Going out on your own? Get started on a strong legal footing.
By Dave Thayer, featured in ColoradoBiz
Starting a new business may have been on your mind for some time. Maybe you are tired of waiting on a paycheck from someone else? Or, you’ve lost your job or seen your pay cut during COVID-19? Perhaps you find the idea of building something that will outlast you inspiring?
This challenging economy may actually be the perfect time to flex your entrepreneurial spirit. From a legal perspective, that means choosing an entity, raising capital, and navigating other start-up considerations that will help guide your business decisions, tax efficiencies and ability to scale.
Just like real estate’s three “L’s” (location, location, location), business formation has its own three “L’s”: liability, liability, liability! An entrepreneur who opens shop without operating through an entity is a sole proprietor and is personally liable for all of the business’ liabilities and losses. If two or more entrepreneurs open shop without forming an entity, they will likely be deemed a general partnership and each partner will be personally liable for all of the partnership’s losses and liability including, unfortunately, those arising from the acts of your partner(s), even when those acts are completely unknown to you.
Personal ruin is not a good business plan; form an entity. Single or multiple owner business entities can be formed by filing articles of incorporation or organization, which require little information and a nominal filing fee.
The most common entity is a limited liability company (LLC), which provides personal liability protection for owners between their business and personal assets. Flexible and well-suited for small businesses, a single owner LLC formed with the appropriate state government office does not have to do anything more than properly operate his or her business under the LLC’s name. Proper operation includes keeping business and personal assets separate and maintaining appropriate business financial records. LLC’s with two or more owners should consider negotiating and executing a contractual operating agreement to set forth the economics among the owners, voting rights, and other operational matters.
A corporation is more formal and less flexible. Management, voting and economic rights are set forth by statute and corporations must follow certain corporate formalities to ensure they retain their corporate status and benefits. If going public is part of your dream, then electing corporate status may be the appropriate entity to form. In forming a new corporation, typically Bylaws and organizational minutes are prepared to memorialize how the corporation will be operated, appoint the initial Board of Directors and officers, issue the initial shares of common stock, and adopt other applicable matters of importance to the new company.
Taxes play a primary role in entity selection. Pass-through taxation generally applies to LLCs with two or more members, while single member LLCs are treated as a disregarded entity for tax purposes. By default, an LLC is not taxed at the entity level, although an LLC can elect to be taxed differently. Tax losses from LLC operations can often be “passed through” to LLC members and used to offset income from other sources.
A corporation generally files its own tax return and pays taxes at the corporate level, while dividends paid to shareholders are separately taxed on their personal returns, leading to the “dreaded” double-taxation dilemma. “Check the box” tax regulations give corporations the option to be taxed as a pass-through partnership, thereby avoiding double taxation.
Similarly, a regular corporation can elect a special “S-Corp” tax status and be taxed much like a partnership, with certain differences and limitations. Only individuals and certain trusts can be shareholders. Accidentally admitting an LLC as a shareholder and the company has likely blown its S-Corp status and a taxation disaster may follow. The decision to use an S-Corp or an LLC can be complex and generally the advice of an attorney or CPA should be sought.
If the new enterprise intends to privately raise capital from investors, an entrepreneur should select the entity structure that will be most attractive to potential investors while allowing the entrepreneur to retain control of the entity. Once again, LLC’s tend to be the entity of choice due to their flexibility in creating varying classes of economic interests while separately designating management authority to the entrepreneur. Limited partnerships and its related variations also offer significant flexibility.
For many startups, funding initially comes from friends and family. What’s the harm in selling some equity interests or debt instruments in your new venture to several family members and/or acquaintances, right? Well there can be plenty of problems if what you sell falls under federal and state securities laws. A promissory note might not look like a security (after all, it is debt, not equity), but it might be. Federal and state securities laws define securities broadly to generally include stock, LLC and partnership interests, bonds, debentures, evidence of indebtedness, certificates of interest or participation in any profit-sharing agreement, investment contracts, fractional undivided interests in oil, gas, or other mineral rights, and the list goes on.
