How to Establish Your Technology Startup as a Business Entity

You've decided to take the next step with your technology business. Up until now, you've handled your business affairs informally. Now, the stakes are higher. At this point, you might have partners and employees. The contractual arrangements and projects and your clients' needs are more complex. With that complexity comes the need to attend to details not in your area of expertise: in short, the legal details.

Related: The Business of Development: Guidance for Professional Software Developers

Failure to pay heed to the legal aspects of your business can lead to grave consequences for your business and for you personally. But take heart: The good news is that with the right guidance, your startup can begin on the right legal footing. In this article I provide some basic tips that can help you establish your business as a legal entity. Because this is an article about legal matters, of course, there is a caveat: This article isn't a substitute for competent legal advice in your jurisdiction (i.e., the laws that apply in the locale of your business—specifically, in the United States). For purposes of this article, when examples are given, they are assumed to be relevant in the United States only.

Tip 1: Think of your startup as a full-fledged business, and treat it as such

Even though this tip might seem obvious, too often a startup is often treated as a glorified form of an independent-contractor developer. You have decided to create a business that's bigger than just yourself. You want your business to scale beyond what you could do working 2,000 hours a year. To achieve your goals, you must have a plan and recognize that your business is a separate and distinct entity from you. Creating your business plan requires discipline, which is a necessary characteristic of leadership. (See "From Software Developer to Business Leader" for an in-depth discussion of the importance of discipline in business leadership.)

You must be able to answer questions such as these: What is the purpose of your business? What industries will you focus on? Do you intend to seek bank financing? Do you have a business plan? These questions represent the tip of the iceberg. You need to know the answers to such questions because the attorney you hire to represent your business will ask you those questions and others. When I was an attorney in private practice and advised established businesses and startups, I asked many of these questions.

Nobody knows your business and goals better than you. Understanding what your business needs to thrive as an entity unto itself is a crucial first step. You might not have all the answers yet. Nevertheless, you must begin to confront these questions immediately. When you're starting a business, I suggest you read Rework, by Jason Fried and David Heinemeier Hansson. In Rework, Fried and Hansson advise you to start a business, not a startup. Their point is a simple one: Act as if you have done this before. Be in the game to win. To win, you need a plan. You will find that there is a strong correlation between success in a business venture and the amount and quality of planning that went into that venture.

Tip 2: Establish a relationship with a lawyer and an accountant

With planning and discipline comes the realization that you need to build a team, and that team should include a lawyer and an accountant. Who is the right lawyer for you? You definitely want an attorney who has experience working with startups and specifically, technical startups. You also want a qualified person you feel comfortable with and actually like. Remember, he or she will be one of your most trusted advisers.

Where do you find the right lawyer? Findlaw.com is a good place to start. In terms of specialties, you want a business lawyer who has experience with creating legal entities and creating and negotiating contracts and is familiar with the technical consulting landscape. You might also want to ask your colleagues about who they use to provide their legal services.

In addition to finding the right expert to handle legal affairs for your business, you'll need to find an accountant (CPA) who can advise your business on financial and tax matters. In many cases, lawyers are prohibited from providing financial and tax guidance. The notable exception is when the lawyer is also a licensed CPA. Often an established business attorney will work in collaboration with an accountant to coordinate on financial, tax, and legal matters.

It's important when you engage your attorney and accountant that you treat them as part of your team. Their success is directly tied to your success. Consider the fees you pay these professionals as an investment in the well-being of your business. Your attorney can assist you with the tasks discussed in the subsequent tips.

Tip 3: Establish your business as a legal entity

Even if you don't initially seek legal advice, the process of creating a legal entity is fairly simple and straightforward. There are a number of firms that do nothing but create legal entities. They don't provide legal advice. For a fee, this type of firm will meet your specifications to establish your new legal entity in your jurisdiction.

When establishing your business as a legal entity, you must first determine which type of entity is right for you. In most cases, the limited liability corporation (LLC) is a good place to start. An LLC is a hybrid form of entity that combines the simplicity of a sole proprietorship or partnership with the protections that a corporate entity offers. If you plan to be a single-member entity, you will need to make sure that an LLC is right or feasible for you. In a moment, I'll discuss the potential tax implications of the LLC.

Another entity type is the C corporation. This is the classic type of stock or non-stock entity that has existed for hundreds of years. Unlike an LLC, a C corporation has a number of requirements—such as an annual meeting, officers, and retention of a written record of the proceedings of each meeting (minutes). Historically, if these corporate formalities were not followed, the so-called "corporate veil" could be "pierced," meaning that officers and management could be made personally liable for some cause of action.

For both the LLC and C corporation, you can elect taxation under subchapter S of the Internal Revenue Code (IRC)—aka an "S corporation" or "S corp." This means that the net income or loss from an LLC or corporation flows directly to your personal tax return. This is how profits from a sole proprietorship or partnership are always treated. If you opt not to use the subchapter S method of taxation, the business entity itself pays taxes. Usually an entity opts for the subchapter S method so as to avoid double taxation.

In addition to establishing your business as a legal entity, you also need to obtain a tax ID number (TIN). Applying for a TIN is a straightforward process with the Internal Revenue Service (IRS). Often you need to obtain a TIN before you register your entity with your state. Before you can open a checking account in the name of your entity, you will need a TIN.

