Several factors that can have significant consequences on your eventual success need to be considered early in the process of forming your company. For example, the entity that you form will affect your ability to raise money and offer stock options to employees. Be sure to discuss these issues with a competent attorney.
Common legal entities are C corps, LLCs, and S corps. All businesses have different requirements and your entity selection should reflect your vision for the company. C corps are generally best suited for life sciences companies for the following reasons. These points are taken directly from StartupCompanyLawyer.com, an invaluable resource for legal matters faced by founders of technology based companies.
- Fund Raising. Most venture and institutional investors favor C corps because they may have separate classes of stock, allowing for the creation of various levels of preferences, protections, and share valuations. A C corp is also the easiest type of entity to take public in an initial public offering.
- Stock Options. Businesses that plan to use equity incentives (e.g., stock options) to attract and retain talent often prefer to operate as C corps. C corps can offer incentive stock option plans that allow employees to defer tax on the equity compensation until they sell the underlying stock. Additionally, C corps may offer certain fringe benefits to employees that are tax-deductible to the company and also tax-free to the employee.
- Ownership. C corps may have an unlimited number of stockholders. The owners do not need to have a relationship with one another nor have a role in running the day-to-day affairs of the company. Additionally, they may transfer their ownership freely and readily (by selling their stock) without affecting the continuing existence of the business or the title to its assets. Thus, the perpetual existence of the entity is unaffected by the death or withdrawal of any one shareholder.
- Governance and Structure. C corps have well-defined structural accountability, with governance responsibilities held separate and apart from the owners. Management is accountable to the board of directors and therefore has the ability to transact business without stockholder participation in each decision.
- Taxation. The earnings of a C corporation are generally taxed twice: once at the corporate level on the corporation’s taxable income and a second time at the stockholder level on dividends or distributions. Although the double-taxation feature of C corps may be undesirable, its impact may be diminished where a company does not pay dividends or generates taxable income at a lower marginal tax rate than the rate applicable to the individual stockholders. If a C corp generates net operating losses rather than net income, these are carried forward to offset future corporate taxable income.
There are many events that will encourage the transition from an idea into the incorporation of a company. Several of the events pertinent to life sciences companies are highlighted here. These considerations and others are covered in more detail by StartupCompanyLawyer.com.
- Raising Money. If third party investors want to invest in a startup idea, there needs to be an entity to accept the investment. Generally, founder’s stock is issued at nominal prices well in advance of a Series A preferred stock financing because it is difficult to justify that common stock should be priced at $0.001 per share while Series A preferred stock is issued at $1.00 per share.
- More than one founder. If there is more than one founder, the likelihood of an argument about how the equity should be split in the new company increases dramatically. Incorporating a company and issuing stock to the founders will help prevent misunderstandings among the founders about equity splits.
- Intellectual Property. If there is any Intellectual Property (IP) created and there is more than one founder, then incorporating an entity and assigning IP to the entity is important. Otherwise, if a founder leaves before incorporation and IP has not been assigned to the other founder or an entity, then use of IP created by the former founder may be problematic.
- Issuing stock options. Many entrepreneurs do not have the cash to pay third parties and may partially compensate third parties by granting stock options or giving them the opportunity to purchase equity at nominal prices. Although it is possible to have pre-incorporation agreements to grant equity upon incorporation, it is simply easier to incorporate a company and grant stock options or equity to satisfy these promises.
- Hiring employees or third party contractors. Most founders will need to incorporate a company if they intend to hire employees. In addition, if an entrepreneur needs to engage third party contractors, it generally makes sense to incorporate a company so that the third party enters into an agreement with a company instead of an individual. Accordingly, any IP created by the contractor can be assigned to the company instead of an individual founder.
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