract that requires the payment of $10,000 or more (i.e., an equipment or real estate lease).
While using an inexpensive online incorporation service may seem like a good idea, the boilerplate documents those services spit out are only going to confuse the issues if Facebook-type problems arise, and the cost of retaining attorneys to help clear things up will be a lot more expensive then bringing one aboard from the start. The last thing you want is to become a victim of your own success.
Entrepreneurs are well advised to consult with an attorney on the issue of whether and when to incorporate as soon as the business is conceived. An experienced business attorney can help clarify the issues that are likely to arise as the business grows, and plan accordingly.