Business Law

Legal Mistakes That Cost Entrepreneurs Time, Money and Headaches…And How to Avoid Them

Entrepreneurs must navigate through a maze of legal issues and decisions when launching a new business. At the outset, you may think some seem inconsequential – but, tragically, that would likely be your first of many mistakes. The choices you make today will have lasting effects on the viability and profitability of your new business venture. Below are some of the most common mistakes made by first-time entrepreneurs, and what you can do to avoid making them yourself.

Choosing the Wrong Business Structure

The type of business entity you select will affect your liability exposure, income tax obligations and opportunities to raise capital throughout the duration of your venture. Sole proprietorships, C-corporations, S-corporations and limited liability companies (LLC) all have their advantages and drawbacks. Sole proprietorships are simple to start up, but leave your personal assets vulnerable and offer few tax advantages. C-corporations and S-corporations shield your personal assets, and each afford different tax advantages and disadvantages. Additionally, maintaining the protection afforded by the corporate business structure requires a certain amount of record-keeping and forms which must be filed with governmental agencies. LLCs offer you liability protection, but may not be the best choice depending on various factors, including taxes, ownership structure and, in some states, professional licensure. Often, the corporate structure is the most advantageous, but this decision really should be made in consultation with a business or tax attorney.

The “Gentlemen’s Agreement” – A Handshake and Your Word

Your word may be your honor, but a written contract is the only way to be sure all parties share a mutual understanding regarding their obligations. Whether it is your best client, that independent contractor you’ve been courting, or vendors you have known for years, do not assume everything will go according to plan. Putting your agreement in writing not only ensures that everyone’s expectations are clear, it is also valuable evidence in the courtroom, should things not proceed according to plan. Bottom line – get it in writing!

Adding Partners Without a Written Agreement

It’s easy to sweep this one aside when you are passionately focused on the work of getting your business off the ground. And those new partners likely share your same passion. However, until a detailed written Partnership Agreement is drafted and signed, you may be unclear about each other’s expectations in the short term, or, if your business is wildly successful, tied up in protracted, long-term litigation, to establish who owns what (Facebook comes to mind). Redirect some of that passion, and benefit from the goodwill it creates, to negotiate a Partnership Agreement early on that covers responsibilities, ownership structure, provisions for transferring ownership, and what happens when there’s a disagreement about the direction of the company.

Sharing Ownership 50/50

Establishing equal percentages of ownership in the company sounds like a fair and reasonable arrangement. However, this type of situation makes it difficult to bring on investors, and can bring the company to a standstill if the partners cannot agree on a decision. Instead, issue shares in the company in such a manner that investors can be added later; and make sure those shares are distributed to the founders with at least a 51/49 split, giving the majority shareholder the authority to make executive decisions even if there is a stalemate.

Family Businesses: Simple Steps to Avoid Common Pitfalls

If you have a family business or are thinking about starting one, kudos to you! There are few better ways to create tradition, meaning and bonds within a family, and a family business can be a gratifying way by which to build wealth.

Family enterprises, however, can bring conflict, legal challenges and financial distress when simple preventative steps are not taken. A business law attorney can assist you with the following issues commonly faced by family businesses:

• The absence of a succession plan. If the leader of a business dies, sells or becomes incapacitated, the business he or she leaves behind will appoint a leader, somehow, by necessity. The succession process at that point, however, will likely be complicated, and the result may not be optimal for the business or your family. An attorney can assist in identifying all of your options, and help you select one that works best for you and your business. For instance, if the business belongs exclusively to you, you can simply leave it to the person you feel should own and run it. If the business is professional in nature, such as a medical or legal practice, you can identify an outside buyer/successor and prepare him or her using a process agreeable to both of you. If the business belongs to two or more family members or other individuals, a contractual succession plan can be devised, lessening stress both now and at the time the succession occurs.
   
• The lack of employment agreements. It’s rare that families who start businesses together are initially comfortable discussing the particulars of vacation and sick days, wages, raises and absenteeism. Yet these issues affect every business and will affect yours. The time for all parties to discuss expectations and rules is now, before issues arise, not later, when issues have already led to resentment and confusion.
   
