My worst memory of the first startup I co-founded? Writing the final check to the lawyer to close the company.
It was in 2000, toward the end of the dot-com bubble. We had done everything by the book to start our company: each of the four co-founders wrote a $1,000 check and our lawyer created a Delaware C corporation. We looked for VC funding but it never materialized. So we eventually had to shut down the company before it never had any real activity.
To add insult to injury, there was a late charge on our lawyer’s bill that seemed bogus to us, so we called to enquire. The following month, we got charged 15 minutes of the lawyer’s time ($100) for the voice mail we had left. It was clear that any further discussion would result in more charges. So we did what we had to: we all wrote the final check to close down the company.
Writing that check is one of the most depressing moments in the life of a startup. It clearly is wasted money. When you get started, you have big dreams of success. The money you put down is an investment. But when you write the check to shutdown your business, there is nothing to look forward to. It’s a sunk cost, with no returns, and you know it.
Which brings me to the topic of this post: why incorporating is not necessarily the smart thing to do as the first step when you are just about to start a new business (caveat: I am not a lawyer so I can’t pretend to be giving any legal advice).
1. Doing incorporation right is expensive
A good corporation needs stock to motivate early contributors. Stock needs vesting or you’ll be very sorry some day. Do you need a stock option plan? How does it work with the independent contractor agreement you are using since you are not paying your early contributors?
Setting up a corporation properly is expensive, it costs thousands of dollars. Some law firms will offer you to defer payment for six months for instance. It sounds like a great deal on day one, but don’t take it. The six months go by very quickly, and then you have to pay a pretty substantial bill.
2. Doing incorporation on the cheap will be expensive
It’s tempting to go online and find a site that has templates for incorporating a company. It sort of works, until something goes wrong. A simple template for a partnership, LLC or even C corporation doesn’t cover the what-ifs. When something goes wrong, there is a disagreement between co-founders, you then realize that you are not protected.
To fix those problems later, it will cost you as much or more money than what you saved upfront. It’s a false savings.
3. Your revenue may not justify a corporation
Say you have a blog that makes $100/month in revenue. It’s a nice side income for you. Pocket the money and pay your taxes. But if you turn your blog into a business, expect to have fixed costs that will eat most of your earnings. Talk about a motivation killer!
4. Corporations are a pain to maintain
Incorporating is a one time cost, but entrepreneurs tend to ignore or minimize the recurring costs of keeping a corporation alive. When you start, one year feels like an eternity, but it eventually happens. Time to file annual taxes and get the accounting in order. Those all cost time and money. Again, and again. The IRS doesn’t care if your business is not really active. And then there is the dreadful final check that I mentioned in the opening story.
An entrepreneur, who approached us at a conference, told me that FairSoftware would be useful to him. In the past, he had started six startups — and spent more money on legal fees starting three of those than he ever made from them. If you can postpone all legal expenses until you know you have a viable business, you win.
5. Incorporating solves the wrong problem
Your problem when you start a business is to get a product ready that is good enough for consumer consumption. It means bringing together a small team of dedicated talent, working toward that goal. In that context, incorporating is a distraction that doesn’t bring you any closer to the goal. For online businesses at least, overhead is minimal.
A Fair business will take care of getting the team together and make sure all the intellectual property is in order. There’s not much else needed at that point.
To conclude, keep in mind that I am a little biased since FairSoftware is offering an alternative to incorporation. I’m not really claiming that incorporating is bad. It’s probably appropriate in 80% of all cases.
I was just trying to challenge conventional wisdom and make sure you pause for a second to analyze why you want to incorporate. Do it for the right reasons, not because your neighbor did.
FairSoftware is a community of entrepreneurs where you can find co-founders, form your first startup instantly and help each other by exchanging advice on how to start web and iPhone apps.
1) You won't get any investment money if you're not incorporated; the sole purpose of the corporate form (and its descendants) is to protect investors.
1a) Don't incorporate as a Delaware corporation unless you're national or you're in Delaware. Delaware business law is not friendly to shareholders; it places the interests of management above all else.
