Essential Steps in Forming Startup Entity

Name Validation

Once you decide to form a startup company, one of the first decisions you will make is what business name to give the company. Before deciding on the name, it is advisable to do a business name search in the local company registration database. You should also do a trademark search as well a website domain search. It is important to do a name search because you don’t want to select a name, spend considerable resource creating a brand based on that name, only to later find out that is already in use by another entity. In a worst case scenario, you might be infringing on a registered trademark and therefore subject to litigation. Once satisfied that the selected name is unencumbered, you can proceed to register the business. The same approach should be taken with the naming of any products or services that the business creates and markets.

Equity Allocation

Consideration should be given to the equity in the new business and how it will be distributed among the founders and employees. The founders usually forego salaries or accept reduced salaries in the startup stage in exchange for equity share. If there is more than one founder, equity is generally allocated based on the contributions by the founders. One founder may have generated the idea on which the based is based, while another founder may have provided capital to get the business started. Yet another founder might be the one doing the actual work to drive the business along. In such a scenario, it is up to the partners to the value provided by each and to allocate equity in a fair and reasonable way.

Equity allocation is also an effective method of managing the company’s cash flow at an early stage when the business is likely not generating significant revenue. It is not uncommon to create an equity pool to provide shares in the startup to early stage employees.  By offering an equity share in lieu of a market competitive salary the company can acquire quality employees that it otherwise could not afford to hire. This allows the business to conserve cash flow while trying to grow the company. Equity allocation can function to create a performance incentive, as well as a mechanism to retain employees.

However the equity is distributed among the founders and first hires, note that the shares will be subject to dilution as investors provide successive rounds of funding. Early stage money obtained from friends and family is normally considered a loan to be repaid, and therefore is not allocated an equity share.

Stock Options

Equity is normally issued in the form of stock options that vest over time, typically four (4) years, with 25% vested at the end of the first year, 50% vested at the end of the second year, etc. This schedule allows the company to retain key employees by ensuring that those employees stay the full four years before they can cash out their entire equity. But it also permits the employee to realize some gain from the options that have already vested.

To exercise the option, the employee pays a predetermined strike price, usually well below the fair market value (FMV) of the stock. The liquidity of the options is generally dependent on an exit event, usually the acquisition of the company by another entity, or an initial public offering (IPO) by the company.

Assignment of IP

Draft and execute agreements assigning all intellectual property created on behalf of the company, to the company. This applies to work product produced by the founders, employees and consultants retained by the company. Failure to secure such assets, particularly if they are core to the company’s business, could result in a founder or employee leaving and being entitled to take the IP with them. This would also apply to a consultant.