• The failure to acquire a business license. Often, small business start-ups skip the step of acquiring a business license that may be required in a particular industry, perhaps choosing instead to wait and see whether the business will succeed. It’s important, though, not to avoid this step. By not acquiring a business license and necessary zoning permits and by not meeting other legal requirements, you expose your business not only to penalties but also the possibility of being shut down with financial and reputational consequences that accompany an unexpected closing.
   
• Mixing personal and business funds. The separation of personal and business funds isn’t just good business; it can save you money. When personal money “disappears” into a business owned by you and others, you’ve lost at least part of those funds regardless of how successfully they’re put to use by the business. An issue related to separating personal and business funds is that of separating personal liability from that of the business. By housing the business in a legal entity, such as a corporation or limited liability company, you can shield yourself from liabilities faced by the business.

Drafting contracts, obtaining needed licenses, negotiating with municipal entities and selecting and creating a business entity can involve complex legal issues. To ensure success and to protect your interests, contact a qualified business law attorney.

Limited Liability Company (LLC): An Overview

The limited liability company (LLC) is a hybrid type of business structure, offering business owners the best of both worlds: the simplicity of a sole proprietorship or partnership, with the liability protection of a corporation. A limited liability company consists of one or more owners (called “members”) who actively manage the company’s business affairs. LLCs are relatively simple to establish and operate, with minimal annual filing requirements in most jurisdictions.

The best form of business structure depends on many factors, and must be determined according to your particular business and overall goals:

Advantages

• LLC members enjoy a limited liability, similar to that of a shareholder in a corporation. In general, your risk is limited to the amount of your investment in the limited liability company. Since none of the members will have personal liability and may not necessarily be required to personally perform any tasks of management, it is easier to attract investors to the limited liability company form of business than to a general partnership.

• LLC members share in the profits and in the tax deductions of the limited liability company while limiting the potential financial risks.

• LLCs offer a relatively flexible management structure. The business may be managed either by members or by managers. Thus, depending on needs or desires, the limited liability company can be a hands-on, owner-managed company, or a relatively hands-off operation for its members where hired managers actually operate the company.

• Because the IRS treats the limited liability company as a pass-through entity, the profits and losses of the company pass directly to each member and are taxed only at the individual level (which may or may not be an advantage to you, depending on the profitability of the LLC and your personal income tax bracket).

• Members of an LLC have flexibility in dividing the profits and losses. In a corporation or partnership, profits must be divided according to percentage of ownership. However, with an LLC, special allocations are permitted, so long as they have a “substantial economic effect” (e.g. they must be based upon legitimate economic circumstances, and may not be used to simply reduce one member’s tax liability).

Disadvantages

• Limited liability companies are, generally, a more complex form of business operation than either the sole proprietorship or the general partnership. They are subject to more paperwork requirements than a simple partnership but less than a corporation. Annual filings typically include statement and nominal filing fee payable to the Secretary of State, informational returns to the IRS, and filing of a state tax return.

• In certain jurisdictions, single member LLCs may not be afforded the same level of limited liability protection as that of an incorporated entity.

Also note that in many states, an LLC is prohibited from rendering “professional services” which can include companies providing services that require a license, registration or certification.   Such professionals typically have to establish a Professional LLC which does not offer limited liability for professional malpractice.

Overview: Buy-Sell Agreements and Your Small Business

If you co-own a business, you need a buy-sell agreement. Also called a buyout agreement, this document is essentially the business world’s equivalent of a prenup. An effective buy-sell agreement helps prevent conflict between the company’s owners, while also preserving the company’s closely held status. Any business with more than one owner should address this issue upfront, before problems arise.

With a proper buy-sell agreement, all business owners are protected in the event one of the owners wishes to leave the company. The buy-sell agreement establishes clear procedures that must be followed if an owner retires, sells his or her shares, divorces his or her spouse, becomes disabled, or dies. The agreement will establish the price and terms of a buyout, ensuring the company continues in the absence of the departing owner.

