I work with start-ups and entrepeneurs in my law practice all time – one common question / concern I get from my clients is regarding the right time to organize / incorporate their business into a formal, legal business entity. Some ask because they are trying to save the money associated with the process until they know that their business will be a forward concern, some ask just out of general curiosity.
As a rule of thumb, I typically tell clients they need to form a legal entity separate from themselves anytime (1) there is more than one founder or (2) the business is about to engage ANY sort of third party for ANYTHING. The first point is obviously based on the need to put down pre-incorporation/organization agreement in writing (i.e. avoid arguments and conflicts among founders), the second based on the need to shield potential liability.
I came across an excellent posting on this topic by Yoichiro (”Yokum”) Taku, a west coast attorney who maintains StartupCompanyLawyer.com. He has some points that expand nicely upon my second rule of thumb above, some of which I have included below:
Funding. Obviously, if third party investors want to invest in a startup idea, there needs to be an entity to accept the investment. Generally, I prefer to incorporate and issue founder’s stock at nominal prices well in advance of a Series A preferred stock financing because it is difficult to justify that common stock should be priced at $0.001 per share while Series A preferred stock is issued at $1.00 per share.
Launching a service/product and general liability issues. One important reason for incorporating a company is to protect the stockholders against personal liability. If a company complies with corporate formalities, creditors of the company generally cannot reach the stockholders to satisfy the company’s liabilities. Thus, a company should generally incorporate before launching a product or a service due to potential liability issues, as the risk of liability to a founder increases with customers or users.
Hiring employees or third party contractors. Although I’ve run into a situation where the former CEO of a Fortune 500 company personally paid an “employee” out of his own pocket for a year prior to incorporation while incubating an idea, most founders will need to incorporate a company if they intend to hire employees. In addition, if an entrepreneur needs to engage third party contractors, it generally makes sense to incorporate a company so that the third party enters into an agreement with a company instead of an individual. In addition, any IP created by the contractor can be assigned to the company instead of an individual founder.
You can find the original posting here.