False starts are an everyday occurrence in the land of startups. To avoid tripping yourself out of the gate, pay attention to several critical founding decisions, which we'll review in this chapter.
Being in possession of a bright, promising, exciting, game-changing new business idea is a euphoric rush of emotions. The 🥳 emoji sums it up for me. Initially, it’s all party, party, party!
If you’ve experienced that rush before, then you may be familiar with the nosedive those emotions can take when the dream leads to questions about the legal, tax, financing, and related matters you may know little to nothing about that are blocking you from bringing your dream to life. That mental state shift is best represented by the 🤯 emoji.
Thankfully, setting up and incorporating your business doesn’t need to trigger a nuclear winter inside your head. As long as you learn the ropes and proceed in an organized manner, you can get your new business in gear without too much of a headache.
To set the stage, here are some of the valuable lessons you’ll learn in this chapter as we explore how to intelligently set up and incorporate your new business:
- Why you should never form a new business venture with a co-founder until you and your partner have reached alignment on the fundamentals.
- How to capitalize your new business venture with the cash it needs to get started and operate, and why you need to care about this during the formation process.
- What it takes to develop an operating agreement for your business that empowers its initial formation and successfully governs its ongoing operations.
- What the differences are among the various business entity types so that you can make the most informed decision about which one is best for your new venture.
- Why your state of incorporation matters, and why incorporating in the State of Delaware may be an advantage.
- What the heck an S-corp election is and how to harness it to potentially reap significant tax benefits.
- Where to actually register your business with federal, state, and local agencies so that it is fully recognized as legitimate and functioning.
- What online tools exist to ease your business formation burdens, including a special option from one of the world’s most respected financial technology companies.
- When to consider engaging professional advisors such as attorneys and accountants to help you set up and incorporate your business the right way the first time.
Now, with that stage set, let’s get on with the learning!
1. Reach Alignment With Your Co-Founders, If Any
It’s critical to align expectations with any co-founders you may have for your new venture before officially forming it. Without such alignment, troubles will almost certainly arise related to individual roles and responsibilities, how to make key decisions, how to resolve conflict, how to break ties when alignment cannot be found, and much more.
Specifically, here are some of the big risks that can be avoided when founders talk with humility, honesty, and intention upfront in the business formation process:
- Uncalibrated equity allocations based on what each person is bringing to the table for the company’s benefit, which is perhaps the most sensitive topic to get right up front before inking any documents to avoid major disagreements, trouble, and legal fees later.
- Ambiguity about what happens if the founders find themselves at a deadlock on essential matters such as whether or not to raise capital, hire (or fire) a team member, and what direction to take the company, especially once the company’s product or service has reached the market and there is data to consider in reflection of the company’s business model and business practices.
- Resentment toward one another on alleged grounds that one person is putting in more time and energy than the other, or that one person is held more accountable to producing results than the other (or both), which may not seem fair in connection with each person’s compensation, including their respective equity positions in the company.
- Difficulty to exit one of the founders from the company, for any reason whatsoever, because a proper “buy/sell” (or equivalent) provision wasn’t thought up and agreed to in advance of forming the company.
It may sound weird, but these talks with potential co-founders are very similar to “define the relationship” (a.k.a., the “DTR”) conversations with your potential life partner. When you’ve reached the stage in your relationship (and discussion of the business idea at hand) where this conversation needs to happen, that’s usually a good thing because it suggests that you both are serious about one another, share a common vision and set of values upon which to form the company, and may be committed to taking this crazy business idea seriously enough to turn into something special.
Of course, the talk may not go the way you hope. That’s okay. Before encumbering yourself (and your co-founder[s]) with the legal bonds that come with the actual formation of the company, evaluate whether or not you both are on the same page. Having a vivid business model on paper—that you worked on in chapter 1—will help with these conversations. Talk about your needs, wants, hopes, and fears as much as the business mechanics. If you don’t fully vet each other now with all cards on the table, there’s always the chance that some unspoken thing will come back to bite you later.
