Given the existing economic and geo-political environment, starting a new business venture is challenging enough! But its outcome is also the product of team work – not one that’s prone to success if tackled by a single individual. Because of the myriad aspects of corporate law, including structure, registration, shareholder and partner’s rights and obligations, and patents and intellectual property, success depends on multiple experts working together. However, if there’s one professional who plays an outsized role on the team, it’s your startup business lawyer. This post explains the legal issues with starting a business, and underscores why having the right advice at startup matters.
— Type of Entity
The choice of the type of legal entity, i.e., how you structure the business, determines the obligations of, and level of legal protection conferred upon, the business and its partners, founders, agents, employees and other internal and external stakeholders. These are often very sensitive, and sometimes misunderstood aspects of forming a business. Proceeding to set up a business without intimate knowledge of corporate structure, and the legal repercussions it has, can come back to haunt the entity many years later.
Here are some considerations around choosing a business structure, that warrant consultations with an experienced startup law firm.
A) LLC vs. Corporation
Two common types of entities include a Limited Liability Company (LLC) and a Corporation. The choices you make will determine several factors, including ownership, taxation, and record-keeping – amongst others. Here are some questions to ask to help you determine which type of entity is best for your business:
1. Who owns the company?
2. What type of a relationship do I wish to establish, between the company and it’s owners/investors, and with other internal and external entities and stakeholders?
3. How will the business be operated and managed?
4. How do I want the IRS to treat my business for taxation purposes?
5. What extent of liability protection do I want?
6. What type of record-keeping do I need to maintain?
B) Limited Liability Company (LLC)
1. OWNERSHIP: LLCs are owned by its Members, either individuals or other companies. Stakes in the LLC may be offered to other Members, regardless of financial contributions made to the business. Pursuant to clauses laid out in an LLC Operating Agreement (more on this later), the LLC’s must be dissolved when members terminate or rescind their ownership.
2. MANAGEMENT: LLCs may be managed collectively by its membership or through a select group of members (“member-managed”), or by professionals or investors, who don’t participate in the day-to-day decision-making, but manage the overall operation of the business (“manager-managed”).
3. TAX TREATMENT: The IRS allows LLCs the option of how they choose to be taxed – as a passthrough entity, or as a Corporate entity (more on Corporate tax treatment later). When paying taxes as a passthrough entity, profits are deemed to be “passed through” to the Members, by the LLC. Taxes are, therefore, owed at the individual level, and not by the business.
Business losses and operating expenses may be deducted, and offset, against other personal income on Member’s personal tax returns. Overall, LLC tax calculation and filing is comparatively simpler as a passthrough entity.
4. LIABILITY PROTECTION: Members of an LLC enjoy limited liability in the event of legal disputes arising from normal business of the company. For instance, customers suing an LLC for damages, only have recourse to attaching LLC assets – and not Members’ personal assets – against their claims. The amount of liability that a Member is exposed to is only to the extent of his/her stake in the business. While they are fully liable for their own actions, LLC owners are not liable for tortious conduct (bad acts) or negligence of other co-owners of the company.
5. DAY TO DAY OPERATIONS: Simpler to establish and run
I. The operating agreement will establish details on how the company runs its routine operations, and can be tailored to meet specific needs.
II. In addition to previously stated items, the operating agreement includes structures for how to hold annual meetings, and how other day to day operations must be managed and carried out.
III. It lays out guidelines for the maintenance of good corporate records, keeping separate finances, documenting critical operational actions and relationships, and contracts from personal and business perspectives.
1. OWNERSHIP: The Corporate entity is owned by its shareholders. This confers legally-binding (and often mandated by statutes) obligations to shareholders, by the Corporation. Corporations issue shares to its “owners”, and, pursuant to a Shareholders Agreement (more on this later), those shares are freely transferrable.
Because the law recognizes that Corporations exist in a state of perpetuity, there is no impact on the company, as a going concern, whether existing shareholders leave the company, or new ones join.