Where do you go to register your entity (assuming you are not using a service to do so)? All states in the US have a Department of State, and within that department, there is usually a sub-department for corporations and businesses. In this department you can search for the registered entities in your state.

One of the first things you will need to do is determine whether the name you want for your business entity is available. Your jurisdiction will likely have strict guidelines on how to name your entity. For example, in Pennsylvania, you would contact the Bureau of Corporations to find out the filing requirements for your selected entity.

Depending on your entity choice, you might have more forms to complete. For an LLC, one form will be the certificate of formation. For a corporation, it's articles of incorporation. An LLC has an operating agreement, and a corporation has by-laws. Do not treat these documents as boilerplate and as a mere formality! Should a legal dispute with your business partner(s) occur, these documents will be crucial in helping the court to understand the intent of all parties concerned.

Right now, you head is probably buzzing with all kinds of questions. Perhaps you now realize how important it is to have a lawyer who can guide you to select the right entity for your particular circumstances. The myriad of legal, financial, and tax implications can make your entity-type selection one of the most important decisions you will make.

Tip 4: Have standard engagement contracts

There are several documents that every entity that engages in software development and technical services must have. The first is a master services agreement (MSA). This document is typically executed once between the vendor and client. The purpose of this document is to set forth basic terms and conditions between the parties. Matters such as payment terms, confidentiality and non-disclosure, limitations of liability, intellectual property ownership, and others are spelled out in this document.

A document that's related to the MSA is the statement of work (SOW). This document references and incorporates the MSA terms. The SOW is a much smaller document than the SOW because its scope is limited to the terms of a specific project. The SOW might also contain a number of appendices that specify specific requirements, acceptance criteria, and possibly other details. You might also use the SOW as a place to override certain provisions in the MSA.

You will also want to have a standard independent contractor agreement (IC). An IC agreement is used in place of an MSA and is a smaller version of it. An IC often has the specifics of the job for which your firm is hired. Like the MSA, an IC agreement sets forth terms for items such as payment, intellectual property ownership, and limits of liability.

The key is to have your documents drafted in terms that are most favorable to you. Beware of looking for sample contracts online. Too often I've seen people appropriate bits and pieces from several agreements to cobble together a new agreement. There are many problems with such patched-together agreements. Often they contain contradictory terms or terms that are not in the business's best interest.

Another common problem with such documents is that often the jurisdiction and venue clauses reference states and counties other than where the firm is located. These jurisdiction and venue clauses are not boilerplate that you can disregard. In fact, these clauses determine where you can file a lawsuit. Normally, this will be in your jurisdiction, and your clients, through contract, will agree to be subject to those courts. Without such a clause, you have to go to the client's home jurisdiction. That is what many do-it-yourself non-lawyers sign themselves up for without knowing any better.

Sometimes your clients will demand you use their documents. If you want their business, you will have no choice. In those cases, it's best to have a lawyer review the documents on your behalf. If the client balks at that review, reconsider whether you should do business with that client. Sometimes, the best decision is to walk away. Successful business people always recognize the ability to reject a deal that isn't right for them.

Tip 5: Avoid a lawsuit

You can take precautions to make a lawsuit less likely. Above all, be reasonable. Keep the promises you make. At the same time, don't sign up for a bad deal, which could be a lawsuit waiting to happen.

Don't rely too much on email as a substitute for personal contact with a client. Pick up the phone and call your customers. Ultimately, you are selling a product or a service that provides value to your customers. It's in both parties' best interests for things to work out. Even if you have a seemingly solid agreement with a client, disputes can arise through misunderstandings. In my experience, parties who talk often and work together tend to have positive results.

Going back to the first tip, run your entity like the business it is. Some people think that the existence of their business entity will unfailingly protect them personally from any liability. Although that's often the case, sometimes the corporate veil can be pierced, and, as a result, your personal assets could be taken to satisfy damages resulting from a lawsuit. For example, if a court deems that there is no real distinction between you personally and the business entity, you and not the entity become liable. Make sure your business can meet its obligations. It's usually wise to acquire some level of business liability insurance as well, so that your business assets are protected in the event of a lawsuit.

In the event a client threatens you with a legal action against your business, don't panic. This is when having a lawyer really helps. Lawyers can sort through the facts and review them in the context of the law to give you solid advice. I've never had a client receive a threatening letter from somebody who didn't feel they had a solid case. The fact is, most lawsuits among technology firms are based on breach of contract, and those lawsuits rarely go to trial and even more rarely go to verdict.

When you're faced with a lawsuit, you want to have all your ducks in a row. Make sure you know the answers to the following questions—ideally, your answers will all be "yes." Are you running your business correctly? Do you have the right entity? Are your documents in order? Have you done all you can do to fulfill your promises? Every legal action tells a story. That story is made up of facts that you can prove. The question for you is, what kind of story will the facts in your case tell?

Get Help from Experts

In this article, I've done my best in the short space provided to lay out some simple and practical guidance to help your new business venture succeed. Having a lawyer and accountant as well as an insurance agent and other business professionals as part of your team will go a long way toward ensuring your business's success.

These professionals, however, are only part of the story. They can advise you only based on what they know—which is what you tell them. Success is ultimately determined by what you do in accordance with your plan. Just about every successful business benefited from sound legal, financial, and tax advice. Best wishes on your new venture!