By: Rudman Winchell attorney Jonathan Bench
Many online-only businesses offer do-it-yourself entity formation, employment and purchase contracts and wills, just to name a few products. Although do-it-yourself projects often appear simple at first blush, halfway through you may come to realize you have invested more time and effort than you originally budgeted for the whole project. Even after getting to the end of a do-it-yourself project, you may wonder if your end product will withstand the tests of time and the unknown future. Legal products are no different.
When forming an entity out of which to operate a business, many major decisions usually benefit from a practiced hand, which you may not possess. The following is a list of some important considerations and potential pitfalls the business owner should address when forming a business entity, or deciding whether one is needed:
1. Corporation vs. LLC vs. Sole Proprietorship vs. Partnership
Pitfall: Choosing wrong at the outset can be difficult to reverse, and at least as between a corporation and an LLC, the Secretary of State’s website makes one entity look as promising as another. Establishing a corporation when you should have chosen an LLC can mean unwelcome tax complications in the future, and not all business entities can be easily (if at all) converted into another type once you realize your mistake.
2. LLC Agreement/Corporate Bylaws/Shareholder Agreement
Pitfall: A business entity without properly conceived governing documents is akin to a ship without a rudder and a mast. Similarly, a business entity with insufficiently clear governing documents is nearly as difficult to steer as one without governing documents.
3. Statement of Authority
Pitfall: For an LLC, you may not want every charter member of your business to have the authority to bind your company in third party contracts, especially financing or long-term leases. Filing a Statement of Authority may be the right thing to do for your business, but it also may create unnecessary restrictions if done haphazardly.
4. Different Types of Stock/Economic Interests
Pitfall: Giving disproportionate economic rights to the various owners of the business entity does not have the same effect as giving different salaries to those same people. There are many options when choosing the optimal capital structure for the business, such as voting or non-voting shares or other ownership rights, preferred stock, convertible debt, different classes of members, and the like. Even in small businesses, some of these “bells and whistles” are not only economical, but conducive to success.
5. Liability Protection for Shareholders or LLC Members
Pitfall: A do-it-yourself website will not tell you that your new business entity cannot protect you from your own negligence, even though the words “limited liability” are comforting to read. While adhering to business and corporate formalities with which you may be unfamiliar or not appreciate the importance may be cumbersome until they become routine, those are the same formalities that can shield you from your business missteps.
6. Governance and Control
Pitfall: Not knowing the difference between a board meeting and a shareholders meeting, or a members meeting and a management meeting, or not understanding the requirements of notice and a quorum, can lead to serious problems when you least need them, namely, when your business is at an important turning point in an important transaction.
7. Company Financing
Pitfall: Falling prey to financial covenants you may not be able to maintain, and losing track of the financial covenants to which you are beholden can create major restraints on your financial flexibility. Good corporate records, including formal resolutions of boards or managers, are not only necessary but will help keep your relationships with your financial institutions and your investors on an even keel.
8. Geographical Scope of Business and Intellectual Property Rights
Pitfall: While this is partially a business decision, expanding your territory too widely without appropriate, advance due diligence can lead to legal troubles, especially if you have already spent considerable resources in trying to develop a strong brand name or other valuable intellectual property. Misunderstanding the differences between copyright, patent, trade secret, trade names, and trade and service marks can leave you stranded.