Your business is important to you. As such, it is equally important for your legal advisor to fully grasp your needs and goals so that the advice given helps you achieve them. If you are considering starting your own business, take a few minutes to think about the topics below. These are not in any set order, in fact, you probably addressed some of these issues already, but taking the time to reflect upon how they all fit together can help you establish a plan to reach your goals.
1. Owners of the Company
Yes, this is a pretty basic question; yet, it is one of the things that several small businesses struggle with identifying. For sole proprietors looking to protect their assets, this question is not that difficult. For those businesses that come about because of the work/thoughts/ideas of several individuals, but the financial backing of just a few, this becomes a much harder process. For instance, when multiple people are involved, is there any one person’s special skills, or resources, that are needed when compared to others? Will you be offering incentive plans to retain certain employees? Will you seek or need funding from outside sources? Will those investors be actively or passively involved in the day-to-day operations of the business? While this list can become overwhelming, these basic questions should be addressed, even if it is merely in your own mind, because the answers can impact how you structure your business from a legal perspective.
2. Rights of the Owners
Once we know who the owners are, we then need to figure out the scope of their ownership rights. For instance, will all shareholders have a say in the day-to-day operations? If there are only two owners, how will decisions occur when there is a difference of opinion about which course of action to pursue? Are there going to be different classes of stock to address the different types of owners – meaning passive versus active, or founders versus later investors? The best example of this is Ford. When Ford was founded, there was one class of stock, as it grew and needed outside capital to fund its expansion, multiple classes of stock were formed, each with different rights, while the original shares retained an overly-large percentage of the overall voting power. That is why, to this day, the Ford family still retains considerable sway in the strategic management of the Company. If additional capital contributions are needed because of operating losses, are all owners required to contribute the same amount in total, or is it based upon their ownership percentage? Without a plan in place that addresses ownership rights, you can be laying the groundwork for future disputes.
3. Profits and Losses
The distribution of profits and losses is closely tied to the notion of ownership and ownership rights. If the goal is to have an equal voting share, but a splitting of profits and losses that is based upon time spent working on the business, that is important to know now so that the correct legal structure is selected. Is the salary that an owner earns while working in the business going to count towards their percentage of how profits or losses are split? This is an important issue that needs careful consideration so that the expectations of the owners are addressed at the front-end, and any grumbling is kept to a minimum. There is nothing worse than owners squabbling over money which leads to the downfall of a profitable business, or the ending of a long-time relationship.
4. Management of the Company
This may seem like an unnecessary step for some business; however, having a plan in place for how the day-to-day operations of the business are managed is important to the company’s long-term health and growth. Providing a clear reporting structure for those tasked with the day-to-day operations is critical for the continued success of a business. There is nothing worse than finding yourself having to answer to two masters, each of whom has a different idea as to how to proceed with a project.
Not only is a detailed reporting structure necessary, but so is the delegation of duties/responsibilities to management. Nothing kills morale quicker than assigning a task, but not empowering the person with the requisite authority to achieve that task. Establishing concrete guidelines relating to the authority that management has not only aids in morale, but also lets those dealing with your business know if they have a deal that can be relied upon, or if additional approval is necessary. There is nothing more frustrating than spending your time negotiating a deal only to learn that the person you are dealing with does not have the authority to make the deal because no one told them that they did not have that power. As your business grows, you will need to determine how much authority is delegated to others, and how much you will keep.
5. Buy-Sell Agreement
You’ve created the company with your business partner, someone that you know, like and trust. Then, a year down the road, two years down the road, the unexpected happens – whether it be a falling out, the need for money, or something more traumatic like death or divorce – you now are faced with having someone that you don’t know, or like, or trust, being your co-owner/partner in your business. All is not lost. There is a way to avoid this situation with proper planning, and a knowledgeable attorney guiding you through the process. How, you may ask, can I minimize the chance of this happening since no one knows what tomorrow holds? The answer is simple – a buy-sell agreement between all shareholders that addresses these, and additional issues, in such a way that ensure you, or the company, has the ability to purchase the shares first before this outsider sticks their nose in your tent.
6. Type of Entity
After addressing the first five questions, you are in a better position to figure out the next step – what type of entity you need to form for your business. Why is this a big deal? Simple, the type of entity that you form impacts multiple facets of how 1) the company is operated; 2) how taxes are assessed, and 3) are their legal restrictions imposed upon your area of business? There are multiple options, they are briefly, and I do mean briefly, outlined below to give you a general idea as to what option may be best for your situation. For a more detailed discussion, please download my free business structure guide.
a) Sole Proprietorship
A sole proprietorship is the most basic type of business to establish. You alone own the company and are responsible for its assets and liabilities. Unfortunately, there is no liability protection for you or your stuff, but it is the simplest entity to control.
There are several different types of partnerships, which depend on the nature of the arrangement and partner responsibility for the business.
People form cooperatives to meet a collective need or to provide a service that benefits all member-owners. The best example of this is Land O’Lakes. Yep, the butter and cheese manufacturer is actually a cooperative. Most cooperatives are in the agriculture area, but they can be used in certain other areas as well.
This is the most recognizable entity, and there are two types from a tax perspective – a C Corporation, or an S Corporation. Most small businesses will benefit from making a Subchapter S election with the IRS, thereby becoming an S Corporation, and enjoying certain tax advantages. Yes, there are eligibility requirements to become an S Corporation, but they are relatively straightforward and easy to meet. A C Corporation is suggested if you have a large number of shareholders, or want more than one type of stock.
e) Limited Liability Company
A LLC provides some of the same limited liability features of a corporation, but under certain circumstances they can provide additional tax benefits.
f) Professional Corporation, or Professional Limited Liability Company
Yep, there is a separate category of corporate entities available to professionals. In Texas a Professional Corporation or Professional Limited Liability Company is open to more types of professionals than other states. For instances, Home Inspectors licensed through TREC can have a professional corporation.
7. Exit Strategy
The most overlooked area when forming a company is having an exit strategy. Whether it is a personal one, or one for the company as a whole, it is something worth thinking about and, depending upon how formal you want to get, putting the requisite documents in place to ensure that the plan is executed. For instance, does your plan involve family members taking part in the business at a later time? How will you move ownership to them? Do you just plan to grow and sell the business off to an outside interest? Is the business primarily used as a means of income for the owners until retirement or will it be an investment vehicle to be sold later? A solid exit strategy will make this transition as smooth as possible for when the time comes.
By thinking through these questions first it will give you some idea of the process in which I help many business owners get started as painless as possible so they can begin growing and making decisions they are confident in. With an ironclad plan in place, you will maximize your company’s chances of success by ensuring everything has been done correctly in a legal manner.