If you have a co-founder in mind, and if you do find strong alignment with him or her, make sure to spend some dedicated time discussing the startup capital needs of this beautiful business idea you both are contemplating. If you do not have a co-founder joining you on this venture, then figuring out the startup capital needs for your business is squarely on your shoulders.
2. Make Decisions Regarding Startup Capital
Capital (a fancy word for cash) is the energy source all businesses need to enter the world, operate, and (hopefully) grow and mature into strong, vibrant companies.
While you don’t need startup capital in your bank account to set up and incorporate your business, it’s advisable to have your funding strategy generally figured out before you actually form your company so that you don’t waste time and resources. And if you do have a co-founder(s) from the beginning, then aligning with them on funding is one of those make or break things you want to fully vet before inking formation documents so as to avoid straining the relationship to potentially disastrous consequences.
Fundamentally, there are three options for funding your startup business:
- You use your own savings or positive cash flow from other income sources (such as a day job, side hustle, or another business you’re running), which is the definition of bootstrapping your new venture. Once your new venture starts to generate its own revenue, this cash also counts as part of bootstrapping.
- You use credit, which can take many different forms: a business line of credit from a financial institution like a bank; debt financing from startup accelerators/incubators, state-run programs, or similar; even credit cards (which I’ll say right here and now that I do not advise).
- You raise capital from family, friends, or others. The others are almost always investors of some ilk: venture capitalists (VCs), angel investors, private equity firms. In recent years, crowdfunding via such platforms as Kickstarter.com and Indiegogo.com has become a popular option to raise capital directly from fans, supporters, and early adopters.
We'll dig into each of these three options in the next chapter, which is fully devoted to the startup capital needs for your new business. For now, merely recognize that the topic of money—with emphasis on startup money needs—is one of those important foundational pillars to get right from the get-go.
Oh, and take note now that, clearly, there’s no one-size-fits-all plan for funding your new business. Devise a plan that’s right for you (and your co-founders, if you have them) so that when you do set up and formalize your company it’s positioned to make gains out of the gate.
3. Develop an Operating Agreement
Whether you’re starting your business as a solo founder or forming it as part of a founder team, you almost always need an operating agreement. While it’s not a requirement to have one, it’s still wildly advisable to have one to avoid operational issues.
The purpose of an operating agreement, as defined by an article published on the United States Government’s Small Business Administration (SBA) blog, is “to govern the internal operations of the business in a way that suits the specific needs of the business owners. Once the document is signed by the members of the limited liability company, it acts as an official contract binding them to its terms.”
The US SBA blog article lists three reasons why an operating agreement is necessary:
- To protect the business’ limited liability status
- To clarify verbal agreements
- To protect your agreement in the eyes of your state
Developing an operating agreement may sound as pleasurable as walking over hot coals on bare feet. And it will be if you head into this experience with that mindset. Instead, think of an operating agreement as merely the output of how you (and your co-founder[s]) desire to operate the business, codified in proper terms, and it really isn’t that bad.
If you’re a solo founder, then establishing an operating agreement during the setup and incorporation phase of your business is remarkably easy. There’s no negotiation of terms to manage with others. Simple single-member operating agreement templates abound online that you can find via a simple Google search. Or, as we’ll get to later in this chapter, you can engage a legal firm that specializes in business formation, or even just use an online tool like StartPack to get an operating agreement (among other critical founding documents) in place.
A few critical elements of an operating agreement are necessary to call out now as they are required inputs when you register your business with federal, state, and (maybe) local agencies. Those elements are as follows:
- Ownership, management structure, or directors
- Number and value of shares (if you’ve chosen a corporation entity type, which we’ll explore in the next section)
Do not disrespect or take lightly the operating agreement development process, particularly with regard to the above elements. Get these right up front so that the registration process does not become difficult, and especially so that the actual operation of the company isn’t handicapped from the get go.
