Deciding the right time to incorporate a startup is one of the most consequential decisions a founder will face. Each year, thousands of startups are founded, each with its own unique vision, goals, and market positioning. And yet, 18% of businesses close in their first year, while half shut down by their fifth year, and 65% don’t make it past the 10th year, according to the Bureau of Labor Statistics. One factor that can influence this figure is the timing and strategy around incorporation.
Incorporation is more than just a legal standing—it sets the foundational structure for a startup’s operational, financial, and governance models. A well-timed incorporation can optimize tax implications, protect founders and investors, and provide a favorable environment for growth. Premature or delayed incorporation, on the other hand, can lead to financial complications and potential legal liabilities and even deter potential investors.
Below, we’ll examine the details around deciding when to incorporate a startup. Here’s what you need to know to make the most strategic decision about this important milestone.
What’s in this article?
- What does it mean to incorporate?
- Types of corporate structures to choose from
- When to incorporate: Factors to consider
- How to decide when to incorporate
What does it mean to incorporate?
Incorporation is the legal process of forming a corporation, which is a distinct legal entity separate from its owners. The transformation from an individual operation or a partnership into a corporation entails a range of legal, financial, and operational implications.
Incorporation provides a business with its own legal identity. This means the corporation can own property, enter into contracts, sue or be sued, and carry out other functions without directly involving its owners or shareholders. The corporation acts as a shield, separating business and personal activities.
Selecting the right corporate structure has a big impact on the operational, financial, and tax issues a business will face. Each structure carries its own set of advantages and limitations. Here’s a look at common corporate structures:
Sole proprietorship
A sole proprietorship is a business owned by an individual.
- Ownership: A single owner operates the business.
- Liability: The owner has unlimited personal liability.
- Taxation: The owner reports profits and losses on their personal income tax returns.
Partnership
This involves two or more individuals who jointly own a business venture.
- Ownership: The business is owned by two or more partners.
- Liability: Depending on the type of partnership (general or limited), partners may have unlimited personal liability or limited liability.
- Taxation: The business doesn’t pay taxes. Instead, profits and losses flow through to the partners’ individual tax returns.
Limited liability company (LLC)
LLCs combine features of corporations and partnerships.
- Ownership: The business is owned by members who can be individuals, other LLCs, or corporations.
- Liability: Members have protection from personal liability.
- Taxation: This option offers flexibility; the business can be taxed as a sole proprietorship, partnership, or corporation.
Corporation (C corp)
C corps are separate legal entities with distinct advantages and obligations.
- Ownership: The business is owned by shareholders who hold its stock.
- Liability: Shareholders have limited liability, which protects personal assets.
- Taxation: This structure is subject to double taxation; the corporation pays corporate taxes, and shareholders pay taxes on dividends.
S corporation (S corp)
An S corp is a corporation that elects to pass corporate income, losses, and deductions through to shareholders.
- Ownership: An S corp can have up to 100 shareholders; only one class of stock is allowed.
- Liability: Shareholders have limited liability.
- Taxation: This structure avoids double taxation; income and losses flow through to shareholders’ individual tax returns.
B corporation (B corp)
This structure meets specific standards of social and environmental performance.
- Ownership: A B corp is owned by shareholders.
- Liability: Shareholders have limited liability.
- Taxation: This structure is similar to C corps but with the stipulation to create general public benefit.
Nonprofit corporation
Nonprofits serve public or mutual benefits other than the pursuit of profit.
- Ownership: A nonprofit is managed by a board of directors but has no shareholders.
- Liability: Directors and officers have limited liability.
- Taxation: A nonprofit can apply for tax-exempt status, meaning it pays no tax on income related to the nonprofit’s purpose.
Choosing the right option for your startup involves a detailed analysis of the business’s goals, the industry in which it operates, and its financial considerations. The type of corporate structure you choose can also affect when to incorporate.
When to incorporate: Factors to consider
Incorporation is more than just a legal process. It’s a move that transforms how a business operates, grows, and interacts with its stakeholders. The decision to incorporate offers numerous advantages, but it also introduces complexities that require careful management and understanding. With this in mind, deciding when to incorporate is an important step in the early stages of any business. Here are the key factors to consider when deciding when to incorporate:
Liability exposure: As a business grows, so does its exposure to risks—and sole proprietors and partners face personal liability for business obligations. Incorporating can shield personal assets from certain business liabilities, making it a prudent move for businesses entering sectors with higher risk profiles or those experiencing increased operational risks.
Tax implications: The tax treatment of corporations differs from that of other business structures. It’s important for a business to evaluate the potential tax benefits and drawbacks of incorporation. For instance, a corporation might provide access to lower tax rates, specific deductions, or the ability to split income. However, it can also introduce double taxation. Timing the incorporation to align with the fiscal year or significant financial shifts can offer advantages.
