Business Law Basics >> Each section contains key Action Items located within the downloadable Action Guide >> Click to Download Action Guide.
2.0 GETTING STARTED – YOUR FORM OF BUSINESS AND OWNERSHIP TEAM
As you think about starting and growing your business, the first question that comes up is often what form of business should you be? To reach the decision that’s right for you, look first at:
- Ownership: will you have more than one owner?
- Exit strategy: when and why would you want to exit the business?
- Liability: Are your personal assets protected?
2.1 Is a sole proprietorship or partnership the right form for your business?
A sole proprietorship is an easy form. It’s not expensive – just file a certificate with the county clerk. No annual minutes to prepare, like a corporation or a limited liability company.
But here’s a drawback: you can’t have more than one owner of a sole proprietorship. The minute you want to add another owner, you have to choose another form.
With a sole proprietorship, your exit strategy is limited. You can’t sell the business to someone else because you ARE the business. As far as liability, you are exposed. Insurance may cover the damages . . . but, if the judgment is higher than your insurance limits, you are SOL – So outta luck.
A general partnership is like a sole proprietorship for more than one person. Yes, cheaper to file, but again, you’re exposed when it comes to liability. In addition, and we’ll discuss this in Lesson 2.4, it’s crucial that you have a partnership agreement so that you can sort out who owns what when it comes to the partnership – and how you’ll handle the comings and goings of partners should they need to leave the business.
2.2 Is a corporation the right form for your business?
A corporation has one major advantage over a sole proprietorship or partnership: your personal assets are generally protected against liability. In many states, you can even be the sole owner of a corporation. From a legal point of view, by forming a corporation, you now have something you can sell. Someone else can buy your corporation. They can’t buy your sole proprietorship.
But there are costs and maintenance:
- Costs more to form
- Additional accounting costs
- Preparation of annual minutes
Two kinds of corporations: S Corporations and C Corporations
Important differences between them:
|Factor||S Corporations||C Corporations|
|Taxes||Avoids federal and state tax||Pays federal and state tax (“:double taxation”)|
|Ownership classes||Only one class of stock allowed – every owner has the same rights and obligations||Can have multiple classes of stock, depending on how you want to reward the various levels of ownership and outside investment|
|Can trade publicly?||No – limited to 100 owners||Can trade publicly on national exchanges (like NYSE)|
2.3 Is a limited liability company the right form for your business?
Limited liability companies are, in some ways, a cross between a partnership and a corporation.
|Protects personal assets –>||Like a C or S Corporation|
|Can have a single owner –>||Like a C or S corporation (depending on the state)|
|Not taxed at federal or state level –>||Like an S Corporation|
|Flexibility to structure multiple classes –> of ownership if owners are making different contributions to the company||Like a partnership|
Flexibility comes with a price: if you have more than one owner of an LLC, it’s vital that you spend the money to have an attorney create your ownership agreement.
How to weigh and balance
If you’re envisioning a tight, active ownership team where everyone contributes equally (or where you’re owning it alone), your choice will probably be between an S Corp and an LLC.
If you’re seeking passive investors, you’ll be weighing the benefits of a C Corp and an LLC. Again, it’s an area where it helps to talk this out with your accountant and attorney.
Online filing services can provide information, but only your accountant and attorney can provide advice specific to your new business.
2.4 Will you have active business partners working with you?
If you are in business with someone other than yourself, you will save yourself a lot of tears and headaches if you have an agreement – a written agreement – with your business partners. In a general partnership, the agreement is called a partnership agreement; in a corporation, it’s a shareholder’s agreement; in a limited liability company, it’s an operating agreement.
The Three M’s of Partnerships
- Management: Who does what? You want to make sure that you’re not duplicating efforts but also that things are not falling through the cracks. Are you choosing a business partner who fills some of those gaps you identified in Lesson 1.4, or are you choosing your clone? If the latter, you’re not helping your business. Decision-making authority is important for any business that has more than one owner. You may be equal owners, but how do you decide what’s going to happen with the business? How do you make sure it’s not stalemated?
- Money: How much are you putting in? How much can you take out? What if somebody takes out more than their fair share? How do you address it?
- Moving On (“exit strategy”): There could be any number of reasons that you went into business with someone and you need to get out of business with someone, other than despising your partner. One or the other of you could die, become disabled, become mentally incompetent as the result of an accident, go bankrupt, or get divorced. Or there’s a stalemate, not seeing eye to eye. How are you going to value the company?
Families, too, should have ownership agreements. Don’t assume you’re on the same page because of the family relationship.
2.5 Are you seeking investment capital?
Investors are a different kind of business partner – sometimes called “silent partners.”
Silent partners can provide alternative financing to a business loan.
|You Want||Angel Wants|
|Money/cash infusion||Return on investment (some say 27% is the average)|
|Expertise||Opportunity to give back|
Part of the legal documentation you’ll have with an investor includes a representation that they are “sophisticated investors.”
Check in with them monthly at a minimum. They will appreciate regular reports. Much more intensive communication — perhaps daily phone calls and regular visits — are a possibility but depend on the investor.
The presence of passive investors in your company raises certain securities law issues. Do not work with investors without hiring an attorney who is familiar with that area and the documents that need to be created.
ACTION ITEMS: Complete the Action Items in your Action Guide.
START by reviewing each form of business and highlight what you like about each one.
RESEARCH your competitors to see what form of business they have become.
NEXT, consult a CPA/accountant and a lawyer experienced in working with clients in your type of business. Ask them what forms of business are typical for your type of business. Why? Learn as much as you can before filing for a particular form of business. Yes, you can change it later, but it is worth the effort to try and make the best decision first.
PREPARE to meet with a lawyer and a CPA (Accountant) if you decide to form a partnership. Be sure to have everything in writing: who does what, who gets what if a partner must leave, what is the agreed upon exit strategy, salary, etc.