While doing a business, or planning to start a new business, one of the key issues an entrepreneur must face is whether to incorporate, and if so, when. His primary concern remains the importance to form and incorporate a legal entity, and how to decide which type of legal entity is the right choice for his business. This post will address the first part of the question, as to when is the right time to incorporate a legal entity.
Generally, most entrepreneurs start their businesses as sole proprietors mainly because they want to test their business by starting to sell a product or offer a service. On other occasions, they don’t prefer to make the effort or incur the cost of incorporating until they know if the business model is viable.
As a common trend observed worldwide, founders of startups and new businesses often wait to incorporate a legal entity until they have the confidence that their concept is viable or capable of receiving funding. However, at some point, an entrepreneur is required to formally incorporate a legal entity, primarily because of one or more reasons, as explained hereinbelow.
It shall be worthwhile noting that the decision to incorporate may not have a significant impact on the day-to-day operations of a business, but, the implications may become obvious for the purpose of taxation, or while applying for a loan, or in case of a lawsuit.
As a standard practice, it is advisable to incorporate a legal entity in case of one of the following situations:
(a) Multiple founders: In case of more than one founder, the possibility of a disagreement about dividing the equity in the new business increases, and hence, incorporating a company and issuing stocks to the founders shall help in preventing misunderstandings among the founders about equity splits.
(b) Intellectual Property Rights (IPR): If an IP is created, such as, for example, patent (technology involving a new product, or a new process, or both), trademark (a brand name, and / or a logo, and / or a tagline), copyright (source code of a software, literary work etc.), and there are more than one founders, then incorporating a legal entity and assigning Intellectual Property Rights to such entity is strongly advisable. Otherwise, it may be catastrophic if a founder leaves before incorporation and Intellectual Property Rights have not been assigned to other founders or to a legal entity.
(c) Funding and Stock Options: if a third party investor prefers to invest in a startup idea, there needs to be a legal entity to accept the investment. Also, most of the times, entrepreneurs do not wish to pay cash to third parties due to lack of funds, and hence, they may partially compensate third parties by issuing stock options or giving them the opportunity to purchase equity at nominal prices. Although it is not impossible to issue stock options prior to incorporation by means of pre-incorporation agreements, it makes it simpler to incorporate a legal entity and grant stock options or equity to satisfy such promises.
Therefore, as may be seen, incorporating a legal entity is a crucial step that results in additional costs in addition to ongoing tax and other mandatory filing obligations as per the regulations of the jurisdiction. However, doing business without incorporating a legal entity may often cost more to hire an attorney to clean up the situation than it would have to get the legal entity properly incorporated and organized in the first place by utilizing the services of a startup business attorney having significant exposure to latest laws and regulations, with expertise in handling complex business transactions involving intellectual property rights (patents, trademarks, copyrights), funding, angel investments, venture capital, joint ventures, licensing, cross border mergers and acquisitions.
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