6 Most Common Mistakes Made When Incorporating a New Business

Costly mistakes entrepreneurs make through self-incorporation

Q.   My business partner and I are looking into incorporating our new professional engineer recruitment firm. What should we consider when we prepare these documents? We want to avoid making early mistakes.

A.   Every startup entrepreneur is busy—really busy. There are business plans to write, projections to prepare and products to design. In an entrepreneur's desire to get ahead quickly, it's easy for them to overlook the very issues that can slow down any promising company.

So what are the trickier areas of business incorporation? I asked Joe Whitford, a law partner with Davis Wright Tremaine and long-time advisor and advocate of productive venture building.

Whitford says there are very few incorporation mistakes that can't be corrected by competent legal counsel. Of course it's prudent to put in place a corporate structure that can easily adjust to changing business and financing needs.

Here's a short list of issues about which Whitford is often called in for a fast document clean up.

• Authorize preferred stock too. Young companies that expect to raise funds from private investors and venture funds should incorporate with two classes of stock: common stock and preferred stock. Business founders should receive common shares. Preferred shares should be set aside for future investors. Whitford typically recommends that entrepreneurs authorize about 30 million shares of common stock and 20 million shares of preferred stock at the time of incorporation. Entrepreneurs who incorporate in states like Delaware that charge annual fees based on total authorized shares should consider smaller numbers.
• Over-allocation of shares. Founders tend to distribute too many common shares to founders, first employees, and consultants. Here, entrepreneurs should demonstrate restraint and issue about 1/4 to 1/3 of authorized common shares to founders and reserve the balance for stock option plans and corporate funding needs.
• Set conservative share valuations. Whenever business founders hand out common stock to consultants in exchange for services, the Internal Revenue Service requires stock recipients to pay income tax based on the estimated market value of shares received. This "phantom income tax bill" can be especially nasty if founders establish a high initial value to the startup shares.
• Omit certain shareholder rights. Entrepreneurs should omit provisions in corporate articles of incorporation that allow shareholders to acquire additional shares in future financing transactions. These rights should be negotiated on a per transaction basis.
• Assignment of inventions. Technologies that have been developed by founders or consultants prior to business incorporation should be assigned to the corporation in writing. Venture investors frequently find during due diligence document reviews that key intellectual property is not owned by the company. This is the fastest way innovative companies can lose technology alliances and new funding opportunities. Ouch!
• Stock purchase agreements. Agreements among business professionals are best laid out in writing to avoid future misunderstandings. And because startup companies typically take longer than originally expected to complete product development or generate revenues, one or more founders can lose career interest in the venture. At the time of business formation, all founding partners should agree on the length of service that is required in order to "vest" or retain rights to founders shares of stock. These documents are difficult to put in place after founders shares have been issued.

In my coaching sessions I routinely advise entrepreneurs to surround themselves with good people. This means hiring knowledgeable advisors who provide guidance that not only solves today's needs but doesn't create more problems in the future.

Do you want to find reliable investors for your business? Write to Susan at susan@takecommand.org for great funding references and tips designed especially for startup entrepreneurs, sole proprietors and fast growth companies.

Back to Top Email Printer Friendly View

RATE THIS ARTICLE
Rate it:

Overall Rating: Good