When to Form
To determine when to form a corporation, founders typically consider the benefits set forth below.
Personal Liability Protection
Forming a corporation helps protect the founders from personal liability. If the corporation is sued, the assets of its founders are more likely to be protected.
Clarity with Co-Founders
When more than one founder is involved in the startup, the corporate formation process helps clarify and formalize the relationship between the founders. This is particularly true with regard to equity ownership and intellectual property ownership.
During the formation process, founders decide how the equity ownership will be split. Additionally, founders often place restrictions on the ownership of their stock, some of which lapse according to a vesting schedule. Vesting incentivizes founders to work together for a certain period of time and also defines what happens to their shares if they leave the company before the end of that period. These early decisions help align interests and minimize ownership disputes.
The formation documents should ensure that the company owns the intellectual property (commonly referred to as IP) created by the founders. IP is often at the heart of a startup’s value, so it’s important to make sure that the company can use the IP without any restrictions, even after founders depart.
When done properly, forming a corporation enables the business to receive investments from third parties. Startup investors generally expect stock, or a security convertible into stock. Forming a corporation creates an entity that is capable of issuing this stock.
Enables Equity Compensation
Corporations can create stock plans and offer equity compensation to employees and consultants. Equity compensation is often key in attracting and hiring top talent, so the ability to issue it is a practical necessity.
Finally, some founders find that having a legal entity is helpful in projecting an image of company maturity to potential customers, partners, or investors.