A properly drafted buy-sell agreement takes into consideration exactly what the owners wish to happen if one owner departs, whether voluntarily or involuntarily.  Do the owners want to permit a new, unknown partner, should the departing owner wish to sell to an uninvolved third party? What happens if an owner’s spouse is involved in the business and that owner gets a divorce or passes away? How are interests valued when a triggering event occurs?

In crafting your buy-sell agreement, consider the following issues:

• Triggering Events - What events trigger the provisions of the agreement?  These normally include death, disability, bankruptcy, divorce and retirement.
   
• Business Valuation - How will the value of shares being transferred be determined? Owners may determine the value of shares annually, by agreement, appraisal or formula.  The agreement may require that the appraisal be performed by a business valuation expert at the time of the triggering event.  Some agreements may also include a “shotgun provision” in which one party proposes a price, giving the other party the obligation to accept or counter with a new offer.
   
• Funding - How will the departing owner be paid?  Many business owners will obtain insurance coverage, including life, disability, or business continuation insurance on the life or disability of the other owners.  With respect to life insurance, the agreement may provide that the company redeem the departing owner’s shares (“redemption”).  Alternatively, each of the owners may purchase life insurance on the lives of the other owners to provide the liquidity needed to purchase the departing owner’s shares (“cross purchase agreement”).   The agreement may also authorize the company to use it’s cash reserves to buy-out the departing owners.  
   

You’ve Planned for Your Business, But Do You Have an Adequate Business Plan?

Much like the blueprints that help a contractor build a house, your business plan is an essential component of your start-up activities, helping you define where you want your company to be within a few years and how you plan to get there. Business plans can vary from simple, one-page documents to lengthy tomes.

Once created, your business plan is not set in stone. Your company will naturally evolve over time and be influenced by outside factors. As such, successful entrepreneurs consider their business plans to be a work-in-progress, to be updated to reflect changes in the marketplace. The important thing to remember is that a good plan includes only the information you need, nothing more and nothing less.

Some successful entrepreneurs have abandoned the old notion of lengthy business plans containing extraneous information. As the company evolves, much of a comprehensive document may become obsolete and have to be discarded. Or, worse, you might find yourself so invested in the plan itself that you resist changes that may be beneficial to the company. Instead, think of a business plan as the following four items:

• A description of the business and leadership team
• A well-defined target market
• Competitive advantage(s) of your product or service
• Three years of projected financial statements

When you are in the early stages, attempting to secure the first round of capital financing, investors are most concerned with the leadership team and what they are going to do. In later stages, the financial data takes on a more pivotal role. Care should be taken to focus on your target market and the overall concept, rather than getting bogged down in the details of a complicated business plan. Potential investors will be closely examining many areas of your business plan, including the team, target market, product or service you offer and financial projections.

Your Leadership Team
The best start-up business teams include a mix of varied strengths that complement each other. The individual who will be managing the business and developing the products or services offered are of the utmost importance.

The Target Market
Your business plan must describe the target market sufficiently to convince investors that you will have customers and that there is a need for whatever it is you have to sell. Be realistic, and include parameters such as the size of the market and the competition.

Competitive Advantage
What is your competitive advantage?  Is it something unique about the product or service your company offers?  And if you do have a killer concept, what prevents a competitor from copying it?  What is the barrier to entry? If the product or service itself is not unique, be sure to demonstrate how you intend on marketing it in a way that sets it apart from the competition.  

Financial Projections
Provide a reasonable estimation of what your profit and loss will be over the course of the first few years of business operations. Of course, this estimate is subject to change, but it will provide some guidelines to let investors, and your leadership team, know what milestones you expect to meet along the way.

Above all, make sure you demonstrate to potential investors that you have carefully and realistically thought through your business plan, and that you are prepared to make changes along the way when adjustments are necessary.

Do You Need Meeting Minutes?

