- Commercial Law Advisors
What is the right point to incorporate company?
There are several criteria that should be kept in mind while deciding when to incorporate the company.
One of the most important reasons for incorporation is to avoid personal liability. A separate legal entity ensures that after proper formalities are done, the creditors or courts cannot delve into personal assets. Incorporation also helps in taking loans without personal credit risk as it is a separate legal entity. Incorporation also helps in hiring staff or while involving third- party contractors. This broad overarching theme being protecting personal assets from any liability.
Incorporation before raising money via crowdfunding is also a strategic step that helps in ensuring that if the project does not work out, there is no personal liability of the founders. An incorporate entity, allows for issuance of ESOPs (employee stock option plan) to the employees at times when the company is short of cash. ESOPs cannot be sold at a price lower than the fair market value. Thus, it is important for the startup to grant them earlier at a cheaper price to ensure higher profits.
At times with more than one founders, there can be conflicts with respect to the manner in which equity splits. Incorporating helps in issuing stocks to founders while avoiding misunderstandings. Incorporation also helps founders to purchase stock at a nominal purchase price. Sweat equity can be issued to founders only post incorporation. When the company gets acquired, incorporation helps in getting tax benefits rather than paying the standard high rate income.
Incorporating the company and assigning Intellectual Property to it ensures that the buyer purchases the stock of the company and not the company itself. It is usually ideal for a company to hold Intellectual Property instead of individuals. If multiple individuals hold an Intellectual Property, it might lead a situation where if a co-founder quits, there would be no legal entity to which the Intellectual Property belongs.
When the shares are held for a period longer than one year, the company is eligible for long- term capital gain tax too. When the founders want to focus on the growth of the company, incorporation helps in reducing taxations. If the founders choose to not pocket the profits, it can be used for the growth and be taxed at a lower corporate level facilitating reinvestment.
Incorporation is a formal structure that helps while approaching Venture Capital or Private Equity Investments. There are preferred stocks and common stocks allowed post incorporation and this lures investors to choose the type of stock they want. Incorporation also ensures that if the exit strategy is an IPO, there is a structure for it. Waiting for an investor before incorporating can lead to valuation problems.
If there is uncertainty about the business idea, then one should not go for incorporation. A prior non-compete agreement will increase risk of litigation if a company is forming a competing business. It is for this reason that sound legal advice at the birthing stage of the idea allows for smooth sailing with regard to the legal structure of the business and protects value leakage.