you bring up some good points in the psychological aspect of things. if they do incorporate now though, there may be future legal problems ahead. Someone can correct me, but I feel the main problem is that typical $135 dollar incorporation services don't include important terms like vesting, so if this other person decided to walk away after incorporation; he would still own x percentage of the company...

since I'm not a lawyer I don't know of any loopholes, but I have met people who had this happen to them (three person medical imaging startup. 3rd person quits and still owns a piece of the company no matter what happens...)

to incorporate the right way, I think it costs about 4-5k (in california and delaware that is)