In light of this seriousness, I’ve heard some entrepreneurs refer to operating agreements as “business prenups.” That’s kinda true because good ones contain thoughtful exit provisions for their members. Far more importantly, a bona fide operating agreement is a bedrock legal instrument that validates the legitimacy of your business, protects it from subjective interpretation—whether by other persons or state agencies—and positions it for operational growth and success.
When you’re working on your operating agreement, a seminal question to ask and answer is: What kind of business should it be? Welcome to the world of different business entity types.
4. Choose a Business Entity Type
Selecting your business entity type is similar to selecting your character in a role-playing game like Dungeons and Dragons or World of Warcraft. Each option has its unique strengths and weaknesses, and it’s important to make an informed decision because it will directly impact very serious matters such as your taxes.
The US SBA describes the importance of your business entity type selection by stating, “The business structure you choose influences everything from day-to-day operations, to taxes, to how much of your personal assets are at risk. You should choose a business structure that gives you the right balance of legal protections and benefits.”
The most common forms of businesses are the following:
- Sole proprietorship
- Limited liability company (LLC)
- Corporation (C-corp, S-corp, or B-corp)
The US SBA’s “Choose a business structure” web page is a wonderful resource to read up on the specifics of each entity type. You may also want to reference the IRS business structures web page, which provides additional context as well as associated tax forms for each common entity type.
By default, if you generate income from work you do on your own without a properly formed business entity in place, then you’re operating a sole proprietorship. That may be okay for you, especially if you’re just doing side hustle work as an independent contractor in a low-risk industry. But as you research the other entity types, you’ll quickly learn that a sole proprietorship doesn’t provide nearly the caliber of protections and benefits as, say, an LLC.
If you are looking to incorporate your new business venture with more legal protections than a sole proprietorship can provide, then chances are good that an LLC is the most appropriate choice for you. It usually is for single-member founders who care to establish a business entity separate from themselves and who intend to provide professional services or information products. LLCs are quick, easy, and relatively inexpensive to set up. And LLCs can be bolstered by additional legal and tax provisions, as we’ll see when we crack into the opportunity for an S-corp election for an LLC.
If you’re raising capital from major league investors like venerable Angels or VCs, then a corporation may be the better choice. If this is your circumstance, I advise engaging an experienced attorney or law firm who can help you navigate the complicated waters of structuring and closing an investment round. I’ve been through this experience as a co-founder and board member of an e-commerce software-as-a-service (SaaS) company. It’s a trippy universe that can easily make your head explode. If you care to read up more on this subject, I highly recommend Brad Feld’s book, Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist.
5. Choose a State of Incorporation
Choosing the state to incorporate your business in is thankfully less involved than your business entity type selection. That said, it’s still a seminal decision.
Here are the two most common options:
- Your home state
If you’d prefer to not strategize this choice, then simply go with your home state. Done.
However, if you do want to consider some strategy, then investigate the tradeoffs between your home state’s laws (including tax regulations) and those of the State of Delaware. This option is particularly useful for those entrepreneurs forming corporations (C-corps, versus LLCs) involving investors that may demand that the company be incorporated in Delaware for investment-related advantages.
Why is Delaware so popular for business incorporation? There are two main reasons: (a) its business laws are very modern and up-to-date as compared to other states, which in part means that its laws are among the most business-friendly in the country; and (b) it has a high-quality and efficient judiciary process including its special court, the Court of Chancery, that specializes in business law.
Incorporating in Delaware does have its disadvantages. Some include extra incorporation fees, additional fees for a registered agent based in the State of Delaware, and an annual franchise tax, which may be extremely nominal in the grand scheme of things, but still.
If you care to read up more on the advantages and disadvantages of incorporating in the State of Delaware or any state in the US, here are two worthwhile reads:
- What is the Best State to Form My LLC In (StartPack)
- The Advantages and Disadvantages of a Delaware LLC (StartPack)
Don’t overthink this choice. Pick a direction and go with it.
6. Decide if the IRS S-Corp Election Is Right for Your Business
Tax rules and regulations vary based on your business entity type. Normally, those rules and regulations are fixed to your base entity type selection. However, there is an option to have your company taxed as an S-corp even if it is, say, an LLC entity.
