This module will cover three important decisions that every business owner must make: whether to go into business alone or with a partner, what business organization to use, and what professional resources are needed.
- Should You Have Partners?
- Partners versus members of the founding team
- Pro's and con's
- What is Liability and Where Does it Come From?
- How does timing factor in liability?
- What Type of Business Organization is Right for You?
- Sole proprietorship
- Limited partnership
- Limited liability company (LLC)
- Benefit or social purpose corporation
- Steps You Should Take to Organize Your Business
- Professionals That Can Help
- Top Ten Do's and Don'ts
- Business Plan
Should You Have Partners?
Partners versus members of the founding team
The term "partner" should be reserved for individuals who will actively be involved in managing the business. In the early stages of starting your business, you may be tempted to trade an ownership in the business for goods or services that your business needs to get started. Everyone with an ownership stake is a partner, and partners will have rights under the law. If a partner is fired or decides to stop working with the company, his or her ownership interest in the company may continue. Imagine the uncomfortable situation of having to seek that person's vote or input on a business matter, despite the fact that you have parted ways. Therefore, before deciding to make someone a partner or owner/shareholder in the company, you will want to consider factors such as:
- The individual’s dedication – whether the individual will also be working for other businesses/ventures or employers while also working with you;
- Whether the individual’s skills complement your own;
- Whether the individual’s work hours are similar to yours;
- Whether the individual’s vision for the business matches your own;
- The individual’s track record in growing and running businesses and/or working with other partners;
- The nature of the individual’s contribution to the business; will he or she be contributing standard services that can be outsourced from other organizations, or more important attributes such as strategic advice, needed funding, or key intellectual property?
Pro's and con's
You may want to prepare a list of reasons for and against having partners in your business.
- Pro's of having a partner
- There is safety in numbers. In other words, you have two heads instead of one to discuss issues and make decisions. In the words of Solomon: "Two can accomplish more than twice as much as one. If one fails, the other pulls him up; but if a man falls when he is alone, he's in trouble. And one standing alone can be attacked and defeated, but two can stand back-to-back and conquer. Three is even better, for a triple-braided cord is not easily broken."
- You will not need to be at the business at all times. You will have someone else who will be there to share the load and permit you to take a vacation and have sick time.
- You will also have a highly motivated co-worker, not just someone who is earning a paycheck.
- No one can be good at everything. Partners can bring skills in areas that are complementary to yours.
- It may be necessary to have a partner to contribute capital and share the risk when things do not proceed as planned.
- Partners bring along their own networks of friends, colleagues, and professionals which could be beneficial for your business.
- Con's of having a partner
- You will have to share the rewards if the business is successful.
- You will not be able to make decisions about the business without including your partner.
- You will need to disclose and share any and all financial information with your partner.
- You will lose total control over the business, this can be challenging particularly if you and your partner have difficulty in making decisions.
- You will have to share the recognition that will come if the business is successful.
- A partner can be a disaster if his or her judgment is not good.
- Your partner might make decisions or take actions that you do not agree with.
- If you are 50/50 equal partners, then it may be difficult to resolve differences of opinion.
- You run the risk of a falling out and perhaps the necessity of one partner buying the other out if dissension arises.
What is Liability and Where Does it Come From?
One of the important differences between various types of business organizations, or entities, is relating to how responsibility is assigned the responsibility of the owners for the acts of the business. Responsibility for these acts is known as liability, or the liabilities of the business assigned, or “liabilities.” Liabilities arise as the business grows, for example, from activities such as the following:
- Contracts: Contractual obligations of the company, such as loans, leases, supply agreements, or subscriptions, can cause potential liability.
- Workers: Hiring employees or independent contractors can cause potential liability.
- Partners: Having partners or co-founders can cause potential liability, especially if those individuals do not have a written agreement.
- Product or service offerings: Issues can arise with products or services that are offered by your business, such as warranties, defects, or other harm.
- Regulatory compliance: If your business is in an industry that is subject to regulations, then lack of compliance with these regulations can be a sources of liability.
