Whether you’re a pro in your field or you are literally just stating out, there are several things you really need to take care of, but today I’m just going to cover six that fall under the Pretty Big Deal department of business law.
It is critical to the health of your future company to determine how best to set up your business. The business entity you choose depends upon how you intend to run your business and on your long-term goals. Common business entity options include organization as a C Corp, S Corp, or an LLC. C Corps pay taxes. LLCs partnerships, and S Corps do not. They are pass through organizations and the owners pay directly.
Money is an opportunity creator–If your goal is to attract equity financing, you do not want to be set up as an LLC, an S Corp, partnership or an LLC taxed as an S Corp. Instead, you want to form a C Corp for your company. S Corps cannot seek outside equity financing and can only accept single individual financing. Stated another way, no private equity can be given in exchange for funds to grow your business if you are an S Corp.
Businesses structured as C-Corps are preferred by venture capital firms because a C Corp is a good vehicle for businesses that are focused on building long-term equity value in the business as opposed to distributing profits right away directly to shareholders. Simply put, if you are seeking equity financing or want to give your employees equity in the startup as a form of payment, a C Corp is the right vehicle to accomplish these goals.
Venture Capital firms prefer C Corps because:
- There are no limits on how many shareholders the C Corp can have.
- A C Corp allows you to have different classes of shareholders with different rights.
- Many Limited Partners of venture capital firms are tax free entities (i.e. non-profits, endowments, foundations) and investing in a pass through entitles, such as an LLC, creates a potential tax risk for Limited Partners. This fact dissuades them from investing any entities other than C Corps.
If you are not seeking VC funding or planning to give equity to employees or to secure funding through giving equity in your business, then generally speaking, an LLC is the best entity for your business.
2. Funding the business on a shoestring
New business owners need to spell out what each owner is putting into the business, how each owner gets paid, and how to allocate losses. You can fund your business in the following ways:
- Out of pocket.
- If you have a good month, out of proceeds. Plough those extra dollars back into the business
- Friends and family- a couple thousand dollars here and a couple thousand dollars there can pay your bills for a month or pay for upgrades to boost your business.
- Crowdfunding and social media.
- Sweat equity-if your business has significant potential, you may be able to get employees to work for equity in the business. Of course, this arrangement must be spelled out clearly in the governing documents of your business.
If there is more than one owner, new businesses should think about when certain ownership rights will vest, which is typically after some set of agreed upon requirements for each owner are met. The basic purpose of your agreement regarding vesting should be to create a long-term incentive to help the business grow. If you are dealing with stock options, there are different ways to structure stock options, which have different tax consequences, and you should meet with a seasoned attorney to discuss this.
4. Leaving the business
Owners need to think about the circumstances which would justify you and your co-founder’s removal from the business and, if necessary, from the board of directors. Also, a new business owner needs to think about how to disentangle owners from the business should they decide to sell. Your governance documents should have provisions addressing these scenarios. If the business is a corporation, you probably need to implement transfer restrictions on stock, meaning that a shareholder cannot sell shares without the board’s consent. At a minimum, your company needs a right-of-first-refusal agreement
5. Protect your business interests
New businesses need to make sure they protect their trade secrets and intellectual property. Have an attorney prepare employment agreements, independent contractor agreements, non-competes, and non-solicitation agreements to protect your business interests.
It is important to have an attorney draft and/or review your contracts. Even if you are a small business and don’t have the leverage to negotiate as much as you would like, you should understand what you are signing. (This includes leases, agreements from service providers, and contracts provided by clients.) Not only do you want to ensure your business is complying with the law, but you also need to properly understand what you might be “signing away.” No one ever wants to think badly about another person, even a friend, but contracts are essential for protecting both parties!
This list is, of course, not exhaustive, but it’s a good place to start. And if you’re confused by any of it, or really don’t know where to start, I’m always glad to help!