Entity Formation Series :: Part 1 - When Should You Form an Entity?

Whether you are venturing off on your own or working with a group, one of the first decisions a business must make is when it should officially form an entity. This post provides some guidance on when to make this decision.

Attorneys will often advise clients that entities should be formed the moment the client even thinks about going into business. On the other hand, a business just starting out will often want to put off forming an entity because the business has no cash flow or income of its own, and the owners do not want or are unable to personally pay for the initial formation-related costs.

While many of the benefits and costs of forming an entity can vary depending on the type of entity you form (See Entity Formation Series Part II - What Type of Entity You Should Form?), the main benefit derived from forming any type of entity that requires the filing of a Certificate of Formation (or an equivalent document, which varies by name depending on the state in which the business is being formed) is protection of your personal assets against liabilities of the entity. The liability shield that surrounds your personal assets as soon as the Certificate is filed is a significant benefit.

Generally, as long as you are not using the entity to promote fraud and follow some simple rules, such as keeping your personal and business finances separate, filing a Certificate of Formation often means you can only lose as much money (or whatever other property) as you put into the company. On the other hand, without a liability shield, you can potentially lose all of your personal property, including your house, car, and anything else you have acquired over the years, if the business ends up having debts or obligations that it is unable to cover.

While the initial costs of forming an entity properly can vary greatly depending on the entity choice, state of formation, complexity of the entity structure, number of initial investors, etc., the associated costs are rarely going to be more than a few thousand dollars for a relatively simple business even when working with an experienced, high-quality attorney or law firm, especially if the attorney or law firm works with a lot of startups/small businesses and understands founders’ tendencies to be hesitant to spend when their businesses are first starting out.

Therefore, in my opinion, the choice of when you should form an entity all boils down to these two considerations:

(1)       Unless you do not believe that the business will be able to earn a few thousand dollars of profit in its lifetime (or whatever other amount it will cost to properly form the entity in the first place), you should move forward with forming an entity sooner rather than later.

(2)       If you do not think that the business will make more than a few thousand dollars of profit over the course of the businesses’ life, then you should probably not start the business altogether or at least reassess your business model.

To sum up, if you are serious about starting a business and actually looking to dedicate any time to or make any money from your venture, then you should probably form an entity as soon as you have access to enough available funding that you can cover the filing, legal, accounting, and insurance costs associated with forming the entity and will still have enough funding left over to move forward with operating the business. Ideally, you would not start a business before having this amount of funding available to invest, but we know that this is not always the case. Even if the costs of forming an entity seem steep from the point of view of the founder of a brand-new business, having a liability shield around the founder’s personal assets is such a valuable benefit that it should be viewed as dwarfing the costs associated with formation.

However, as a firm that works with a lot of startups and artists, some of which have limited initial personal money to invest, we understand that a business cannot always afford to form an entity right off the bat. If this is the case, then it may be best to simply try and save your money or find some other way of funding your venture before getting started; however, in practice, we know that people often ignore this type of advice and proceed with operating a business without forming any entity requiring the filing of a Certificate of Formation. With this in mind, if you are unable or unwilling to form an entity at the onset of your business, here are some factors that indicate that you really should be operating a business through an entity that requires a filing of a Certificate of Formation:

o   The business is in a dangerous industry or an industry with a particularly high chance of being sued;

o   There are multiple co-founders, owners, or partners;

o   The business is entering into contracts with clients, vendors, or any other third parties;

o   One or more of the owners of the business is working on the business as his or her full time job;

o   The business plan is to operate the business for more than a very short period of time;

o   The business involves any type of previously developed intellectual property or plans on creating intellectual property in the future; and/or,

o   The business plans on hiring employees.

On the other hand, while it is not recommended that you put off formation of an entity, here are some factors that indicate you are less likely to suffer the consequences of not having a liability shield and may possibly be able to get away with waiting a little bit before filing a Certificate of Formation:

o   The business is an industry with very little danger and an industry where lawsuits are very rare;

o   There is a single co-founder/owner;

o   The business is not entering into any contracts;

o   None of the owners are treating the business as a full-time job;

o   The business will only be operating for a very short period of time;

o   The business does not involve any intellectual property and has no plans to develop any in the future; and/or,

o   The business does not plan on hiring any employees.

Most businesses wrestling with this decision are going to have factors on both of these lists rather than having factors exclusive to one only list or the other. If you meet all of the factors on the second list, then it is hard to imagine that you are actually operating much of a business at all. When it comes time to for you to decide whether you should form an entity or not, an attorney’s job is to present you with all of the relevant legal information needed to make an informed decision, which may include suggesting a course of action.

In this post, I have attempted to provide general guidance and have stated that, in most cases, I believe an entity should be formed sooner rather than later. However, ultimately, you - not your attorney or any other advisor - are going to be the one responsible for your choices and are going to be the one that must make the business decision based on the information provided.