Avoiding Key Legal Mistakes in Startup Companies: Part 1
There are inherent risks that come with starting a business. From concerns on structuring the business, acquiring new customers, to issues with cash flow, starting a business is a stressful endeavor. However, it is an endeavor that many entrepreneurs find incredibly rewarding. Understanding and managing your business’s legal risks is vital for long-term success. If planning is conducted effectively, a business can avoid common pitfalls, or at least mitigate the impact and cost of previous mistakes. This blog series is intended to help you understand and avoid the key legal mistakes that many startups encounter, and hopefully help you discover that rewarding feeling associated with starting-up a business a little earlier in the process.
1) Select the Appropriate Entity for the Startup.
Every startup needs to determine the type of business entity that is most appropriate for the legal, tax, and investment strategy of the founders and investors. The most common mistake I see is entrepreneurs who pick a business entity for no particular reason other than it being an entity that their research showed was popular. This is a bad decision because it carries unnecessary risk and potentially hampers the long-term viability of the startup. At the outset of any startup, it is vital that founders consider the goals and objectives of the business and use this information to pick an appropriate legal entity. Some initial factors to consider in picking a business entity include:
Plans for future growth;
The type and amount of funds sought to be raised in order to operate the business; and
How much equity, if any, to offer outside investors.
However, the type of business entity that a startup chooses impacts everything from:
How the startup is treated from a tax perspective;
How the founders and investors participate in the startup;
How ownership interests in the startup are transferred;
How financing for the operation and growth of the startup may be obtained; and
What liability could potentially be imposed on founders and investors related to the startup.
Current tax law incentivizes startups to structure themselves as partnerships, LLCs, or S corporations in order to take advantage of pass-through taxation and avoid double taxation of corporate earnings. However, if a startup plans to seek substantial outside investment, they should consider organizing as a C corporation.
Benefits of Limited Liability
Some business entities provide a way of limiting the personal exposure to legal liability for founders and investors such as limited partnerships, LLPs, LLCs, and corporations. Let’s consider this in relation to LLCs. This limited liability means that members of the LLC are protected from personal liability for the debts and obligations of other members and the business itself, but members are always liable for their own negligence or wrongful conduct. Entrepreneurs should be aware that this liability shield is not absolute. In order to enjoy the liability protections of an LLC, the members must establish and operate the LLC as a separate legal entity
To illustrate this point, I like to use the example of an empty chair. Imagine an entrepreneur forms an LLC. Later, the entrepreneur is opening business bank accounts for the LLC. While the entrepreneur and banker are sitting in their respective chairs going through the bank account setup process, imagine the LLC is sitting there with them in a third chair. Obviously, this third chair is empty, but for purposes of this legal demonstration it represents the LLC. The LLC is present, and it is the LLC which is opening the bank accounts, not the entrepreneur. Now imagine every other business task or contract which the entrepreneur undertakes for that LLC. It is the LLC which occupies that third, empty chair at every single meeting. The entrepreneur merely acts on the behalf of the LLC. In essence, all business should be conducted through the LLC, once formed. To ensure that the LLC maintains its liability protections, founders and investors should keep their personal interests separate and apart from the company’s interests.
In sum, it is extremely important for entrepreneurs to discuss their business with a lawyer. This allows the lawyer to understand the startup’s business and recommend the business entity which best suits their needs.
Check out the whole series: Part 1, Part 2, Part 3, Part 4, Part 5, Part 6, Part 7, and Part 8.
Contact us today to see how we can help your business select the right legal entity!
*The material and information in this blog is for general informational purposes only. In no way is this information to be construed as legal advice for a particular situation.*