As startup lawyers, we often receive inquiries from passionate entrepreneurs and founders seeking guidance on when they should consider taking their side projects to the next step by forming a legal entity. Forming a company is a “crossing the Rubicon” moment for any startup. It’s an essential step that provides numerous benefits, such as protecting the founders’ interests, enabling smooth operations, and facilitating future growth. But it also adds administrative burdens and costs.
While the safest answer is “you should form a legal entity as soon as possible,” the complex reality of managing and paying for the costs of a startup means the process is delayed until it becomes a necessity. In this blog post, we will explore three common scenarios in which founders should seriously consider forming a legal entity. Note that many of these scenarios exist simultaneously.
Scenario One: You Are Creating Something Meaningful
When founders invest their time, expertise, and resources into creating something meaningful—like core intellectual property (IP), a proof of concept, or a minimum viable product (MVP)—it’s crucial to establish a legal entity to protect their interests, make key decisions, and ensure fair treatment among all contributors. Here’s why:
- Division of equity. Founders can use a legal entity to define and formalize the division of equity between themselves, ensuring transparency and avoiding potential disputes in the future. Clear agreements on equity distribution will provide stability and motivate all founders to work toward the venture’s success.
- Establishes governance roles. Establishing a legal entity allows founders to define the key decision-makers and the founders’ formal roles and responsibilities within the organization. For example, who are the officers and directors? Even if there is shared responsibility among the founders, providing a clear framework for corporate governance can provide a layer of accountability and a process for resolving disputes and conflicts and making decisions. This allows the company to move forward with a clear plan of attack.
- Contains the assets. A legal entity allows founders to accurately document and own collective assets, such as IP, cash, or physical assets, creating a clear distinction between personal and business assets. Without a properly formed entity, legal ownership of these assets becomes vague. In turn, this leads to ambiguity and disputes over who owns these assets or how much the assets are worth. Without clear ownership over the company’s assets, investors will be very reluctant to entrust their money to the enterprise.
- Founder exit arrangements. Finally, forming an entity allows the founders to establish “prenuptial”-type arrangements for handling founder exits, ensuring a smooth transition, and protecting the enterprise’s continuity. These arrangements can determine everything from vesting arrangements on founder equity (the most common tool in venture-backed business), to buy-sell agreements, and voting agreements between founders.
Scenario Two: You Want To Enter Into a Contract or Hire Someone
When a startup project reaches a stage where it requires contracts (with a vendor, potential customer, or beta tester) or service providers (e.g., an advisor, employee, or independent contractor), forming a legal entity becomes imperative. Here’s why:
- Benefits flow to the enterprise. A legal entity ensures that any benefits from the contracts or the service providers (in the form of revenue, provided services, or created IP) flow to the legal entity for the benefit of the entire organization. It’s worth repeating, that without clear ownership over the company’s assets, investors will be very reluctant to entrust their money to the enterprise.
- Limited liability for founders. By forming a legal entity, founders can limit their personal liability for any debts or legal obligations incurred by the business. This separation protects founders’ personal assets in case of legal disputes or financial liabilities. This protection ensures that personal assets remain safeguarded, even if the venture encounters challenges or faces legal action. Note that this limitation of liability is not absolute, so remember to work with your legal advisor to understand what steps you can take to maximize this protection—and understand where you remain personally liable (e.g., for employee’s unpaid wages).
Scenario Three: You Want To Raise Money
Having a legal entity becomes essential for founders seeking outside investment. Investors will only invest in startups that have established legal entities. All of the issues covered in Scenario One of this blog post are important to the investor as well. By creating a legal entity, founders demonstrate their commitment, professionalism, and readiness to engage in complex investment negotiations.
- Form the entity well in advance of fundraising. Note that you should not wait until you have a term sheet to form your entity. There are some serious tax consequences for the founders if they wait too long—which can cause avoidable tax risks to the founders and delay the fundraising process. Remember, it’s always wise to consult with a startup lawyer or legal professional to ensure compliance with relevant laws and regulations specific to your jurisdiction.
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