Timing and liability
When deciding whether to set up an official business entity such as an LLC or corporation (see more below), you should consider the potential liability that your business may be incurring based on the stage that you are in. For example, if most of your business’ activities are relating to prototype development, then your business may not yet be taking on a large risk of liability. As you business grows and faces more liability, you can change your legal structure.
What Type of Business Organization is Right for You?
- Sole Proprietorship: A sole proprietorship is one person alone who is running a business, even if he or she has not taken official steps to set up a business entity. For example, Maxine, a culinary school graduate, starts getting paid by friends and family to make wedding cakes. She would be considered a sole proprietor. Some characteristics of a sole proprietorship include:
- The sole proprietor will have unlimited personal liability for the business.
- The income or loss from the business will be reported on the sole proprietor’s personal income tax return along with all other income, expense, and personal assets he or she normally reports (although it will be on a separate schedule).
- The sole proprietorship avoids the expense of forming an LLC or corporation.
- Many start businesses this way by default because they are unfamiliar with the other forms of organizations.
- Partnership: A partnership is similar to a sole proprietorship, because even without taking any action to set up a business entity, two or more individuals working on a business can be considered a partnership. For example, Maxine the culinary school graduate continues to make wedding cakes, but realizes that many weddings need someone to make appetizers as well. She and another friend come up with a name, and sell package deals of appetizers and cakes for weddings under that business name. They would be a partnership. Some characteristics of a partnership include:
- Each of the two or more partners will have unlimited liability for the business. So in other words, two partners do not split liability 50/50 -- both are fully responsible.
- The income and expense is reported on a separate return for tax purposes, but each partner then reports his or her pro rata (or proportionate) share of the profit or loss from the business as one line on the personal tax return. This is called “pass-through taxation.”
- Partners each have the ability to make decisions on behalf of the organization, so a formal agreement as to percent ownership and voting power is recommended.
- A partnership agreement should have provisions made for exit strategies, and you will need experts experienced in succession planning. What happens if a partner dies or becomes disabled? Or if family members want to join or quit the firm? In our Business Expansion course, Session 14 Selling Your Business and Session 15 Considerations for Family Succession can provide important insights and who to call upon for advice.
- If some partners have special skills or talents, the partnership agreement may allow some partners to veto or approve important decisions in his or her area of expertise.
- The partnership agreement should have buy-sell provisions that are clear about what happens to the partnership in the event of a disagreement, and how the purchaser will pay for the portion of the business he or she is buying (and whether you should fund the buy-sell agreement with insurance in the event of the death of a partner).
- Limited Partnership: Limited partnerships have a two-tiered partnership structure. As an example, Jennifer and Alex start a consulting business whereby they both act as general partners, but after a few years decide to promote one of their employees to partner. Because their associate is young and relatively inexperienced in operating a business, they choose a limited partnership so the employee can be a limited partner. Some characteristics of a limited partnership include:
- With a limited partnership, each of the general partners has unlimited liability for the debts of the partnership, but the limited partner's exposure is limited to the contribution that partner has made to the partnership.
- With certain minor exceptions, the income and expense reporting for tax purposes is the same as for a general partnership.
- Similar to a partnership, a limited partnership should employ a partnership agreement that sets forth important provisions such as how the partners will make decisions, split up ownership, and what happens when a partner quits, retires, or dies.
- Limited Liability Company: A limited liability company (or “LLC”) combines the limited liability for owners of a corporation with the flexibility and pass-through taxation of a partnership. As an example LLC, Susan, Bianca, and Hillary, three experienced computer engineers, decide to start an IT consulting company where they make house calls to help people install and fix their home computer equipment. They choose to be an LLC where each of the three of them shares voting rights and the income and expenses of the business equally. Some of the characteristics of LLCs include:
- An LLC has the benefit of protecting owners from personally being responsible for the liabilities of the business.
