Prior to co-founding crowdSPRING, I spent 13 years practicing law (representing small, medium and Fortune 500 clients around the world). Along the way, I advised many small businesses and startups. Entrepreneurs and small businesses often ask me about legal problems facing most small businesses and startups and for tips on how to avoid those problems. Here are the top 10 mistakes and tips on how to avoid them:
1. Choosing The Wrong Ownership Structure. This is your most important first decision when starting a business. The decision you make will impact whether or not you’ll be able to accept investors, how many and what types of investors, whether you’ll easily be able to sell your company, what your personal legal liability will be, what your tax liability and benefits will be, and many other significant issues.
Why This Is A Problem: If you’re going to be looking for outside investment, you’ll want to create an ownership structure that’s friendly to those investors. For example, most outside investors prefer the stock structure of a corporation (or limited liability company) as opposed to a partnership. If you select the wrong ownership structure, you might expose yourself to unlimited personal liability for your company’s debts. Keep in mind that you should create your ownership structure BEFORE you enter into any agreements/contracts.
How You Can Avoid This Problem: Consider the following issues when deciding on what type of entity to start: what are the potential liabilities/risks? What are the anticipated tax benefits from being taxed as a partnership as opposed to a corporation? Do you intend to have outside investors? Do you anticipate selling your company in the future? Are you pursuing a risky business where you might be sued?
If you’re a sole proprietor, you are personally liable for your business debts. While this is generally the simplest form of ownership, it is also risky.
In a partnership, the partners can be personally liable for the debts of the business. One benefit of both sole proprietorship and partnership is that the income/loss from the business flows directly to you (the corporation doesn’t pay a separate corporate tax).
To insulate yourself from legal risk, you can form a corporation. Corporations have the most demanding record-keeping requirements and are subject to a separate corporate tax (in additional to your personal liability for your share of the money distribute by the corporation). As long as you follow all corporate formalities (hold periodic meetings, keep good corporate records, etc.) you’ll generally insulate yourself from personal liability for the debts of your company. Because of the expense involved in maintaining corporate records, many small businesses don’t use the corporate ownership structure (although many startups do – because that structure often makes it easier to sell the company).
You can get the tax benefits of a partnership and the legal protection benefits of a corporation by organizing as a limited liability company (LLC). LLCs are subject to annual taxes or reporting fees (typically, hundreds of dollars) but have far fewer corporate records requirements than do corporations. After considering our own situation, we organized crowdSPRING as an LLC.
image credit:SplaTT
2. Lack of or Poor Organizational Documents. It’s not enough to decide on the right ownership structure for your business. If you decide on a structure that requires documentation – such as a corporation – you must follow the formalities and create/maintain such documents.
Why This Is A Problem: If you don’t have solid organizational documents or fail to follow corporate formalities (such as for a corporation), you expose yourself to personal risk because courts may “pierce the corporate veil” and find you personally liable if they believe that the corporation wasn’t properly established or maintained. You also will lose credibility before your investors if they believe you don’t know how to properly maintain your entity.
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