How to Avoid Mistakes in Forming Your Startup

Thanks to the internet, forming a new company is now a quick and easy task.  Perhaps too easy.  But many entrepreneurs don’t know there is more to forming a new entity than filling out an online form and as a result they fail to establish a good foundation from which to build their company. Not doing things right, or only doing half the things you need to do to get started is like building a house without a foundation.  My goal in this article is to help you build that foundation by providing a general overview of the three steps to new entity formation:  how to register a new entity, how to organize it, and how to initially capitalize it.

How to Register a New Entity

In most instances, all that is required to form a new entity is to provide very minimal information to the secretary of state for the state you want to form in, either via a form or online.  This is the step that is the focus of online businesses like Legalzoom and is the most familiar to entrepreneurs.  What most entrepreneurs don’t realize is that they can do this step on their own and for free (not including the state filing fees) by going to the website of the state’s secretary of state and downloading a form that you can then fax or using the state’s online filing process (these links are for Washington).  The information you usually have to provide consists of (i) selecting a unique name for the entity and appending the correct company label, like “Inc.;”  (ii) selecting the name and address of a registered agent; (iii) selecting the amount and type of the authorized capital for the company; (iv) selecting the duration of the entity; and (v) selecting the name and address of the incorporator.  Doing it yourself is usually fast and cheap, so long as you know what you’re doing.

Once you have provided this information and submitted the form, most states will then instantaneously (where the form is submitted online) confirm the registration and issue you some sort of uniform business identification number that you will use in communicating with the state for future filings.  You will need this number to open a business checking account.  The state will typically follow-up by mailing a certificate to the registered agent that shows the date the organization was officially formed.  You are then done, right?  Wrong.  You have just completed the first step in setting up your new company, typically referred to as “company formation.”

How to Organize a New Entity

Once your company has been formed, i.e. when you have received the confirmation from the state’s secretary of state, you then have to organize your company.  Company organization is about implementing the governance structure of your company and is usually mandated by state law.

Company organization is about implementing the governance structure of your company and is usually mandated by state law.

This is the step that most entrepreneurs don’t know about.  This consists of selecting what the governing body of the organization will be (their is only a choice for an LLC; corporations must have a board of directors), naming who will be part of that governing body, and then holding a meeting, either physically or in writing to complete the rest of the organizational tasks of the company.  At minimum, these tasks include electing the officers of the company (a President, Secretary and Treasurer are the three usually required) and then giving them the authority to perform certain predefined tasks, like opening a bank account or selling the equity of the company.

All this information is usually memorialized in a writing called “organizational meeting minutes,” and then maintained in the official records of the company.  Many states require that the names and addresses of the owners, elected officers and governing body members be disclosed to the state’s secretary of state who then makes them public via an online database.

How to Initially Capitalize a New Entity

The last step in forming your new entity is capitalization.  The intention here is to begin the life of the company as a separate legal person who has independent finances from its owners.  This is the step that is often times overlooked or ignored by most startups.  New companies may have their state’s authority to exist (but not to conduct business, which is a topic for another time) and they may have elected officers to complete the organization of the company but without money, what’s the point?  Adequate capitalization is usually a requirement of state law and no distributions may be lawfully made until the company can satisfy its debts.

So, where does the money come from?  You and the rest of the owners, of course, unless you have some initial investor interest in your company.  But assuming you are funding your startup initially yourself, this is done by way of selling the equity of the company, whether units for an LLC or shares for a corporation, to yourself and any other founders involved.  The terms of this sale have usually been approved in writing by the governing body of the company (see above) before any sale takes place, thereby giving it the official stamp of approval.  Many others have written about setting a very low par value for shares, for example, but what they don’t discuss is where the rest of the money to do the things the company needs to do will come from.  I am not advocating setting a par value that is other than a very small value, say $0.0001 per share, but the total purchase price of the equity you sell yourself should add up to the initial capital you need to conduct the day-to-day operations of the company.  Otherwise, you will have to provide the company additional paid-in capital that is not in any way compensated, at least not directly.  I prefer the former approach.

You, as the founder, have to do a little math to figure out how much money you need to get the company going – for your ISP, to register domains, to purchase hardware and software, etc. – and then work with your attorney to come up with a low par value and large enough number of shares that give you at least this initial amount of money.  You then have to document the sales transaction, which is usually done in the form of a purchase agreement.  I will save the particulars of the purchase agreement for a future post but suffice it to say, this is a necessary step to effect the sale and transfer of the company’s equity from the company itself to you thereby making you an official owner.  Until you actually do this, you are most likely not an owner.  You may be an incorporator or promoter of the company (the person that registered the company with the state’s secretary of state), but you are not an owner.

These tasks may all seem a little overkill to someone who just wants to get going but are very important if you plan on signing contracts with third parties; getting grants, loans or outside investment; or if you have one or more co-founders.  Moreover, these initial structural tasks do not need to be expensive.  My firm, for example, uses a fixed fee model to help entrepreneurs plow through this stuff with cost predictability and plenty of free counseling.  So, before forming your new entity online, chat with a local attorney and see if you can work something out to make sure you get everything in place to get off to a solid start.