2. MANAGEMENT: The management structure of Corporate entities is more rigorous. A shareholder-elected Board of Directors (BoD) oversees the direction of the corporation, which typically has a formal management structure in place. Though shareholders elect the BoD, and vote on significant management activity/decisions, they (shareholders) remain separate from the Corporation. Other corporate “agents” (employees, contractors, consultants) carry out the day-to-day management of the company.
3. TAX TREATMENT: Profits earned by a Corporate entity, as well as dividends paid to shareholders, are taxed at the statutory federal rate, as well as state corporate taxes rates. However, dividends distributed to shareholders (by the Corporation) are then taxed at a personal level when shareholders file their personal taxes.
This type of tax treatment is often referred to as “double taxation”. To manage the impact of double taxation, some corporations use corporate tax strategies, including forming themselves under other types of legal entities, such as C-Corporations or S-corporations. A start up lawyer experienced in taxation can help fledgling ventures determine the best way to optimize their tax status.
4. LIABILITY PROTECTION: Shareholders have no personal liability for any actions conducted by the Corporation. Hence, shareholders are protected against any liability arising from a customer/partner suing the corporation. However, the company (and by extension, a Shareholder’s stake in the organization) is held liable for any actions conducted on its behalf by legally-designated agents/representatives.
5. DAY TO DAY OPERATIONS
I. Record keeping must meet state requirement, which includes the maintenance of good corporate records, maintaining separate finances, segregation of corporate actions, and delineating contracts between personal and business dealings.
II. Corporate structure and operations are defined by by-laws.
III. By-laws outline annual meeting requirements and, if necessary, additional BoD meetings.
— LLC Operating Agreement
One unique aspect of a Limited Liability Company (LLC) is that it can offer ownership stakes to its members, regardless of the financial contribution made by that (those) member/s. For instance, a member contributing 1% of the capital might still be eligible to receive a 50% stake in the company. Because of such sensitive issues, especially in the evolving FinTech, Blockchain, and Crypto sector, startup lawyers always advise caution when drawing up an LLC Operating Agreement.
Other notable aspects of the Agreement that merit consideration include:
A) Needs to state who owns how much, who manages the company, state the responsibilities, and how voting is allotted, and what voting power is necessary to make decisions (e.g.: Simple majority; 50%+1 etc.).
B) Outlines how profits and losses are allocated along with how income is distributed.
C) Maps out change in ownership and how/when LLC is dissolved.
— Corporate Shareholder Agreement
The Shareholders’ Agreement outlines, for shareholders, how the company should operate, and what rights, privileges, and obligations the agreement bestows on them (Shareholders). Often, when venture entrepreneurs don’t consult an experienced lawyer for business startup, they may mistakenly equate the company bylaws to a shareholders’ agreement – which can be a huge misstep! Bylaws function in tandem with the Articles of Incorporation to form the legal basis for the company’s existence.
The optional Shareholders’ Agreement, on the other hand, lays out a formal relationship between its stakeholders – primarily the shareholders. Other critical aspects covered by the Agreement includes:
A) Corporate governance
1. It is used to designate officers and directors of the corporation, and to explain what decisions are made by Board, Officers, and/or the shareholders.
B) How stock sold or transferred
1. Does anyone have the right of first refusal?
2. Can outside parties (e.g., financiers, creditors) acquire stock and become shareholders in future?
3. What safeguards are in place for minority shareholders if other shareholders sell their shares to majority stockholders?
4. Must explicitly say how value of stock would be determined: Shareholder vote, book value, or another formula?
C) Rights of Shareholders, can shareholders compete with the company?
The Agreement should set out in detail how the rights of every shareholder are protected, and how each is treated fairly in the event of a dispute. Litigation can be expensive, especially when the actions of a shareholder appear to compete with the rights of others in the company. That’s why it helps to consult a veteran lawyer for starting a business to add appropriate conflict of interest clauses in the shareholders’ agreement.