Although many company founders are reluctant to take the plunge into creating a corporate entity, often putting this step off for as long as possible, there are some good reasons to consider forming as soon as possible.
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The IRS will look at the time between forming and value given for stock at that time, and the company’s value at any financing or liquidity event. Hypothetically, if founders gave $.01 of value for their shares at formation, and they receive a funding round that values the company at $.50/share a week later, they need to be able to convince the IRS in an audit that they created enough value in the company in that one week to warrant the 50x increase in the value of the company. In a situation like this, your company is more than likely to arouse the suspicion that you sold yourselves shares at below market value.
The General Partnership
Many states, including Washington, have ratified some version of the Uniform Partnership Act (UPA). Washington’s is codified as chapter 25.05 of the Revised Code of Washington. Although the preferred form of entity for most startups is a C corporation, a founder should also be attentive to the provisions of the UPA or its equivalent in his or her state. The reason for this is that many of these acts contain provisions similar to the following from RCW 25.05.055:
(1) Except as otherwise provided in subsection (2) of this section, the association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership.
Reading this closely, we see that all it takes to form an entity in Washington is for two people to get together and decide to go into business for profit (hopefully all businesses hope to make a profit). That’s it. No registration, and beyond this, the statute makes clear that a partnership can be formed even if neither person intended to form a partnership!
This form of partnership is referred to as a “general partnership”, and although it may not be clear from this clause, there are several dangers of forming an unintended general partnership.
First, in a general partnership, there is no limitation on liability between the partners. This means that the acts of each partner can bind the other partners, both financially and legally. Second, partnership statutes often provide for joint and several liability between the partners in a general partnership. This means that if one of your partners commits an act that creates a liability binding on the partnership, the claimant can not only include you in a lawsuit, but if your partner(s) have no money and you have a lot, they could potentially come after you for all of the claim amount.
By way of hypothetical, lets say that you and your college buddy decide to launch a web site. You are paying for the startup costs with income from your corporate law job, and your poor-but-smart friend is providing the programming talent to get the site off the ground. You have a nifty name, and have done some work on making the site a reality, but have not formed a company yet. Now lets say that your friend buys an expensive web server on credit holding himself out as “Chief Technology Officer” of your company and signs a binding commitment for five years worth of dedicated server bandwidth using the same title. To celebrate his purchase, your friend less-than-totally-responsible friend pops open a bottle of whiskey on his way from the computer store to the data center to install the server. Just before reaching the datacenter, his 1976 Econoline van crosses the centerline, hitting a Prius head on, and severely injuring the driver and passenger, and putting your friend in intensive care. Your friend has no insurance, no income and no savings, but you’ve been lucky enough to build a nice nest egg of around $350,000 since starting your job. Guess who is going to end up paying for the server, the accident, and the contract with the datacenter?
Better to spend a little bit up front to formalize the entity.
Working with Outside Contractors
Similar to issues with liability, a pre-formation company can run into problems with regard to IP ownership when working both with independent contractors and among themselves. If you are working with 3rd party contractors to develop code, build a web site, or perform other services for your business idea, it needs to be clear that such work product is owned by the company. In order for this to happen, there needs to be an entity formed that is capable of contracting with these 3rd parties. For work being performed by co-founders of the company prior to formation, IP contributions at formation should be made clear in the founder’s agreement.