- In some states, the LLC can choose to be taxed like a corporation or like a partnership, so the owners can enjoy the “pass-through” nature of expense and income reporting.
- The LLC is flexible because it can be managed by all of the members or can have centralized management in one or more of the members.
- One downside to an LLC is that generally venture capitalists will not invest in an LLC. However, if venture capital funding is not required soon, a business may want to form as an LLC because an LLC can be converted to a corporation if this becomes an issue.
- An LLC is governed by an operating agreement amongst its owners (also called “members”), which is similar to a partnership agreement.
- Corporation: A corporation provides limited liability for the owners (called “shareholders” or “stockholders”), and has a more formal business structure than an LLC. For example, assume four recent engineering graduates decide that they're going to start a company to sell personal rocket packs. They know that they will not be able to make the company work without large amounts of investment from a venture capitalist (VC). They choose to start their business as a corporation right from the beginning, since VC financing is a necessity, and this business entity will be compatible. Some of the characteristics of corporations include:
- In general, none of the shareholders in a corporation is obligated for the liabilities of the corporation; creditors can look only to the corporation's assets for payment.
- The corporation has the downside of being subject to double taxation under federal income tax rules. The corporation files its own tax return and pays taxes on its income, and then if the corporation distributes some of its earnings in the form of dividends to its owners, the recipients must pay taxes on those dividends even though the corporation has paid taxes on its earnings.
- A corporation is more difficult to maintain than a partnership or LLC, in that corporate laws require formalities from corporations such as appointing a board of directors and officers, holding regular meetings of the board and shareholders, and providing owners with annual financial reports.
- S-Corporation: An S-corporation (or “S-corp”) is not a different type of entity than a corporation; in fact, they are registered and organized the same way. However, if the corporation’s shareholders meet the tests that are set forth by the U.S. Internal Revenue Service, then the corporation can make an election to be an "S" corporation for federal income tax purposes. An S-corporation is treated as a partnership for tax purposes, although it is treated as a regular corporation for other purposes.
- In most cases, the S-election is not available if one of the shareholders is an investment organization. Therefore, if the corporation takes on a venture capitalist as a shareholder, then the company can no longer enjoy the pass-through taxation.
- Benefit or social purpose corporation: A benefit or social purpose corporation is generally similar to a corporation in the way that it is organized and operated, except that in its Articles of Incorporation (or sometimes called a “Certificate” or “Charter”), the corporation sets forth a social purpose. Some characteristics of a social purpose corporation include:
- The social purpose is hard-wired into the business decisions of the corporation because the board and management must consider the social purpose set forth in the articles.
- The board of directors is protected when it makes decisions that further the social purpose, even if the decision may not make the most profit for the shareholders.
- A benefit or social purpose corporation may be able to be treated as an “S-corp.”
- Companies who organize as benefit or social purposes corporations typically do so not because they want to enjoy tax benefits, but because they perceive some benefit in adopting a social purpose. For example, Patagonia, Inc., an outdoor products company, became a Benefit Corporation in California in 2012. Their founder Yvon Chouinard said, “Benefit corporation legislation creates the legal framework to enable mission-driven companies like Patagonia to stay mission-driven through succession, capital raises, and even changes in ownership, by institutionalizing the values, culture, processes, and high standards put in place by founding entrepreneurs.”
- Nonprofit: Nonprofit companies are beneficial because they typically are not subject to income taxes. They are organized for an acceptable public purpose, such as charitable or religious purposes, and must be approved by the taxing authorities (such as the IRS) to enjoy tax exempt status. A downside of a nonprofit is that there are generally no private owners of the organization. The assets of the organization belong to the public, and cannot be used for purposes that do not further the nonprofit mission.
- For example, founder Jamie would like to set up an organization that will collect used eyeglasses in the United States, and distribute them to people with bad eyesight in countries who would not otherwise be able to afford eyeglasses. Jamie is not looking to make personal profit through growing the business, other than a reasonable salary in working for the organization. She chooses to organize as a nonprofit and apply for nonprofit status with the taxing authorities.