Capital needs: If a business is poised for rapid expansion or a significant capital injection, incorporation can make raising funds simpler. Corporations can issue shares or bonds, providing a business with more avenues to gather capital.
Ownership structure and flexibility: Businesses that are contemplating changes in ownership, or those in which owners may frequently change, could benefit from the flexibility incorporation offers. A corporation’s shares can make transferring ownership easier, whether it’s through sales, gifting, or inheritance.
Operational complexity: Incorporation introduces specific operational formalities, such as board meetings, annual reports, and regulatory compliance. If a business isn’t prepared to manage these complexities or if those issues seem excessive for its current scale, delaying incorporation might be worth it.
Access to benefits: Corporations often have an easier time negotiating benefits for employees, including health insurance and retirement plans, compared with businesses that are not incorporated. If attracting and retaining top-tier talent is a priority, exploring the advantages of incorporation might be beneficial.
Business longevity: For businesses planning for the long term—beyond the involvement of the original founders—incorporating can ensure the business continues to exist regardless of changes in ownership or management.
Cost considerations: Incorporating involves immediate and recurring costs. While there’s the immediate expense of the incorporation process, corporations also face recurring fees, more stringent accounting practices, and potentially higher legal costs.
Reputation and credibility: For many stakeholders, corporations represent a level of legitimacy that nonincorporated entities lack. Suppliers, customers, and potential partners may perceive incorporated businesses as more stable or established. If a business is at a juncture where credibility can drive growth, it may be time to consider incorporation.
Exit strategy: If there’s a possibility of selling the business in the near future, becoming a corporation can make the sale smoother. Many investors or acquirers prefer dealing with corporations because of the clear delineation of assets, liabilities, and ownership.
Deciding when to incorporate requires a nuanced understanding of a business’s standing, its anticipated trajectory, and the advantages incorporation can offer. While incorporation offers several benefits, the timing of such a decision must align with the business’s broader goals and operational realities.
How to decide when to incorporate
Making an informed decision about when to incorporate requires thorough research, analysis, and consultation. Here’s a structured approach to help businesses decide the optimal time to make this transition:
1. Conduct a risk assessment: Start by assessing the potential risks associated with the business. Look into factors such as personal liability exposure, potential litigation, and contractual obligations. An elevated risk profile can indicate a need for the protective structure a corporation provides.
2. Financial analysis: Dive deep into the fiscal health and projections of the business. This involves:
- Tax analysis: Engage a tax professional to evaluate potential tax benefits or liabilities that might result from incorporation. This includes looking at the possibility of double taxation, access to tax deductions, and any available credits.
- Growth projections: Assess the business’s anticipated growth trajectory. If rapid expansion is on the horizon, the ability of a corporation to raise capital through share issuance becomes invaluable.
3. Operational readiness: Consider the managerial implications of incorporation. Can the business handle the additional operational requirements that come with incorporation, such as more rigorous accounting practices, regular board meetings, and annual reporting?
4. Stakeholder consultation: Engage stakeholders, including cofounders, key employees, investors, and major clients. Their insights can be invaluable in understanding the broader consequences of incorporation.
5. Legal consultation: Legal intricacies play a significant role in the incorporation decision. Working with an attorney can help businesses understand regulatory requirements, potential legal protections, and any obligations or limitations that incorporation might introduce.
6. Talent and benefits evaluation: Evaluate the current and future talent needs of the business. If the business is in a competitive space and needs to attract top-tier professionals, the benefits structures that corporate setup allows might be a compelling reason to incorporate sooner rather than later.
7. Long-term vision: Revisit the business’s plan and vision. A business aiming for longevity, targeting consistent growth, or considering a sale or merger might find the stability of a corporate structure more accommodating to these goals.
8. Cost-benefit analysis: Weigh the immediate and recurring costs of incorporation against the anticipated benefits. This also involves considering the intangibles, such as reputation, credibility, and long-term flexibility.
9. Market perception and credibility: Evaluate how the market and key industry players perceive incorporation. For some industries or regions, an incorporated business might carry more weight and credibility.
10. Review and decision: After gathering all the relevant information and insights, consolidate your findings and make an informed decision.
Ultimately, a business should approach the question of when to incorporate holistically, by considering the immediate implications and the long-term direction of the enterprise. This evaluation, combined with an understanding of the benefits and challenges of incorporation, should guide the decision-making process.
As with most aspects of starting a business—and defining, legally, how it will exist—seeking advice from legal and financial experts can provide valuable insights about your situation. Incorporation doesn’t come down to a one-size-fits-all solution, and neither does the decision of when to incorporate.