When is it necessary to create a legal entity for a startup?

You should never wait until there is a problem to form your business entity. There are many reasons to form early, and some others to put it off (cost being one of them). If you're working to develop software you need to define who owns that software. If you get down to nitpicking over who wrote what, or who came up with what idea, you're probably in trouble. Having a business entity that all of you assign your work to, in exchange for ownership over the entity is a really good idea most of the time. Having a written agreement between your team members (in the form of a partnership or operating agreement) can also help you decide what happens when your team members disagree (and they almost inevitably will, even if it's only over a small issue). It is far better to plan for the worst when everything is going well than to try to sort it all out once there is an issue.

As far as the cost (and complexity) that really depends on what sort of entity you decide to form. Partnerships and LLCs, generally, give you really good flexibility with very low formation costs. When the time comes to have a fully formed corporation for business purposes you can make the change, bear the cost, and deal with the corporate formalities. Until then, protect yourself by planning ahead and give yourselves the best chance of success.