Do You Need To Incorporate Your Startup?

Startup incorporation
Image credits: David Castillo Dominici at FreeDigitalPhotos.net

You got an idea; you started working on it, maybe with some friends or with some hired developers or even alone. The thought of getting your startup incorporated strikes you occasionally but you don't really know if it's indeed required or not. And you keep shelving this decision. Your confusion is right; there is no thumb rule about incorporation.

Neither we can say that you should incorporate right away the moment you start working on your startup, nor it is something to just forget about for quite long a period. The decision needs to take a lot of factors into consideration like the number of co-founders, the chemistry between them; is a startup making money, does it need investment etc.

To incorporate or not to incorporate your startup

Let's try to understand various factors and their role in letting you decide if you should incorporate your startup or not.

  1. Distribution of Equity: Do you need to distribute equity among different people? A common case is equity distribution among co-founders, particularly when the relation between the co-founders is a bit professional one and they didn't share a personal relationship before coming together as a team. Another case could be when you need to build a team but you don't have money to offer to people and you want to offer equity to get people on board to work with you.
    If you foresee above scenarios, it's better to invest a little time and money to get incorporated. It would speed up your process of creating a team or finding a co-founder. On the other hand, if you already have, say some friends in your team and your team is sufficient to build your startup, you can afford to shelve incorporation.
  2. Chemistry between Founders: The chemistry between the co-founders is another important factor to consider for incorporation. It is very commonly observed that some startups fail when some misunderstanding crops up between the founders and in the absence of a formal way to resolve the issue the startup dismantles. A proper legal structure helps a business avoid major conflicts. Also in case of conflicts, it helps find out ways to resolve them instead of breaking the startup apart.
    But if you believe that there is good chemistry and trust between the co-founders and you don't foresee many day-to-day conflicts, you can strike out this factor from consideration.
  3. Creation and Ownership of IP (Intellectual Property): Any business that involves IP, cannot grow without the appropriate legal business structures, as establishing a crystal clear ownership is must. For example, in case of startup with multiple founders, one founder may write all the code but in absence of legal entity, he is sole owner of that code which is contrary to what founders would prefer, i.e. business owning that code and without a legal entity in place, that is not possible.
    Assess the worth and ownership of the IP being created in your startup. Higher the worth or implications of ownership of IP, higher is the recommendation for getting incorporated. If it's just another website build upon some open source technology etc., you need not worry about this factor.
  4. Liability: Liability is a common word used while discussing importance of incorporating a new business. It is always said that having a proper business structure in place ensures that the founders have minimum personal liability. What this actually means is that during the course of business, it is a routine to deal with vendors, consultants and clients, which expose the founders in their personal capacity.
    Effectively, in case of any issue, founder(s) becomes personally responsible for the lapse whereas in case of a legal entity, all that responsibility (liability) lies with the entity and not with the founders. Again, higher the implications of any possible liability, higher should be your inclination towards getting incorporated and vice-versa.
  5. Are you making money, and how much: If you are not charging your customers, it gives you a leeway to shelve incorporation. But if you are charging money, you better start thinking about incorporating your startup. Another factor is the net revenue you make in one financial year, if it crosses a certain figure e.g. 10 lakh in India, you will need to pay certain taxes to the government. So you should better talk to your CA and start working towards incorporation.
  6. Hiring employees: If you want to hire employees for your startup, getting your startup incorporated helps you a lot. Firstly, you can attract good talent with an incorporated startup. Then it's always easy to offer ESOPs or get more formal employment agreement, NDA or Non-compete agreements etc. for a properly incorporated startup.
  7. Approaching the Investors for Fundraising: Even if fundraising is a long-term goal, it is not uncommon for startups to pitch to investors during early stages. Incorporation becomes extremely necessary at that stage because getting proper balance sheet in place prior to raising funds is a must. In simple words, you must incorporate if you are planning to approach investors.

There are certain other subtle benefits of incorporation also. It makes it easy for you to make collaborations, get affiliates, approach customers, deal with government agencies etc. But on the downside, incorporation is not just a onetime activity; it adds some extra regulatory processes e.g. filing taxes etc. to your routine tasks. Secondly, if your startup doesn't take off, it's a big pain to close a company in comparison to an informal structure. So, you need to decide in a little diligent way employing all the factors above and considering all the pros and cons.

Rahul Dev is a patent and trademark attorney and international technology business lawyer. He is a recognized industry expert in Intellectual Property, Patent Strategy & Technology Consulting. He is an active blogger & his views have been published by International Publications, Economic Times, Law Journals, Tech Magazines, Digital News Networks. Read more about him here.

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