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3 Factors To Determine The Timing For Incorporation

When you’re ready to push forward with your startup idea, it’s smart to make it official and form a legal entity early on. 

This step is crucial for a few reasons.

1. You’ll need anyone who helps build your idea to agree that the startup owns their contributions. If you delay creating your company, you might find some team members reluctant to hand over their rights, which can make it hard to get funding later. 
2. When you start sharing your idea with others, you’ll want them to sign agreements like confidentiality or joint development contracts with your company, not with you personally. This protects your personal dealings. 
3. Setting up a company shields your personal assets from business risks since only the company’s assets are on the line if there are any issues.

Pick Your Legal Structure Wisely

When you start a company, you face risks, including the chance of legal action. One major reason to operate through a legal entity like a corporation or a limited liability company (LLC) is to protect your personal assets from any claims against the business. Unlike partnerships, corporations and LLCs generally shield their owners from business liabilities.

Deciding whether to form an LLC or a corporation often comes down to tax considerations. Corporations face double taxation—once on earnings and again when distributing profits to shareholders. LLCs and S Corporations, however, are “pass-through” entities, meaning profits are only taxed once at the owner level. Owners can also potentially offset other personal income with business losses, reducing their overall tax burden.

Despite these benefits, why do most tech and life sciences startups choose to become C-corporations? These startups usually don’t make money for a while. Any income they do generate is often reinvested into research and expansion, avoiding double taxation issues. Also, startup founders typically work full-time on their venture, lacking other income to offset against business losses.

Moreover, C-corporations offer structural advantages for startups planning to raise venture capital, use equity for compensation, or aim for rapid growth and an eventual IPO or sale. C-corporations can have multiple classes of stock and can include entities as shareholders, which isn’t possible with S-corporations. Venture capital investors, who often receive preferred stock and are themselves entities, fit well with C-corporations. Also, issues like negative tax implications for venture capital limited partners in LLCs, the inability to grant incentive stock options (ISOs) in LLCs, and higher administrative costs make LLCs less suitable for high-growth startups.

Thus, if your startup aims for significant growth and external funding, a C-corporation is likely the best choice.

Who Decides What in a Company?

In a company, it’s the shareholders who own the place. They use their shares to vote and elect a group of directors. These directors form a board and make the big decisions about the company’s direction and strategy. They’re supposed to always act in the best interest of the company and its shareholders because they have what’s called fiduciary duties.

The board picks the CEO and other officers who handle the daily tasks of running the company. While these officers manage day-to-day operations, they still have to follow the board’s big-picture plans. The board also has to agree on major decisions, like issuing new shares or signing big contracts.

When a company starts, its shares are usually split among the founders. They vote to elect the first board, which often includes themselves or maybe an advisor. Later, as the company grows and takes on investors, these investors become shareholders too. They usually want a say, so they might join the board. Over time, as more shares are given out to investors, the founders’ control over the company usually gets watered down quite a bit.

How Startups Pay Their Employees

Startups need to pay all employees, including founders, at least the minimum wage as required by law. Some founders choose not to take a salary in the early days, but technically, this isn’t allowed under wage laws. Besides cash, employees might also get equity, which means a share in the company. However, you can’t give equity instead of cash that meets minimum wage requirements.

The amount employees are paid can vary a lot. It depends on what the company can afford and how big it is. Often, startups can’t pay big salaries, so they offer equity as part of the deal. This equity could end up being worth a lot if the company does well. It’s a way to attract and keep good people when you can’t offer top dollar in cash.

Employees today know their worth. They look at the total package—a mix of salary and equity—and compare it to what they’d get elsewhere in their field. What you need to offer to hire someone great depends on what other companies are paying in your industry.

Dividing Equity Among Startup Founders

Talking about how to split equity between founders can be tough and emotional. It’s crucial to tackle this early on to avoid bigger problems later. If a key founder gets too little equity, they might feel undervalued, but giving too much to someone whose role isn’t as critical can cause resentment among the team.

Sometimes, splitting equity equally seems like the simplest solution to avoid arguments. However, research shows that startups that carefully consider equity based on fair contributions tend to succeed more. It’s important to think about what each founder brings to the table. For instance, if one founder came up with the idea and worked on it alone initially, that effort should be recognized. But remember, investors and future team dynamics focus more on what everyone will contribute moving forward than on past efforts.

As the startup evolves, roles will become more defined. The person who ends up leading the company often receives more equity than someone managing just one area, like marketing or engineering. Yet, in tech startups, roles aren’t always straightforward. Someone behind the scenes coding or designing might not be the public face but could be crucial to the startup’s success.

Every startup is different, and finding the right balance in equity shares is an ongoing process. It’s vital to discuss this openly with all co-founders and get everyone’s input early. Once there’s a general agreement, you can involve legal advice to finalize the details, like setting up vesting periods to ensure founders are committed long-term.

Understanding Vesting Terms for Startups

In startups, equity is a key incentive for taking risks and committing to a new venture. Ideally, equity should reflect each person’s contribution to the company’s success. The perfect scenario would involve vesting based on hitting specific milestones, but in reality, predicting long-term milestones is tough for startups. Because of this uncertainty, most startups use time-based vesting.

Here’s how it typically works: Founder shares often vest over four to five years, with the equity distributed either monthly or quarterly. For non-founder employees, the standard is also a four- to five-year vesting period, but with a one-year “cliff.” This means if an employee stays at the company for a year, they vest 25% of their shares, and then continue to vest the rest monthly or quarterly over the next three to four years. The cliff is there to make sure the employee fits well with the company before any shares are permanently owned.

