You're an entrepreneur and want to start your US company. You found this online platform that handles everything for $500 or so. Should you go for it?
We'll be discussing:
- Basic legal terminology.
- Why should you do it?
- When is the right time?
- An overview of the process
- The compliance costs of owning a company.
- Incorporation for foreign founders.
Big disclaimer. I am not a lawyer. I am sharing this from the entrepreneur's perspective, and the stuff that we've had to go through. Please consult your lawyer for any details.
Most companies are incorporated as C-Corporations. The second, rather common alternative is LLCs or limited liability corporations.
Just as a reference, an LLC is a type of company organized under an Operating Agreement, which is a contract between the owners (called "members”) specifying how it will be run and how the economic burdens and returns will be split between the partners. They don't function with shares as we are normally familiar with.
So we'll focus on C-Corps. In our experience with investors and accelerators, most of them will want to invest on Delaware C-Corps: so if your plan is to raise venture capital, that's probably the way you want to go.
A C-corporation is an entity designed to act as an abstraction layer between the operators of the business and the owners of the business, who may or may not be involved in day-to-day business activity. The power of a C-Corp is that it generally separates liability from the business owners.
Ownership is tracked by shares, with each share corresponding to a defined portion of control of the business and entitlement to the economic upside of it. We made a whole video about how shares work, check it out here.
The state of Delaware has a highly developed body of law governing corporations which can lead to a high degree of predictability in the event of a legal dispute. This is why most investors prefer Delaware corps.
You, of course, don't have to be in Delaware to do it. In most cases, this is handled through an entity that acts as your registered Delaware address and simply forwards your mail.
So why doing it?
Clarity with Co-Founders, we talked about founder agreements last week. Check out that video.
While those agreements can be put in paper first, as your product and company increase in value you'll need to have them in full, legal writing, and a legal corporation is the best way to do it.
Allows Equity Ownership and Compensation
Not only for founder shares but for early team members. You'll want to define an option pool for them to compensate them for taking a risk with your company.
If you are developing code, that code belongs to you unless you have a contract with the company. By creating a C-Corporation you can ensure that all code generated is owned by the company, and not by the person who wrote it. This is really important when founders split up.
Personal Liability Protection
If the corporation is sued, the assets of its founders are more likely to be protected.
It Enables Investment
You will probably not be able to raise money to your name. It needs to be put into a corporation.
When is the right time?
This is going to relate mostly to cost. While incorporating normally costs around $500, you need to pay around $500-$800 per year in state fees.
Furthermore, you need to be compliant with accounting and tax filings, depending on which states you are doing business. As a foreign founder, the US tax system scares the hell out of me, so we pay good money to ensure we are compliant.
These fees are going to be at least $1,000 a year for a rather inactive corporation, and as you ramp up revenue and expenses, that can go up. That is expensive, of course, If you are not generating revenue and funding the business yourself, this could be a lot of money that you could be using elsewhere.
Our operation, which is over ~$1MM in annual expenses (go watch that video), pays around $18,000/yr for our bookkeeping and tax filings.
So if I were to start a new company today, I'd wait to file for incorporation until we are ready to start charging customers. Before that, I recommend handling these agreements directly with your co-founders. If you are close to raising money, then you'll need to do it, of course, but most companies these days are raising their seed round after having a decent amount of revenue.
The process is rather straightforward and we laid it out in our platform FounderHub. We built that specifically to help founders navigate this process.
1. Filing takes about a day. You'll receive your stock certificates and a copy of your Certificate of Incorporation.
2. You'll want an EIN number, which will be your company's tax ID.
3. You'll need to define a Board of Directors and company Bylaws. The Bylaws are the rules of the company, so for example, it will determine which decisions or expenses can be approved by the CEO, versus which require Board majority or even unanimous Board approval.
These are all rather standard and normally included with the incorporation. We have a template you can download for reference.
5. Very important, if you are vesting stock, you'll need to file an 83B election form. This form basically says that you will pay taxes for your shares now, and therefore don't have to pay for them as they vest. The advantage is that the company valuation today is very small, compared to a potential investment at a high valuation.
6. Finally, you'll want to sign a Restricted Covenants Agreement between the founders. This document assigns all intellectual property to the company, works as a confidentiality agreement and prohibits founders to go work for a competitor company. It's a standard agreement you need to have to protect yourselves, and your first investors will certainly want to see that in place.
We have details on each one of these steps as well as document templates available on our free FounderHub platform. Check it out at founderhub.io.
Now if you are based in the US, you can probably stop reading now. Let us know what other topics you'd like us to cover, in future blogposts.
If you are from outside of the US, this last part is for you. I am originally Costa Rican, so I've had a crash course on the US tax and legal system.
Some quick points here:
- Do you need a US company vs a local company? It depends.
a- If your product is global, and you want to bill customers around the world, it is 'expected' for those credit card charges to come from the US.
b- Charging credit cards as a US company is very, very easy. Stripe and Square are two companies that have perfected that model and they only allow accounts from certain, specific countries, including of course the US.
c- Investment. If you are looking for US investors, or even plan to raise from investors from multiple countries, they can probably all agree to invest on a Delaware C-Corp, versus an entity belonging to one specific country. It's all about being familiar with the legislation.
d- Startup mechanisms such as vesting, stock option pools, and convertible notes: not all countries have legislation or mechanism in place to handle these agreements, while it's all quite standardized in the US. Another common question is on requirements. Yes, you can incorporate a US company without setting foot in the US. Companies like Stripe Atlas let you do that remotely and even set up a bank account for you. You don't need a physical office or even a visa, but you probably want to make sure you can get into the country where your business is based.
The extra cost of being a foreign founder is mainly, ´
- Your mail forwarding fees.
- Some extra tax forms, mainly the 5472 for any foreign founder with over 25% ownership of the company.
Finally, your US Corporation can easily be the parent company of a foreign entity. If you have staff or operations in a certain country, you'll probably want to use this model to centralize everything in the top company, and still be compliant with other legislation.