Four
to Consider When Starting a Company
From business structure to taxes, there are numerous legal issues to address when starting a company, many of which can bring a promising start-up to a grinding halt if the proper steps are not taken. The following four issues most frequently cause problems.
1. Trademarks : Register your trademark. Simply reserving a domain name does not guarantee legal rights. Since interNIC does not deal with trademark disputes, federal trademarks take precedence over domain registrations. Unregistered trademarks do not hold up well; it is best to register the trademark federally. However, the PTO will not register a trademark if it is not distinctive enough. The
2. Deals with cofounders : Document all deals with cofounders in case disputes arise at a later date.
3. Employees : Consider legal issues of hiring employees. The largest area of potential liability for an entrepreneur often is employment law. Employees have many legal rights that must not be neglected.
4. Contract liability : Establish limits of liability in contracts by limiting the maximum liability to that of the contract and by excluding consequential damages.
The American Legal System
Sources of Law
· Constitutional Law is based on a formal document that defines broad powers. Federal constitutional law originates from the
· Statutes and Ordinances are legislation passed on the federal, state, or local levels.
· Common Law is based on the concept of precedence - on how the courts have interpreted the law. Under common law, the facts of a particular case are determined and compared to previous cases having similar facts in order to reach a decision by analogy. Common law applies mostly at the state level. It originated in the 13th century when royal judges began recording their decisions and the reasoning behind the decisions.
· Administrative Law - federal, state, and local level. Administrative law is made by administrative agencies that define the intent of the legislative body that passed the law.
The sources of law have both vertical and horizontal dimensions. Vertical dimensions include federal authority, state authority, and concurrent authority. Federalism refers to this form of government, in which there is national and local authority. Federal authority covers laws related to patents, pensions and profit sharing, and labor issues. State authority covers business association, contracts, and trade secrets. Concurrent authority covers security law, tax law, and employment law. Note that employment law refers to non-union relationships; labor law refers to union relationships.
The horizontal dimension is related to the separation of power between the executive branch, which creates administrative law, the legislative branch, which creates statutes, and the judicial branch, which creates common law. The judicial system in the
-- Supreme Court --
--------- Appellate Courts ---------
-------------------- Trial Courts ---------------------
Actually, there are two pyramid structures - one for federal courts and one for state courts. State courts may use different terminology; for example, trial courts may be called courts of common plea, appellate courts may be called superior courts or commonwealth courts.
Classifications of Law
Substantive law vs. procedural law: Substantive law creates, defines, and regulates legal rights and obligations. Procedural law defines the rules that are used to enforce substantive law.
Common law vs. statutory law: Common law is defined by judges. Statutory law is passed by legislatures. For example, the Securities Act of 1933 is statutory law.
Criminal law vs. civil law: Criminal law is between private parties and society. Civil law is between private parties only.
Jurisdiction
Jurisdiction is the power of a court to hear a particular case. In order for a court to have jurisdiction, it must have both subject matter jurisdiction (the power to hear the type of claim being asserted) and personal jurisdiction (power over the person).
Subject Matter Jurisdiction
Article III of the
1. Federal question jurisdiction - federal courts have federal question jurisdiction in cases involving the federal constitution, federal statutes, or federal treaties.
or
2. Diversity jurisdiction - diversity jurisdiction requires both a) $75,000 or more at issue, and b) the parties must be residents of different states. Diversity jurisdiction applies for example, to a case in which a traveler passing through a different state from his/her home state is accused of a serious offense, and in which the plaintiff, attorneys, and judge may all be close friends.
or
3. suit by or against the
or
4. Miscellaneous - certain types of cases such as those related to patents, bankruptcy, admirality (maritime cases), trademarks and copyrights, etc.
Items 1) and 2) can be tried in either state or federal courts (concurrent state/federal jurisdiction). Items 3) and 4) may be heard only by federal courts.
Personal Jurisdiction
Types of personal jurisdiction:
1. in personam - court has power over a particular person - in personam applies if minimum contact is established. For non-residents of a state, a state court may still have jurisdiction if the person travels regularly to the state on business or has a post office box in the state. Each state has its own definition of what constitutes doing business in the state, as determined by common law.
2. in Rem - a court has power if a particular piece of property is in the state.
3. consent - when a contract specifies in which state any disputes are settled. The contract can specify a third state in which neither party does business.
Just because a case is heard by a particular state court does not mean that that state's laws apply. The states whose laws are used can be specified in the contract. One state's court can hear a case under another state's laws.
Lifecycle of a Lawsuit
In the beginning phase of a lawsuit, there is a complaint, followed by the defendant's answer in which he or she tries to counter everything in the claim. The defendant then may file a counterclaim. Counterclaims are lawsuits within a lawsuit in which the defendant files a claim against the plaintiff. There then may be a preliminary motion, of which the outcome can be dismissal due to no legal claim based on reading the complaint, or a summary judgement in which a decision can be based on the facts of the case that are not in dispute.
The middle phase of a lawsuit is the discovery phase, in which each side attempts to determine how strong their case is. The discovery phase consists of interrogatories, depositions, and admissions. By this point, most cases are settled.
