Legal lifecycles of businesses

December 13, 2010

This is the first of 18 articles that will trace the legal life cycle of a business from its formation, through its operation and to its sale. The legal life cycles of businesses will be outlined in the following articles:

Article Topic

As a Texas attorney located in Lakeway, Texas (outside of Austin in Central Texas), John Drisdale is limiting these articles to a summary of Texas and federal legal matters. As these articles evolve, their numbering and order may be adjusted or supplemented by his blogs as appropriate.

Article One - Business formation

An entrepreneur must make several preliminary legal decisions before starting a business. These include:

(i) business name;
(ii) type of business entity;
(iii) licensing;
(iv) ownership agreements; and
(v) hiring good professionals.

While it is true that online forms are available for most business entities, the "do-it-yourself" entrepreneur may learn too late that the faulty legal foundation of the business destroyed its value from the outset.

Choose an Available Name.
This deceptively simple act requires: (i) contacting the Texas Secretary of State to determine if the name is available for filing purposes; (ii) conducting a trademark search to determine if the name is available on a national level; and (iii) determining the availability of an appropriate domain name for online use. It is not unusual to have the first two name choices rejected by the Texas Secretary of State. Even if the name is available for filing purposes with the Texas Secretary of State, it may not be available on a national level due to a federal trademark registration. The owner of a trademarked name may sue the infringing business for damages in addition to requiring it to change all uses of its business name and logo. Needless to say, revising all directory listings, advertising, forms, signage, bank accounts, licenses and every other instance of name usage is very costly and disruptive. Assuming the foregoing name hurdles are cleared, the entrepreneur should also conduct a domain name search for an appropriate, available name for online marketing and commerce.

Type of Entity. Broadly speaking, the entrepreneur may choose a corporation, limited liability company (LLC) or limited partnership to shield his or her personal assets from the liabilities of the business. However, an informed choice must take into account (i) the levels of protection provided by statute, (ii) the judicial decisions interpreting those statutes, (iii) tax considerations, (iv) the expected means of financing the business, and (v) the desired management structure. In addition, the state of formation may also be important.

Statutes and Case Law. Statutory amendments and judicial decisions are constantly revising the legal landscape. Judicial trends may emphasize differences between jurisdictions. For example, Delaware case law has been trending towards greater liability for corporate directors than Texas case law, particularly with respect to controlling shareholders who change the corporate structure or acquire the business.

Federal Income Tax Considerations. Initial tax considerations include a fundamental decision as to taxation at the entity level versus "pass through" taxation of the business profits to the owners. For federal income tax purposes, a corporation may elect to be taxed as a “C” corporation or as an “S” corporation. In either case, it is a corporation formed under a state’s law such as Texas; the “C” and “S” designations are used as a convenient reference to the applicable provisions of the Internal Revenue Code. If taxed as a "C" corporation, the corporation pays taxes on its profits and its shareholders pay taxes on their dividends (“double taxation”). In contrast, a corporation making an "S" election obtains "pass through" taxation of the corporation's profits to the shareholders without any tax at the entity level (no double taxation). However, the "S" election by a corporation imposes ownership and profit allocation restrictions that may be incompatible with the needs of the business and its owners. These restrictions can be avoided by using a limited liability company. A limited liability company with multiple owners may elect to be taxed as a "partnership" (“pass through” taxation), as a “C” corporation (double taxation) or as an “S” corporation (no double taxation). A limited liability company with only one owner is entirely disregarded for federal income tax purposes, allowing the owner to report business profits and losses on a schedule to Form 1040. These tax considerations are complex and require planning based on the initial and anticipated future of the business and its ownership.

Financing Issues. Venture capital investors have historically preferred investing in “C” corporations. The legal characteristics of some venture capital investors may restrict investments to corporations. However, limited liability companies have been acceptable to venture capital investors in some cases. Regardless of the entity structure, governmental authorities such as the Securities Exchange Commission and state securities authorities regulate the offer and sale of stock or ownership interests as a means of financing businesses. Violation of the securities laws may result in personal liability for the entrepreneur. These financing and securities law issues will be discussed in Articles Five and Six.

Management Structure. In general, a corporation’s organizational structure is established by statute to consist of a Board of Directors who elect and oversee the executive officers of a corporation who in turn discharge the daily business operations. The shareholders of a corporation elect the members of the Board of Directors. These broad parameters may be modified by provisions in the certificate of formation, the corporation's bylaws, and agreements among the shareholders. In fact, venture capital investors will require these types of modifications to protect their investment. Unlike a corporation, the management structure of a limited liability company may range from a partnership format (in which all partners manage the business) to the corporate structure outlined above.

Licensing. The Texas Secretary of State website contains helpful licensing and other new business information.

Ownership Agreements
. These agreements, also known as Shareholder Agreements or Buy-Sell Agreements, document the rights and responsibilities of the business owners. Since ownership changes are inevitable, these agreements are critical to the foundation of any business with multiple owners. Article Two will address Shareholder and Buy-Sell Agreements.

Hiring Professionals.
Hiring a good CPA and an attorney familiar with business entity formations should be the first step in planning a new business. The issues outlined above merely provide an overview without delving into the additional complexities applicable to each individual situation. Frequently the entrepreneur is reluctant to obtain professional advice under the illusion of saving money. While Ben Franklin said that a “penny saved is a penny earned,” he also said that an “ounce of prevention is worth a pound of cure.” While the curative legal costs to preventive legal costs is frequently the same order of magnitude as Ben Franklin’s “ounce to a pound” comparison, in some cases there is no cure. The cost of losing the entire business by failing to plan at the outset would be difficult to quantify for financial or emotional purposes.

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John Drisdale

Drisdale Law Firm

John Drisdale is a principal in the Austin area business law firm of Drisdale Law Firm. Drisdale believes in Ben Franklin’s theory that preventive legal costs are typically a fraction of remedial legal costs such as litigation and dispute resolution. John graduated second in his 1979 law class at Baylor University and was Editor in Chief of the Baylor Law Review. He is a published author and speaker on several important legal topics that affect small business including business entity formation, buy-sell agreements, purchasing and selling businesses, contracts, and commercial real estate. His professional experience includes practicing business law as a partner in an international law firm and serving as general counsel for a publicly traded global corporation. John now focuses on the "entry to exit" preventive business law needs of small to mid-size businesses. Drisdale limits his law practice to the areas he knows best and helps his clients manage the rest. Litigation, tax and other specialty matters are referred to other attorneys and professionals. John’s practice is based in Lakeway Texas where he has been an active Board member of the Lake Travis Chamber of Commerce for many years. He enjoys making business owner educational presentations to area groups and is a lifetime learner.
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