2) In most states, an LLC/S-Corp is very inexpensive. If you're paying thousands of dollars for that, you went to the wrong lawyers. DON'T GO TO A FIRM THAT REPRESENTS LARGE CORPORATIONS. Go to a firm that represents small businesses. Not only are the fees significantly less, but the quality and quantity of the service is better b/c smaller firms will try harder to retain your business. The big firms don't care, since you're a small fry that may not even be around in a few months.
3) An LLC/S-Corp avoids most of the taxation issues you complained about…there's no separate corporate-level tax; the taxes flow straight through to the owners.
3a) If you're making only $100/month, that's not a company. That's not even a job. At best, that's a hobby.
4) That's the point. Corporations have rigorous measures in place to protect the shareholders. The S-Corp and LLC forms exist precisely to address that problem.
5) Incorporating does bringing you closer to your goal IF YOU CHOOSE THE RIGHT FORM. After all, the benefit is investment, which substantially increases your ability to hire the right people, advertise/target your services, develop your services, and provide your services.
6) What you're offering isn't no-incorporation. You're basically telling people to “do business as”. If you've got a one man shop, that's fine. If you've got more than one man involved, you'll have screwed yourself into partnership law, which is absolutely brutal when it comes to co-founder disputes…..PARTNERSHIP LAW IS AUTOMATIC.
7) Seriously, dude, look up LLC law. It's aimed at small business, and is the perfect compromise between partnerships and corporations: all the benefits of both without any of negatives.
Raj,
You are completely right, thanks for the amazingly detailed answer.
I should have been clearer in the opening of the post: I'm focused on a very narrow kind of startups. My interest is for web, iphone apps and other software projects that can basically be accomplished by a handful of programmers working from home.
I was trying to make the case that to get started coding, you don't need to incorporate. Down the road, with customers and partners, it becomes a different story.
Thanx i appreciate that.
[...] 5 Reasons You Shouldn’t Incorporate Your Business « FairSoftware’s … [...]
Your problem when you start a business is to get a product ready that is good enough for consumer consumption…………
And then there is the dreadful final check that I mentioned in the opening story………..
If you can postpone all legal expenses until you know you have a viable business, you win………….
If you can postpone all legal expenses until you know you have a viable business, you win………………
We looked for VC funding but it never materialized. So we eventually had to shut down the company before it never had any real activity……………
Incorporating is a one time cost, but entrepreneurs tend to ignore or minimize the recurring costs of keeping a corporation alive…
It means bringing together a small team of dedicated talent, working toward that goal. In that context, incorporating is a distraction that doesn’t bring you any closer to the goal……………
When you start, one year feels like an eternity, but it eventually happens. Time to file annual taxes and get the accounting in order. Those all cost time and money……..
I partnershipped up with a company called Bankcard Empire. Its been 4 months and I thought I would get my investment back for advertising with them. Nothing so far. Now they want me to incorporate, but I don't have any income yet. I already paid them to set me up but now I'm scared I'm doing the wrong thing….Any advice would be greatly appreciated…
Say you have a blog that makes $100/month in revenue. It’s a nice side income for you. Pocket the money and pay your taxes. But if you turn your blog into a business, expect to have fixed costs that will eat most of your earnings. Talk about a motivation killer!
On the other hand, if you don't incorporate at all, then you can't work with other companies in terms of PO's and invoices, you can't get professional liability insurance for your group, you can't get group health insurance, you can't offer equity to employees, and you can lose your house to a frivolous lawsuit.
On the other hand, if you don't incorporate at all, then you can't work with other companies in terms of PO's and invoices, you can't get professional liability insurance for your group, you can't get group health insurance, you can't offer equity to employees, and you can lose your house to a frivolous lawsuit.
Incorporating does bringing you closer to your goal IF YOU CHOOSE THE RIGHT FORM. After all, the benefit is investment, which substantially increases your ability to hire the right people, advertise/target your services, develop your services, and provide your services.
Although sole proprietorships and general partnerships are
relatively straightforward and inexpensive business entities
to establish and maintain, hence their popularity, neither
of them protects you from personal liability.
A sole proprietorship, then, lets you keep things simple now while also keeping open your future options.