Starting your own business can be an exciting and rewarding experience. Often, the first question a budding entrepreneur will ask is whether to incorporate or not. This is only one, however, among a host of questions that must be asked; it may be far from the most important issue you need to face.
In this article, we address some of the practical questions that should be considered before embarking on a new business venture. We also discuss the forms or types of business ownership and the advantages and disadvantages of each.
What is your present status?
If you are unemployed, does it make better sense, given your skills and resources, to work for another company or to strike out on your own? If you have a job now, will you have to quit your present position to start your own business? What are the reasons for leaving your current job? What are the prospects for advancement in your present job? Can you make it for an extended startup period of time without your salary, health insurance and other fringe benefits? If you are considering leaving your current employer to compete for the same business, are you restricted by a “noncompeting” clause? Your also might be under a duty not to use your employer’s list of customers. If you try to line up customers in advance to follow you, will you be liable for being a disloyal employee?
What are your business goals?
Whether it is your idea for a new business or you are requested to join in someone else’s plans, you should prepare or review a business plan—a summary describing the product or service to be sold; your market; financial and personnel resources the business will require; the equipment and physical plant required; and location.
If others are to be involved, do they have the abilities required? Are they people that you trust and would like to work with for the indefinite future? Choosing someone with whom to start a business is almost as important as choosing a spouse—you will spend as much waking time with your business associates as you will with your spouse.
Will you be playing an active role in operation or management? Or are you looking to make a financial investment only, playing merely a passive role in the business? The answer to these questions may affect the type of business entity chosen.
Where do you fit in?
Do you have management and organizational skills? There are many outstanding plumbers, sales people and lawyers who have neither the expertise nor patience for the details of running a business. Can you keep up with the paperwork required for maintaining accurate financial, employment and customer records? Are you a good judge of people that you may need to hire? Can you evaluate and motivate employees? Can you fire an unproductive, ill-suited or ill-tempered employee? These are all matters that you may be called upon to do in your business. Do you have the financial resources to establish a new business? Starting a business will invariably take longer than you think. You may not make a profit for the first six months to a year, even in the best of circumstances. Can you hold out that long? If you don’t have the personal resources that will be required, do you have investors? Are you able to borrow? If you borrow, will you have the cash flow to pay it back and still pay other expenses and make a profit? If your business fails (and many new businesses do fail), is it likely that you will be able to find other employment?
What special problems or risks need to be addressed?
Will your business involve what’s called “intellectual property,” i.e., expressions, symbols or inventions which will need legal protection under the copyright, trademark or patent laws? Will you handle a substance with the potential to cause personal or environmental injuries for which you might be held liable? Will certain types of arrangements with customers, colleagues or competitors run afoul of antitrust, consumer protection or other laws or regulations? Will your business require licensing or otherwise be regulated by any federal, state or local governmental authority? All these questions may be important in making basic decisions about your business.
What form should the new business take?
Generally, there are three basic types of business entities: sole proprietorship, partnership, and corporation. Each has certain advantages and disadvantages.
A sole proprietorship is a one-person enterprise. The owner has all the rights and responsibilities in the business. Although you may employees, they only work for you; they do not share ownership of or profits from the firm, and they have no voice in management. On the other hand, employees do not share business losses with you, nor need they be concerned about the company’s debts. One of the advantages of a sole proprietorship is that there are few formalities in the formation or operation of the business. You will need a business license, and, if you give your company a trade name, you will need to file a “fictitious name” certificate. There is no double taxation (as there may be with a corporation) because your net income from the business will be reflected in your personal income tax return (Schedule C). It is usually noted that the big disadvantage of a sole proprietorship is that the owner is generally liable for all contract debts as well as all tort liability arising out of the business. However, if you are considering a one-person corporation with no employees, you will still probably face contract liability from creditors who will insist on personal guarantees, and you may also face tort liability for acts that you commit in conducting the corporations’ affairs. In other words, if you’re considering your own business, do not be too quick to opt for the corporate structure solely for the supposed benefit of limited liability.
A partnership is usually defined simply as “an association of two or more persons to carry on as co-owners a business for profit.” The partners own and manage the business. Their rights and responsibilities are either established in a partnership agreement or, if there is no agreement, by state law. Partners may, but are not required to, have equal interests in profits, ownership of assets, and liability for debts or losses. Each general partner is personally responsible for partnership debts and liabilities; and the partnership is usually liable for the actions of any partner in the conduct of partnership. A limited partnership (“LP”) features different classes of partners, some of whom (the “limited partners”) are not personally liable for partnership debts, liabilities, or losses in excess of their investments. As with a sole proprietorship, there are few hard and fast rules for formation or administration of a partnership. It is wise, however, to have a written partnership agreement. Although the partnership must file an informational income tax return (Schedule E), the partnership pays no taxes; all net income or losses are “passed through” and are taxable to the individual partners.
Another variation on the partnership theme is the Limited Liability Partnership (“LLP”), in which none of the partners are liable for the contractual debts of the partnership beyond their own investment; and each partner is shielded from “tort” liability for injuries or damages created by the acts or omissions of another partner.
A corporation is a separate, legal entity—an artificial being capable of acting only through its agents. The corporation is owned by shareholders. Policy decisions are made by directors. Execution of policy and general management are carried out by the officers (e.g., president, secretary). In a small corporation (e.g., where there are only one or just a few shareholders), the shareholders, directors and officers may all be the same person(s). Shareholders, unlike partners or sole proprietors, have the advantage of limited liability—meaning that they will not generally be responsible for corporate debts and liabilities. However, most experienced business people will insist on personal guarantees from the principals of a new or small corporation. One disadvantage of a corporation is that there are certain formalities that must be observed in order to create and maintain this separate entity. Decisions need to be made in an orderly manner and reflected in resolutions. Annual reports must be filed, and annual fees must be paid. Ownership is easily transferable, unless there is a shareholder agreement restricting such transactions. These kinds of restrictions, or “buy-sell agreements,” are not uncommon in small corporations. Unless you elect to be treated for tax purposes like a partnership (a “Subchapter S” corporation), income tax will be payable on the corporation’s income and then again on the dividends or capital gains received by the shareholders.
Limited Liability Company
The Limited Liability Company (LLC) a relatively new type of entity. It is an unincorporated association with one or more members. It has the advantages of a corporation in that members have the same limited liability as shareholders. An LLC affords several different forms of taxation: as a separate entity, like a corporation; as a sole proprietorship, if there is only one member; or as a partnership, if there are two or more members. An LLC must file Articles of Organization with the State Corporation Commission, but there is generally less formality required than with a corporation.
Most LLCs have a written Operating Agreement, which serves a similar function to Bylaws and a Shareholder’s Agreement in a corporation. The LLC is fast becoming the entity of choice, especially for small and mid-size businesses.
Regardless of the choice of entity for your business, there are other legal matters to consider: Commercial leases for your office space are varied and may be extremely complex—do you understand the escalators, add-ons, landlord advertising and build-out terms? Do you have or need standard forms for customer contracts? What kinds of employment agreements are needed or desirable? Depending on the nature of your business, there are myriad other potential problem areas where a little advanced planning could reduce the risk of misunderstanding and thereby avoid expensive litigation.
As you can see, starting a business is a complex decision. There are many factors to consider—some are legal, and some are personal and financial. If you are interested in starting a business, you should not hesitate to consult your lender, your tax advisor, and your attorney. The professional advice you receive can prevent many headaches that could result from poor planning.