Why set up a legal entity for my business and when?

This is one of the most frequent questions I receive as an advisor to very early-stage entrepreneurs.

Sometimes, when you ask a legal or accounting professional this question, you receive an answer that is complex or highly qualified. We’re going to try to provide you with a quick, dirty answer that provides 80% of the practical information with 20% of the verbage.

* This isn’t legal advice. When in doubt, consult your attorney or accountant! *

First, why set up a legal entity at all?

Many people operate small businesses exclusively on their own behalf – “sole proprietorships” - without any legal entity in place.

Sometimes they will file a “Doing Business As” certificate with their state in order to operate and advertize under a brand name other than their own name, i.e. “Superior Lawn Care”.

If a lot of people do that, why bother with a legal entity?

Here are some reasons:

• Legal Liability Protection
  This is the chief reason that business owners incorporate. When you form some kind of incorporation, you move your business activities out from under your personal legal liability, and under the company’s liability. This has important implications. If, for example, one of your employees gets into an auto accident and you are not operating within a legal entity, you may be personally sued for the damages. If you have a legal entity in place, there is a good chance that liability will stop at the entity, and the assets of the entity, rather than your personal home, car and bank account. Without a legal entity, you might become personally liable, and you and your family could lose everything in a lawsuit.
• Investment
  If you want to attract investment, or even a bank loan, you need a properly established business entity. If you want your company to develop business credit through such ratings agencies as Dunn & Bradstreet, you need a legal entity. If you want to bring outside investors into your business, you must have an entity in which they can take an ownership interest.
• Sale of the Business
  Again, you can’t sell yourself, but if you’ve set up a business, you can sell the business. Even if the business has never had outside investors, you still may want to sell it someday. (Some business sales involve on the purchase of the company’s assets. More on that in another post. )
• Tracking, Tracking, Tracking
  Having a corporate entity is the best way to keep your personal and business interests, accounts, money and identity separate. There are people who choose to and are able to keep good track of everything without an entity, but I don’t recommend it. Having a corporate entity brings a degree of organization to your activities that a sole proprietorship does not.

So, when do you set up the entity? Our philosophy is that you set up a business entity – meaning an LLC, partnership or corporation – at the point that you begin these crucial business-building activities:

• Disclosing your business to others who might have an interest in investment, employment or partnership
• Spending money on behalf of the new business
• Begin developing important intellectual property

You really don’t want to do any of these things without having a business entity in place. Sometimes these activities get ahead of the entity formation process, especially in a university setting, but most of the time, you should set up the business legally before you start these activities. Moreover, you can’t get a bank account, file patents, trademarks or taxes on behalf of the business without having the legal entity in place.

You simply must form an entity before doing any of these things:

• Hiring employees
• Setting up bank accounts, credit cards or lines of credit
• Signing contracts with clients
• Contacting investors

So, what do you do if you’re already well down the road when you read this and figure out that you really should have incorporated a long time ago?

Go ahead and incorporate, and then assign any of the intellectual property, assets, receiveables, accounts, or anything else you’ve accumulated over to the company, in exchange for capital stock from the company.

Your attorney can help you with this process. If you are the sole owner, there is typically a single document that you can sign. Talk to your attorney.

Upcoming posts:

• Which entity should I form – The quick and dirty answer for entrepreneurs
• Cool Tool: LegalZoom.com – An inexpensive way to form your first legal entity