Steps You Should Take to Organize Your Business
No matter what business organization you choose, there are certain steps you will need to take to organize your business and minimize risk.
- Decide how organization will be divided. Take into consideration each owner’s contributions to the company. Be sure that contributions to the company (money, assets, talent, intellectual property) are always documented, and that the contributor is clear about what he or she is receiving in return for the contribution. Otherwise, disputes can arise, and contributors may try to argue that they are owners in the company even if that was not intended by you..
- Operate under a written agreement. Even early on in your business, when you may not have a product or service to offer yet, you may be working with other potential co-founders or partners. You should be sure that expectations are clear as to what each person’s expected role will be once the business entity is officially formed. This can be in the form of a simple partnership or pre-incorporation agreement.
- Document intellectual property ownership. Ensure that all registered forms of intellectual property, such as patents, trademarks, and copyrights, are assigned to the company via a formal written assignment signed by the inventor, author, and creator. In addition, all domain names should be in the name of the company. Finally, every person who is doing work on company business, whether as an advisor, employee, or independent contractor, must sign a confidentiality and assignment of intellectual property agreement.
- Issue the founders' stock or ownership shares as soon as the entity is formed. In an LLC, the ownership is defined in an Operating Agreement signed by all of the owners. In a corporation, the stock is typically issued by having each recipient enter into a stock purchase agreement with the company. Work diligently to complete these documents promptly after registering the LLC or corporation, in consultation with your attorney and tax advisor.
- Keep track of agreements. Be sure that when you enter into agreements such as non-disclosure agreements, employee or independent contractor agreements, leases, etc., that you obtain a copy with both parties’ signatures. Keep all signed agreements in a location where they can easily be accessed and tracked.
- Understand which tax laws affect you. Before making any decisions as to what sort of entity to choose, what state to incorporate in, or who should be an owner and for what percentage share of the company, you must seek the advice of a tax advisor to fully understand the tax implications associated with those decisions. As an example, in the United States, businesses and their owners can be responsible for:
- Income tax returns
- Franchise tax returns
- Employment tax returns
- Unemployment tax returns and payment
- Sales tax reports and payment
- Understand other laws and regulations that affect you. Every business must comply with a variety of laws, and consulting with a business attorney will help you to understand which of these apply to your business. The following is a partial list of some areas of law to take into consideration:
- Zoning and local business permitting
- Americans with Disabilities Act (ADA) requirements for US-based businesses
- Data privacy
- Product labeling and packaging
- Import and export
- Employment and labor
- Truth in advertising
- Securities Regulations
Professionals That Can Help
- Corporation filing services: Corporation filing services can assist with getting a business entity, such as an LLC or corporation, set up initially. Be aware, however, that some of these filing services specifically claim that they will not provide any legal advice. Because choosing the appropriate entity for you has many legal considerations, you will want to be sure to obtain competent legal advice and assess whether you can get that competent advice from the filing service.
- Attorneys: Business attorneys are often generalists who can assist a new business with a variety of issues, such as setting up your entity, finalizing investment paperwork, and reviewing contracts. A business attorney can also help to negotiate a lease agreement. Seek the assistance of a business attorney early on in the process of planning your business. Your new business may require specialized legal advice to establish and protect your intellectual property rights.Intellectual property includes your ownership rights to your business name, trademarks, copyrights, and patents. Intellectual property law is a specialized field, and you may need an attorney who specializes in these matters. Some government agencies or universities offer free legal advice to small businesses through events, clinics, or workshops. Check local administrations and mentors for information.
- Accountants: Your accountant can be an important advisor in start-up decisions, such as:
- Deciding the appropriate division of the capital you contribute to a corporation between stock and loans.
- Determining the best type of business entity.
- Advising as to tax implications associated with granting stock to founders or employees.
- Helping set up the books and records of the business.
- Advising software needs for accounting purposes.
- Determing which state to organize in, based upon your ownership structure and business plan.