The article How a Corporation Elects S Corporation Status describes the key benefits of making the S-corp election as follows:
- An S-corp has the same liability protection as a corporation.
- S-corp status can reduce self-employment taxes.
- S-corp status can avoid double taxation.
- S-corp losses can reduce owner taxes.
- S-corp profits are taxed at individual rates.
The same article contains the steps you need to go through in order to properly file for the S-corp election with the IRS. It’s worth noting that the IRS does have qualifications—eight in fact—that you must satisfy in order to be eligible.
Mind you, there are some limitations on S-Corps, including: one class of stock, fewer than 50 shareholders, only US individuals as shareholders, etc. Unless you’re venturing to build a large and complex company with outside investors and potentially international partners, chances are good that your business satisfies those qualifications and, thus, is a candidate for this election.
That said, do what’s right for your circumstance and business.
7. Register Your Business with the Necessary Agencies
In most cases, you will need to register your business with federal, state, and local agencies. However, according to the US SBA, “If you conduct business as yourself using your legal name, you won’t need to register anywhere. But remember, if you don’t register your business, you could miss out on personal liability protection, legal benefits, and tax benefits.”
Based on my experience as an entrepreneur and founder, I would never *not* register my business. Doing it your first time can seem daunting. That’s just because it’s an unknown. Once you gain this experience, it’s a no-brainer decision should you ever have to go through the business formation process again.
Here are a few final considerations—some mandatory, others optional—before you proceed with registering your business:
- S-corp election (if you skipped this topic before, consider it now)
- Trademarks (for your business, brand, product, etc.)
- Articles of incorporation/organization (the key registration document for your state)
- Registered agent (the person or firm you designate to receive official papers and legal documents on behalf of your company)
- Foreign qualifications
Trademarks are purely optional. You do not need to register for them, certainly not as a requirement to form your business and get it up and running. Down the line, registering brand or product trademarks may make good sense for your business.
Articles of incorporation for corporations (or articles of organization for LLCs) are the birth certificates of companies. In either case, the applications for these documents are fairly short and straightforward. In every case, they need to be completed and registered with your chosen state of incorporation.
Registered agents (sometimes called statutory agents) are required to be named for all new businesses. You can act as your own agent, but I prefer having my legal team act on my behalf because they are the subject matter experts on most things that would likely be sent to the registered agent. To say it another way, it’s a big peace of mind for me *not* to serve as my own agent. There are dedicated registered agent services for exactly this purpose. Whomever you choose as your registered agent, they must be located within the same state as your incorporation.
Foreign qualifications sound weird, complex, and scary. They’re not, though their name is misleading. These qualifications have nothing to do with foreign countries. The use of the term “foreign” in this instance applies to states other than your declared state of incorporation, which in this context is considered the “domestic” state. If you have business activities occurring in states beyond your state of incorporation, then you may need to file a “foreign qualification” with those states.
Winning Edits, my creative agency that merged into SPI at the start of 2019, was registered in four additional states beyond its domestic state of Ohio. Why? Because most of my team was remote with respective home bases in Minnesota, Illinois, California, and Massachusetts. During Winning Edits’ integration into SPI, we had to also register SPI in those states for the exact same reason. Given the proliferation of remote workforces, your business may find itself in the same situation either out of the gate or in the future.
Once you have all your ducks in a row, it’s time to file your formation documents with the necessary agencies, which will result in a properly established business in the eyes of the government. It’s an important and exciting step toward becoming a legitimate business!
Here’s the short-list of what you need to do to register:
- Federal: Register for your federal employer identification number (EIN), also known as your federal tax ID. Click here to learn more about an EIN. And click here to cut straight to the IRS web page to submit your EIN application.
- State: Each state is different, so there is no single website to visit for registration. Instead, Google “how to register a business in [state]” to find the appropriate site for you. Look for your chosen state’s Secretary of State website.
- Local: If you intend to run an internet-based business that is relatively simple and small in scope (e.g. a professional services company), then chances are good that you do not need to register anything with your local city or county. That said, still check. Local governments set their own registration requirements.