Offers and sales of instruments sold to as few as one person can constitute an offer or sale of a security, which must generally be registered with the applicable government regulator or be exempt from registration. There is no “friends and family” exemption in the federal securities law. There are, however, limited offering and private placement exemptions that can accommodate a friends and family offer when certain requirements are met.
Regardless of an exemption, all securities offerings are subject to the anti-fraud rules of the federal securities laws, per the Securities and Exchange Commission:
“This means that you and your company will be responsible for false or misleading statements that you or others on your behalf make regarding your company, the securities offered, or the offering. You and your company are responsible for any such statements, whether made by your company or on behalf of the company, and regardless of whether they are made orally or in writing.”
Violations of the federal antifraud rules can mean personal liability—regardless of LLC status—for officers, directors, owners and other people who control the entity that violated the rules. Not only are you and your business entity potentially liable for false or misleading statements, you can be held liable if you failed or omitted to tell an investor about an important matter regarding your business. For instance, if in raising money from investors through the sale of a security you “forget” to mention that your company just filed for bankruptcy, you can probably expect to be sued for securities fraud.
So, how can you and your company avoid securities fraud? By assembling a subscription agreement or private placement memorandum that describes your company’s new venture, the risks relating to the company and its business, and other matters that typically would be important to an investor who is trying to make an informed investment decision.
Lest you think your friends and family would never sue you, think again. Years ago, I was called to give a litigation attorney advice regarding a real estate developer client he was representing. Just prior to the 2008 economic crash, the real estate developer borrowed about $1 million in a promissory note from his wealthy sister-in-law and her husband to build a fancy speculation home. The funding agreement included an “equity kicker” in which the sister-in-law would get to share in the profit on the sale of the home.
The developer finished the house just as the real estate market began to crash and the unsold spec house’s value plummeted. The sister-in-law sued the developer and his wife on the simple default on the promissory note and securities fraud, the latter claim which is generally not dischargeable in bankruptcy.
While there are some special circumstances where a promissory note is not a security, the sale of an equity interest or profits interest is almost always deemed to be a sale of a security. This feature attached to the promissory note made it very difficult to defend that there was no offer or sale of a security involved. Had the developer and his wife delivered to the sister-in-law a document outlining the risks relating to investing in spec homes and obtained acknowledgement that she understood and accepted those risks, securities fraud claims could have likely been avoided. Although perhaps awkward at the time of issuance, this document may very well have preserved family harmony down the road.
Starting a new business should also provide for future uncertainties. Businesses with multiple owners should consider entering into an agreement regarding how the owners will deal with each other should certain life events occur. What happens if one of the owners dies or becomes disabled? Does the surviving owner want to be in business with that person’s spouse or adult children? What about a divorce where part or all of the owner’s ownership interest is awarded to the ex-spouse? A bankruptcy of an owner? An agreement with buy-sell provisions and a methodology for determining the purchase price and how it is to be paid in case of a transfer of an ownership interest in the entity is a must to avoid the types of problems that can tear a business apart.
Previous financial crises have seen entrepreneurs enter the marketplace with innovative business ideas. The coronavirus is similarly giving entrepreneurs the opportunity to identify and meet new needs in changing environments and fluid workplace settings. Only you can decide if now is the right time to go into business. But if it is, do it right. Hire the expertise you need to help you tackle the legal foundational issues so you can focus on getting your new business up and running fast.
About the Author
David A. Thayer, Esq., is a business and corporate finance attorney, and former CPA, who focuses on making deals as he helps clients achieve their business dreams. He can be reached at firstname.lastname@example.org.
*THIS INFORMATION IS NOT INTENDED AS LEGAL ADVICE. SEEK SPECIFIC LEGAL ADVICE BEFORE ACTING.