MILESTONE #6: Legal Foundation
“Morality cannot be legislated, but behavior can be regulated. Judicial decrees may not change the heart, but they can restrain the heartless.”
— Martin Luther King, Jr.
There are certain legal milestones that must be in place to attract capital. The following are a list of the most commonly used legal documents (note: below is not legal advice and we highly advise that you get an experienced attorney – we work with several great attorneys and are happy to refer one to you):
- Incorporation (Entity Structure)
- Partnership Agreements
- Employment Agreements
- Acquiring Intellectual Property
- Investment Documents
- Term Sheet
- Private Placement Memorandum (PPM)
- Convertible Note Package
There are number of different entity structures which may be considered when starting a new company. The three primary business structures used in entrepreneurial businesses are: 1) a limited liability company, 2) a corporation, and 3) a limited partnership.
Limited liability company (“LLC”)
A limited liability company is the most common business structure used by entrepreneurs. It allows the entrepreneur a certain level of liability protection, and a significant tax advantage during the startup phase. The entity created is governed according to state law, and each of the 50 states have their own legislation regarding the creation of a limited liability company. Besides the liability and tax benefits afforded through the limited liability company format, this type of entity is also the simplest type of company to maintain from a legal perspective. The entrepreneur files “articles of organization” with the state Secretary of State’s office and creates an “operating agreement” which controls the activities of the members of the LLC, including voting, profit distribution, dissolution, transfer of ownership, and management control.
Corporations are also entities which are established according to state law. A corporation can be formed by filing “articles of incorporation” with the secretary of state’s office. Corporation law is also different in each of the 50 states. There are other documents that are typically required for the proper establishment of a corporation. These include: bylaws, organizational minutes, resolutions, and a shareholder’s agreement.
“S corporations.” Often times people refer to corporations with the letter S or the letter C. These references, pertaining to chapter headings in the United States Internal Revenue Code. Subchapter S of the code provides benefits to individuals when starting a new business. For example, at the beginning of a new business oftentimes there will be operating losses for extended period of time. Under subchapter S, the entrepreneur may write off these business losses on his or her personal income tax return. Incidentally, this same tax treatment is provided to the owners of an LLC.
Corporations which alas to be taxed according to subchapter C of the code. These are typically companies that have developed a mature business. The tax rate for corporations tax under subchapter C can be favorable, however there is an issue with distributions of profits in a C Corporation which are made in the manner of dividends. What is known as “double taxation” can occur with a C Corporation, because the corporations profits are taxed first, and then the distributions in the manner of dividends to the shareholders are also taxed.
Limited partnerships (“LP”). Limited partnerships are commonly used in real estate investments, oil and gas investments, and in other businesses were the owners are looking for passive income. The components of the limited partnership, include the creation of a general partner who is responsible and liable, for the operation of the business, and limited partners, who are insulated from liability and have no voting rights relative to the operation of the company. Limited partners also enjoy the ability to offset limited partnership profits or losses against other limited partnership interests on their tax returns.
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Selection of the appropriate business entity is the first step of actually creating the business. This election process will also become critical in the design of the capital structure which will be used to attract investment capital. For example, entrepreneurs who are creating technology-related businesses, and who anticipate attracting venture capital for their company will need to consider the creation of a corporation taxed, according to subchapter C of the code. Additionally, venture capital typically also requires that a corporation the organized in the state of Delaware. The reason the state of Delaware is required, is that Delaware has developed the most favorable corporate law structure in the United States and has established a special court system that handles corporate litigation. Similarly, if the entrepreneur is creating a real estate development business, the investors will most likely require the creation of a limited partnership organized in the state in which the real estate is located. Generally however, entrepreneurs who have more traditional businesses in mind will select either a subchapter S corporation, or a limited liability company, organized in the state in which they will operate their business.