For a more exhaustive review on what you need to do to actually register your new business with the various agencies, read the US SBA’s excellent register your business online guide, which links out to a number of useful forms and websites that you’ll need to use if you’re intent on the do-it-yourself approach.
However, if the DIY approach gives you a crippling case of night sweats, then consider engaging some professional advisors or using some trustworthy online tools to help you get across the registration finish line.
8. Consider Online Tools to Help, If You Wish
Business formation is one of those activities that entrepreneurs can and should engage with professionals or online services for assistance. Formation can be a complex process. It’s too important to risk getting wrong, and the costs of professional assistance are too nominal (in most cases) to worry about in the grand scheme of things.
There is also the ongoing recurring aspect of keeping your business compliant after it has been formed including but not limited to a registered agent, annual fees to the state and IRS filing requirements.
If you share that opinion, then online tools are a good first option to consider. That’s what I did way back in 2010 when I formed my very first company.
StartPack is my recommended option.
StartPack is a founder-friendly company that provides a one-stop-shop platform to help entrepreneurs like you:
- Form a US company
- A free tax consultation with a certified US Tax Professional
- Open a business bank account remotely from anywhere in the world
- Obtain your Employer Identification Number (EIN) (as a US or non-US resident)
- Accept payments with Stripe or PayPal
- Join the StartPack Community to connect with other founders globally
- Access over $50,000 in exclusive startup perks and rewards such as credits from Amazon Web Services
- Handle your annual obligations: registered agent, annual reports to the state, taxes, and more
Suffice it to say, StartPack offers more business setup components than merely legal registration, its principal point of differentiation from options like LegalZoom. Unlike LegalZoom and other one-time offerings out there, StartPack is a long-term solution, sort of like having a business partner by your side (if you don’t have one). Instead of forming your company and feeling like you’ve been “thrown to the wolves”, StartPack is a subscription that is there to scale with you and your business as it grows. And they offer business formation in any state in the US.
Pat and I are big fans of StartPack and are proud to be partnering with them to support entrepreneurs and creators everywhere in launching, maintaining, and growing their US business. (Note: If you do not live in the US but need or desire to form your business in the US, StartPack can help you do that.)
All that said, if your new business venture is complex, then you might want to consider engaging a tax/legal professional to help you navigate the business formation waters.
9. Consider Professional Advisors to Help, If You Wish
At this point in my career, my default choice is to engage my legal counsel, accounting firm, and financial advisory team to inform and shepherd along the formation of any new business, whether solo or as part of a founder team. This choice satisfies a few critical needs:
- Peace of mind that it’s going to get done right
- Expediency that it’s going to get done timely (faster than it would if I did it myself)
- Relief to focus on the high-value work that deserves my attention
If you have an established relationship with (a) an attorney or firm that practices business law, or (b) an accounting firm that may be doing your bookkeeping, then it’s worth asking either or both of them to help you set up and form your new business. At minimum, ask them for a quote on what it’d cost to perform these services.
Many firms offer business formation services as a fixed-fee package or similar service offering. Such offerings should be reasonably priced and ideally not based on billable hours, especially if your business venture isn’t that complex. In low-complexity situations, if the fee isn’t fixed nor reasonable, I’d say no thanks and look elsewhere.
In general, if you seek to work with professional advisors, find those that align with your core values, professional standards, and frameworks of working together. That’s true of SPI’s legal counsel, Stansbury Weaver, who advise and help us with a range of business, legal, and compliance needs. If we ever need to form a new business entity, we’ll go to them in large part because our vision at SPI is complemented and enabled by theirs, which is to “serve first and foremost as strategists. And in our vision great strategists must at all times understand and consider not only legal but also business, economic, cultural, and ethical rules, norms, and customs that impact our client’s entire situation.”
Phew, you’re ready to form your business. Now let’s ignite the operational and growth fires, and that means it's time to talk capital, the kindling of startup companies—which is precisely what we'll dig into in the next chapter.