Regardless of the size of the business, corporations (including those organized under Subchapter S) must observe all of the required formalities in order to maximize the benefits of a corporation. Corporate meeting minutes document the decisions made by the company’s board of directors, and are necessary to preserve the “corporate veil” in the event of a lawsuit or other claim against the company. If corporate formalities are not observed, your own personal assets may be at risk.

One such formality is the maintenance of a corporate record book containing minutes of meetings conducted in accordance with the company’s bylaws. Even in a one-person corporation, board resolutions must be drafted, signed and kept in the corporate records. Every major decision that affects the life of the business must be ratified by a board resolution contained in the corporate records.

There is no specific required format for meeting minutes, but the document should include any important decision made regarding the company, its policies and operations. Minutes should include, at a minimum:

• Date, time and location of the meeting
• Names of all officers, directors and others in attendance
• Brief description of issues discussed and actions taken
• Record of how each person voted, whether the vote was unanimous and whether anyone abstained from voting
• Vote and approval of the prior meeting’s minutes

How do you know whether a decision needs to be documented in the meeting minutes? Generally, if a transaction is within the scope of the company’s ordinary course of business, it need not be addressed in the minutes. On the other hand, major decisions should be documented in the minutes, such as:

• Significant contracts
• Leases
• Loans
• Marketing campaigns
• Reorganizations and mergers
• Employee benefit plans
• Elections of directors or officers

Non-incorporated entities such as limited liability companies are generally exempt from performing such formalities.

C-Corporation Vs. S-Corporation: Which Structure Provides the Best Tax Advantages for Your Business?

The difference between a C-Corporation and an S-Corporation is in the way each is taxed. Under the law, a corporation is considered to be an artificial person. Shareholders who work for the corporation are employees; they are not “self-employed” as far as the tax authorities are concerned.

The C-Corporation

In theory, before a C-corporation distributes profits to shareholders, it must pay tax on the income at the corporate rate. Then, leftover profits are distributed to the shareholders as dividends, which are then treated as investment income and taxed to the shareholder. This is the “double taxation” you may have heard about.

C-Corporations enjoy many tax-related advantages :

• Income splitting is the division of income between the corporation and its shareholders in a way that lowers overall taxes, and can avoid or significantly reduce the potential impact of “double taxation.” By working with a knowledgeable tax advisor, you can determine exactly how much money the corporation should pay you as an employee to ensure the lowest tax bill at the end of the year.
• C-Corporations enjoy a wider range of deductible expenses such as those for healthcare and education.  
• A shareholder can borrow up to $10,000 from a C-Corporation, interest-free. Tax-free loans are not available to sole proprietors, partners, LLC members or S-Corporation shareholders.

S-Corporation
S-Corporations pass income through to their shareholders who pay tax on it according to their individual income tax rates. To qualify for S-Corporation status, the corporation must have less than 100 shareholders; all shareholders must be individual U.S. citizens, resident aliens, other S-Corporations, or an electing small business trust; the corporation may have only one class of stock; and all shareholders must consent in writing to the S-Corporation status.

Depending on your situation, an S-Corporation may be more advantageous:

• Electing S-Corporation tax treatment eliminates any possibility of the “double taxation” referenced above. S-Corporations pay no federal corporate income tax, but must file annual tax returns. Because losses also flow through, shareholders who are active in the business can take most business operating losses on their individual tax returns.
• S-Corporations must still file and pay employment taxes on employees, as with a C-Corporation. An S-Corporation may not retain earnings for future growth without the shareholders paying tax on them. The taxable profits of an S-Corporation pass through to the shareholders in the year they are earned.
• S-Corporations cannot provide the full range of fringe benefits that a C-Corporation can.

A Stitch in Time … Strategies to Prevent Business Litigation

A lawsuit can damage more than just the bottom line of your business.  In addition to costing money that could be put to better use, a lawsuit is also an unwelcome distraction for the owner, managers and employees.  It can also do irreparable damage to business relationships and reputation.

It may not be possible to avoid any and all legal conflict during the life of your business, but by considering the following advice, you should be able to minimize the resources you have to devote to litigation – which means more time and money available for your business operations and investments.

