Legal Entity Options for Hardware Entrepeneurs

Adam Thorngate-Gottlund is an entrepreneur and lawyer practicing general corporate law at a law firm in northern California. He has an irrational love of hardware startups, and a border collie. You can contact him at adam@thorngategottlund.com.

I was recently approached by a hardware entrepreneur at an event in San Francisco. He was in the final stages of preparing his crowdfunding campaign, and had that crazed look you see in people who have ridden the crest of their ingenuity for weeks, pulling together a successful campaign. He conceived an idea, refined it, done his market research, whipped up design and engineering teams, and prepared a really professional marketing strategy. He was all ready to go in a week or two, he assured me, and could I help him with the small matter of forming a company?

It’s hard to explain what it is like for me to be part of conversations like this. Try imagining if the head engineer at Pebble came to their CEO a couple of weeks before their campaign and reported that they were all ready to go, they just had to find a place to fit the battery. Or if Misfits had launched with their hardware perfect, but no case to protect it. I can see the engineers shaking their heads at the absurdity of it, but that’s because you’re an engineer – and I’m a lawyer.

If you’re even thinking about starting a business, or designing a product, there simply isn’t anything more important than forming a business entity. Remember Enron? Remember how those executives didn’t get their houses or their cars or their retirement funds taken away in order to pay back the people they swindled? Business entity. By creating a kind of legal wall between the things you own as an individual and the things that are the property of the company you are protected if your project results in some kind of liability: it’s the company’s assets on the line if you get sued, not your kid’s college fund. It is the insurance policy you buy from the government to protect all the things that you think of as yours.

Don’t get me wrong, it’s not that I don’t get it. There’s no reason for most people to have strong feelings on the subject. But like I said, I’m a lawyer. So here’s the deal:

Choose between a corporation, or a limited liability company (LLC). These are familiar structures, and will provide your team with the protection they need. Each state has its own specific laws governing business entities, and you will need to check with your Secretary of State’s Office and go through certain formalities, including paying registration fees and filing some forms, in order to get formed. Where you form your company is up to you, but generally you should only consider forming in the state where the business will be primarily located, or in Delaware (if you choose to form a corporation).

Depending on the laws in your state, there may be a number of differences between corporations and LLCs, but there are some broad trends you should keep in mind. LLCs are a newer legal structure, so the law surrounding them is not as well developed. This means that investors may not be as interested in giving you money, since they don’t have the same level of certainty that it will be protected. However, it is a very flexible structure as far as how you divide ownership with your cofounders, and the formal requirements are minimal. Corporations are more rigid structures, but they offer advantages like the ability to offer options and other complex equity incentives, and (in California, at least) different tax treatment which typically benefits businesses which sell things. Also, if you expect to be considered for funding by angel investors or VCs, forming initially as a Delaware corporation may save you the trouble of converting when they come calling. Of course, after you form your entity, there are supplemental “corporate governance” documents which you’ll need to consider – bylaws or operating agreements, shareholder agreements, and other finer points which can have significant impact on your relationship with your cofounders. Each one is important in its own right, but unfortunately this is already too brief an overview of entity formation, and too long a post.

As for the entrepreneur who I met a few weeks ago, I rushed a Delaware corporation filing through and got him the protection he needed before his campaign began, and as of this writing he has raised over $600 million in contribution crowdfunding. Before long we will need to start talking about equity bonuses and incentives, contracts with vendors and with institutional buyers; we will need to form strategies for his IP portfolio and for dealing with new investors. But for right now, his lawyer is happy because he is protected, and his attention is where it should be: getting his business started.

Please, guys, don’t take this post as legal advice. It’s general information which I hope will give you some ideas when you decide that it’s time to turn your hobby into something more, and I highly recommend that you speak to your lawyer before you do anything discussed here – and just so we’re clear, I’m not your lawyer. If that’s something you would like to change, you know where to find me: adam@thorngategottlund.com.

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2 Comments

  • Great article, would you say the same applies to online businesses?

    Rick
    Octave Malta

    • Hey all, none of the readers have any suggestions?

      Rick
      Octave Malta

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