- Filing tax returns, advising on the compensation of owners, preparing financial statements, helping forecast cash needs, including whether to expand, the addition of employees and determining profitability.
- You will need to decide with your accountant what kind of financial statements are prepared. There are several audit levels that are described in Session 1 Getting Financial Controls in Place in the Business Expansion course.
- Payroll and HR services: It’s a good idea to use a Payroll service provider (PSP) to prepare payroll checks right from the beginning because getting the calculation of pay and withholdings wrong can create liability for your business. PSPs often handle other personnel issues as well, such as managing retirement plans, workers compensation insurance, and pre-employment verification. Many payroll service providers incorporate services such as:
- 401(k) and Simple IRA
- Business tax protection and payment
- Employee and manager training
- Employee postings and handbook
- Health insurance
- Human resources help desk
- Human resources software
- New hire reporting
- Pay-by-Pay workers compensation insurance
- Payroll tax calculation, deposit, and filing
- Pre-employment screening/background checks
- Reporting solutions
- State unemployment insurance management
- Time and attendance solutions
- Benefits consultants: Some payroll or HR providers may also offer advice on benefits; if not, then you may be able to find benefits consultants by doing an internet search. Benefits consultants can help you to understand the benefits that may be available to you as a business owner, such as a tax-deferred pension plan, but can also assist with understanding what benefits are required or recommended for employees.
- Insurance brokers: An insurance broker can help you to assess the appropriate types and coverage amounts to protect your business. Even if you choose to set up a limited liability business entity such as a corporation or LLC, there can be situations in which personal liability can attach to owners, directors, or officers. Therefore, obtaining insurance is recommended for all business forms.
- Pre-employment screening: Pre-employment screening can be especially important when you are starting because you don't have ongoing revenues to offset mistakes. Many new businesses skip screening because they're unfamiliar with it or don't know how to have it done at a reasonable cost. Unfortunately, this can open them up to resume fraud among other undesirable possibilities. Also, many tips on how to go about the hiring process can be found through search engines by entering "hiring tips."
Top Ten Do's and Don'ts
THE TOP TEN DO'S
- Use a "Pro" and "Con" list when deciding if and whom you should have as a partner.
- If considering a partner, look for someone with complementary skills to your own.
- If you take on a partner, be sure to have a partnership agreement in place that provides how decisions will be made even if you don’t agree.
- Consider whether your business is incurring liability, and at what stage it might incur liability, when deciding whether to set up a corporation or LLC.
- Consult with a lawyer when deciding on what form of business best suits your needs.
- Be sure that all partners, founders, and/or other individuals working in the company sign an agreement to assign their intellectual property rights to the business through a formal signed agreement.
- Consult with an accountant or tax advisor before setting up a business entity.
- Use an intellectual property lawyer to protect your intellectual property rights such as your trademarks, company name, logo, or product.
- Outsource your payroll responsibilities to a payroll service provider, as getting the calculation of pay and withholdings wrong can create liability for your business.
- Obtain insurance for your business, even if you have set up a limited liability entity like a corporation or LLC.
THE TOP TEN DON'TS
- Use a sole proprietorship or general partnership if you intend to limit your liability.
- Start a corporation without consulting a lawyer or tax adviser first.
- Fail to issue the founders stock as soon as a corporation is formed.
- Sell stock in a corporation without consulting an attorney and obtaining required governmental approvals.
- Fail to pay your payroll tax liabilities on time. You may be personally liable even if you set up a limited liability company such as a corporation or LLC.
- Sign a lease or important agreements without your lawyer's advice.
- Start your business without retaining an accountant and having an accounting system in place.
- Start a business with a handshake agreement amongst partners or founders.
- Rely on your LLC or corporation as protection from personally guaranteed liabilities.
- Fail to take the advice of your lawyer and accountant seriously.
Business Plan for Session 5: Business Organization
Featured Video: Partnerships, LLCs, Corporations-What's Best for Your Business
Featured Video: Choice of Business Entity and Formation