For board members and advisors, vesting terms are less uniform but should still match the time they’re expected to contribute to the company, typically with monthly vesting. Keeping the vesting terms and grant sizes consistent among similar roles helps prevent issues later on, avoiding the need for individual negotiations and reducing potential resentment over unequal compensation.

Navigating Non-Compete Agreements with Former Employers

Non-compete agreements can limit where you work next, but whether they’re enforceable depends on several factors, including where you are. For instance, in California, these agreements are mostly invalid, except when selling a business. As of October 1, 2018, Massachusetts also tightened its rules on non-competes.

In most other states, a non-compete must be reasonable—if it’s too broad in time or scope, it might not hold up in court. What’s “reasonable” varies, but generally, the agreement should be fair and not overly restrict your future job opportunities.

If you break a valid non-compete, your previous employer could sue for damages or to stop you from working at your new job. Because the enforceability of non-competes really depends on your specific situation, it’s wise to consult with an attorney if you’re unsure about your agreement or if moving to your next job might cause legal issues.

Understanding Intellectual Property Ownership in Startups

For a startup to launch successfully, it’s crucial that it either owns or has the rights to use the intellectual property (IP) crucial to its business. This doesn’t happen by itself; it requires deliberate planning and legal guidance.

At the startup’s outset, each founder should formally transfer any IP related to the business idea to the company. However, founders might not own all relevant IP even if they originated it. For instance, if a founder developed an idea while at a university or while employed elsewhere, that institution or employer might own the IP. This is particularly likely if the founder used the institution’s resources or if the idea was related to their work there. In such cases, it’s important to review any relevant agreements to determine who owns the IP. The startup might need to secure rights through a license or get a waiver from the institution to use the IP commercially.

If the startup’s technology originated from a university or similar institution, typically, a license must be obtained. In return, the startup might need to provide equity, make payments, or pay royalties to the institution.

For copyright matters, such as source code, the rights automatically belong to the original creator unless there’s an agreement that assigns those rights to someone else. For example, if a startup hires someone to write code, a consulting agreement should specify that the IP created, including copyrights, is transferred to the company.

It’s also advisable to consider patent protection for inventions, including software. In the U.S., the original inventor must be the one to file for a patent. If a hired coder significantly contributes to an invention, the startup should secure an assignment of the invention and ensure the coder agrees to assist with the patent application process. These arrangements should be made when the work is commissioned, setting a clear legal groundwork for IP ownership.

Understanding Founder Employment Agreements in Startups

In technology and life sciences startups, founders typically don’t have traditional “employment agreements” like other employees might. These agreements usually include benefits like severance pay and other job protections, which aren’t generally offered to founders. Since startups need to conserve cash and founders often hold significant equity, investors are usually not in favor of offering founders severance rights.

However, it is crucial for founders to sign an employment offer letter that outlines the basic terms of their employment. This letter should clarify that they are “at-will” employees. This means founders can leave the company whenever they choose, although their ability to keep their shares or exercise options will be governed by the vesting terms agreed upon. Similarly, the company can terminate their employment at any time, for any reason or no reason at all.

Founders should also sign an agreement that covers several key areas: they must keep company information confidential, assign any intellectual property they develop to the company, and, in most states, agree not to compete with the company for a designated period after they leave. These agreements help protect the company’s interests and ensure that intellectual property and sensitive information remain secure. For templates or more detailed examples, you might consider using a Document Generator, which provides forms for these purposes.

How Control and Decision-Making Work in a Corporation

In a corporation, the shareholders are the owners. They use their voting power to elect a board of directors. This board oversees management and sets the strategic direction for the company. Directors have a duty to act in the best interests of both the corporation and its shareholders, a responsibility known as fiduciary duty.

The board of directors also selects officers, including the CEO, who manage the day-to-day operations of the company. However, for big decisions like issuing new stocks or signing major contracts, the board’s approval is necessary.

In the day-to-day, corporate officers handle most decision-making, but they remain accountable to the board. The board, in turn, is accountable to the shareholders.

Initially, when a corporation is formed, the founders usually hold all the shares. They elect the first board of directors, which might include just the founders or possibly a key advisor. As the company grows and goes through rounds of funding, new investors often receive shares and may seek board representation. This can dilute the founders’ control and ownership significantly, shifting the balance of power as the corporation matures. This evolution in control underscores the dynamic nature of corporate governance in growing companies.

Understanding the Option Pool in a Startup

The “option pool” is a block of shares a company sets aside to compensate employees, consultants, advisors, and directors. The size of this pool is influenced by the company’s stage, its specific needs, and its plans for hiring. Essentially, shares from this pool are used to attract and retain talent.

When shares from the option pool are issued, they dilute the ownership percentages of existing shareholders. However, shares that are reserved but remain unissued don’t affect current ownership—these shares only impact ownership when they are actually given out.

Initially, the exact size of the option pool might not seem critical—if it turns out to be too small, you can increase it later; if it’s too large, the unused shares don’t harm current shareholders. Typically, startups reserve a sufficiently large pool to meet their expected hiring needs for about six months to a year.

However, the situation changes significantly when raising capital. Investors typically consider the entire option pool when calculating their investment, assuming all reserved shares will eventually be issued. This affects how they view their price per share and their ownership percentage. For example, if a company valued at $5 million raises another $5 million, new investors would expect to own 50% of the company. If an option pool covering 20% of the company after the investment is required, this dilution comes out of the original shareholders’ portion, reducing their post-investment ownership from 50% to 30%.

This scenario highlights the tension between needing a large enough pool to offer competitive equity packages and minimizing dilution for existing shareholders. The best approach is to carefully plan your hiring needs up to the next round of financing, reserving just enough in the option pool to cover these needs, plus a small buffer—but not more than necessary. This strategy balances flexibility with the need to protect shareholder value.