1. Don’t rely on a handshake.  Reduce all business agreements to writing, even if they are with your oldest and dearest friend.  Be clear about terms and expectations.
2. Keep a written record of all communications.
3. Keep the lines of communication open, especially when a business relationship starts to sour.  Aggressive communication may be able to cure the damage before a lawsuit becomes necessary.
4. Don’t put your head in the sand.  If a threat appears that could lead to litigation, respond quickly, thoughtfully and thoroughly.
5. Check your compliance with relevant government regulations.  Import/export? Check the laws.  Using hazardous materials? Check the regulations. Don’t allow shortcuts.
6. Create a business culture that rewards employees for reporting violations of any laws or government regulations.  Your employees on the ground can be your best resource for uncovering potential hazards that could lead to litigation.
7. Put cure provisions and mediation provisions into your contracts with vendors.
8. Complete a business succession plan to minimize or eliminate disputes over exit strategies.
9. Conduct regular safety checks of the physical premises, including vehicles used for company business.
10. Conduct criminal background checks on prospective employees that comply with the law.
11. Provide regular health and safety training for employees.
12. Provide ongoing training for human resources personnel.
13. Review whether your employees are properly classified as hourly or salaried workers to comply with the Fair Labor Standards Act.
14. Review whether any independent contractors should be reclassified as employees to comply with the Fair Labor Standards Act.
15. Respond promptly and thoroughly to complaints from employees, customers or vendors.
16. Use email, the internet, your company website and social networking media with caution.  Assume that any information shared via these platforms will be publicly accessible until the end of time.
17. Seek outside advice when necessary.  Don’t let your ego be your downfall.  If you don’t understand your legal obligations and rights in a particular circumstance, consult a qualified commercial law attorney.

Can My Employer Enforce a Covenant Not to Compete?

Many employers require their employees to sign agreements which contain covenants not to compete with the company.  The enforceability of these restrictive provisions varies from state-to-state and depends on a variety of factors. A former employee who violates an enforceable non-compete agreement may be ordered to cease competitive activity and pay damages to the former employer.  In other covenants, the restrictions may be deemed too restrictive and an undue restraint of trade.

A covenant not to compete is a promise by an employee that he or she will not compete with his or her employer for a specified period of time and/or within a particular geographic location. It may be contained within an employment agreement, or may be a separate contract. Agreements which prevent employees from competing with the employer while employed are enforceable in every jurisdiction. However, agreements which affect an employee’s conduct after employment termination are subject to stricter requirements regarding “reasonableness,” and are generally disallowed in some states, such as California which has enacted statutes against such agreements except in very narrow circumstances.

Even in states where such covenants are enforceable, courts generally disfavor them because they are anti-competitive. Nevertheless, such agreements will be enforced if the former employer can demonstrate the following:
 

• The employee received consideration at the time the agreement was signed;
• The agreement protects the employers legitimate business interest; and
• The agreement is reasonable to protect the employer, but not unduly burdensome to the employee who has a right to make a living.

Consideration

Under the principles of contract law, all agreements must be supported by consideration in order to be enforceable. The employee signing the covenant not to compete must receive something of value in exchange for making the promise. If the agreement is signed prior to employment, the employment itself constitutes consideration. If, however, the agreement is signed after employment commences, the employee must receive something else of value in exchange for the agreement to be enforceable.

Legitimate Business Interest

Legitimate business interests can include protecting and preserving confidential information (trade secrets) and customer relationships. Most states recognize an employer’s right to prevent an employee from taking advantage of information acquired or relationships developed as a result of the employment arrangement, in order to later compete against the employer.

Reasonableness

Based on the circumstances, a covenant must be reasonably necessary. If the covenant is overly broad, or unduly burdensome on the employee, the court may refuse to enforce the agreement. Therefore, the covenant must be reasonable in both duration and scope. If a covenant is overly broad, the court may narrow its scope or duration and enforce it accordingly. But if a covenant is so broad that is clearly was designed to prevent lawful competition, as opposed to protecting legitimate business interests, the court may strike down the agreement in its entirety.

To enforce a covenant not to compete, the employer can file a court action seeking an injunction against the employee’s continued violations of the agreement. The company can also seek monetary damages to cover losses resulting from the employee’s breach.

Many business owners establish corporations to shield themselves from personal liability for business debts and protect their personal assets from creditors of the company. When established and maintained properly, a corporation is treated under the law as an independent entity, with many of the rights afforded to individuals. Such rights include the ability to own and transfer property, enter into contracts, obtain funding and to initiate legal action. A corporation is a separate, distinct entity, apart from its shareholders; as a result, only the corporation’s assets can be seized to pay judgments or satisfy other debts owed by the company.

However, the liability protection afforded by the corporate business structure is only available if the integrity of the corporation as a separate entity is respected by the courts and taxing authorities. Certain corporate formalities must be observed in order to preserve the corporation’s status as a separate entity apart from its owners. Failure to comply with these requirements may permit creditors to “pierce the corporate veil” and seek payment from the individual shareholders directly. To ensure the corporate veil remains intact, the corporation must act like a separate and distinct entity, and the shareholders must treat it as such. If certain corporate formalities are not consistently observed, a court may find that the corporation is merely an “alter ego” of the individual owner(s), and the corporate structure may be “disregarded”. When this occurs, the corporate veil is pierced and the individual shareholders can be held personally liable for the debts of the company.

Formalities that must be observed in order to preserve the integrity of the corporation and ensure the protection afforded by the corporate veil remains intact include:

Corporate Records
The corporation’s financial and corporate records must be documented. Most states also require that the shareholders and the directors meet at least once per year. A record of these meetings, in the form of minutes or written resolutions must be properly executed and maintained by the company.

Commingling of Assets
The corporation and the shareholders must treat themselves as separate entities. The corporation should have its own bank and credit card accounts.  Business owners should clearly document and account for expenditures made from corporate accounts if they were for personal benefit.

Capitalization
The corporation must be fully capitalized, or funded. This is typically accomplished by selling shares. Even in a one-person corporation, that individual shareholder must purchase his or her shares of stock in the company.  The corporation should also avoid becoming intentionally insolvent by transferring assets to the shareholders if it is likely that such transfer will inhibit the corporation’s ability to meet its financial obligations.

Failure to Pay Dividends
Payment of dividends is neither required, nor appropriate in every situation. However, if the payment of dividends is appropriate, or required, and the corporation fails to pay them, this could suggest that the corporation is actually an alter ego and not a separate legal entity.
 

Regardless of the size of the business, corporations (including those organized under Subchapter S) must observe all of the required formalities in order to maximize the benefits of a corporation. Corporate meeting minutes document the decisions made by the company’s board of directors, and are necessary to preserve the “corporate veil” in the event of a lawsuit or other claim against the company. If corporate formalities are not observed, your own personal assets may be at risk.

One such formality is the maintenance of a corporate record book containing minutes of meetings conducted in accordance with the company’s bylaws. Even in a one-person corporation, board resolutions must be drafted, signed and kept in the corporate records. Every major decision that affects the life of the business must be ratified by a board resolution contained in the corporate records.

There is no specific required format for meeting minutes, but the document should include any important decision made regarding the company, its policies and operations. Minutes should include, at a minimum:

• Date, time and location of the meeting
• Names of all officers, directors and others in attendance
• Brief description of issues discussed and actions taken
• Record of how each person voted, whether the vote was unanimous and whether anyone abstained from voting
• Vote and approval of the prior meeting’s minutes

How do you know whether a decision needs to be documented in the meeting minutes? Generally, if a transaction is within the scope of the company’s ordinary course of business, it need not be addressed in the minutes. On the other hand, major decisions should be documented in the minutes, such as:

• Significant contracts
• Leases
• Loans
• Marketing campaigns
• Reorganizations and mergers
• Employee benefit plans
• Elections of directors or officers

Non-incorporated entities such as limited liability companies are generally exempt from performing such formalities.