The end phase of a lawsuit is the trial, beginning with a pre-trial conference in which the parties attempt to settle in front of a judge without going to court. The trial then proceeds with the evidence and then a judgement and possibly a post-judgement. The post-judgement may be that a new trial is necessary, such as in cases of mistrial.
The defendant usually has the right to one appeal within a certain period of time. An appeal is filed with the appellate court, there are briefs, oral arguments, and then a decision.
The judgement is enforced by first obtaining an execution that freezes the defendant's assets. The defendant is served and the assets are levied. The defendant, however, may choose to file for bankruptcy protection, in which case all creditors are stopped, including court judgements.
Remedies
There are two types of remedies: legal and equitable. Legal remedies are money-based and seek to financially compensate one for the damage that has occurred. Equitable remedies require a specific performance. Examples of equitable remedies are injunctions, restitution, and reformation. In cases where damages are difficult to quantify, equitable remedies may be more appropriate.
Legal Case Study
When attempting to understand how courts interpret the law, it is worthwhile to study past cases of similar legal issues. Past legal cases provide the opportunity to understand the law by studying well-argued positions from both sides. When studying a case, the following points should be identified:
- Facts. One should identify which facts are important and which are not.
- Issue. One should isolate the specific legal issue relevant to the case.
- Court holding (ruling)
- Reasoning (why the court decided as it did).
Obtaining Legal Counsel
Ways to Reduce Legal Costs
Once a small company having no in-house legal staff finds itself in litigation, it already has lost since the legal fees it pays may be large with respect to the company's size. In the
1. When at all possible, don't litigate - negotiate.
2. Put into contracts a clause requiring the losing party to pay the winning party's legal fees.
3. Put an arbitration clause into contracts. Note that arbitration is binding and enforceable in court whereas mediation is non-binding.
4. Purchase the broadest possible insurance policies in order to have the insurance company pay legal costs.
5. Whenever possible, specify in contracts that any litigation be in your own state. The costs of going to court are much higher away from home.
Types of Attorneys
Two types of attorneys are litigation attorneys, who resolve disputes, and transactional attorneys, who structure transactions, for example, by writing contracts.
Retaining Attorneys
A significant portion of venture funding goes for advertising and legal fees. Lawyers usually make their money through hourly fees. Contingency may be used in litigation of collection cases and personal injury cases. Under contingency, lawyers may take 1/3 to 1/2 of the award; this amount is negotiable. More recently, especially in
Billing rates range from $100 to $500 per hour and are billed in 1/10 of an hour increments. So one phone call would result in a bill for at least six minutes of time. Billing rates are determined by:
1. Size of the law firm
2. Years of experience of the attorney
3. Degree of specialization of the attorney - more specialized attorneys have higher rates.
Usually, charges are added for copies, faxes, printing costs, etc.
There often is no fee for the initial consultation. The partner with whom one meet probably is not the one doing the work, so it might be a good idea to ask to meet the person who actually will be working on the case. Many large law firms ask for an up-front retainer of a few thousand dollars.
Legal Malpractice
Sometimes, the attorney may not perform as well as expected. In such cases, there are two possible remedies:
- Legal malpractice tort - lawyers should perform at a reasonable level as expected by the community. If the performance drops below the standard, the situation is one of malpractice, and monetary damages can be claimed.
- File a complaint with the state Bar for violation of ethical standards. This option does not allow monetary damages to be collected.
Four ethical standards:
- Conflict of interest - an attorney should not represent a client for which the representation would damage another client. If an attorney has an equity interest in a client company, there may be a conflict of interest since the attorney is a minority shareholder but represents the majority shareholders.
- Confidentiality - attorney-client privilege protects disclosures that clients make to their attorneys in confidence. Attorneys usually do not sign non-disclosure agreements because they see so many different ideas.
- Communications / counsel - all communications must go through attorneys. Attorneys should not contact another attorney's client.
- Imputed disqualification - none of the lawyers in a law firm should represent a client that any one of them should not represent. For example, the legal opponent of one of the clients represented by a lawyer in the firm should not be represented by any other lawyer in the firm.
Bold vs. Simpson - Case of Attorney Wrongdoing
In this case, Simpson is an entrepreneur and Bold is his attorney who also invested in Simpson's business. The business failed and Bold sued Simpson for negligently managing the investment. Simpson filed a counterclaim against Bold claiming legal malpractice in advising the structuring of the company and violating his fiduciary duty as a director of the company. Bold claimed that he had told Simpson that he was not qualified to advise the company in securities law issues and that Simpson should find a qualified attorney, but Simpson claimed that Bold was representing him in all legal aspects. Simpson's countersuit won, and Simpson was award $325,000 for legal malpractice, but Bold appealed. In the appeal, the court vacated the award of $325,000.
One lesson from this case is the importance of knowing the scope of the engagement. Bold had not agreed to advise on security law. An engagement letter always should be written by the attorney.
Employment Law and
Duties to One's Former Employer
When starting a company, many entrepreneurs believe that the end justifies the means, and may be lax about fulfilling obligations to former employers. However, the fastest way to put a startup out of business is to sue it for violating duties to a former employer. Even if no duties were breached, such a lawsuit could result in over $100,000 in legal fees.
There are two types of duties to former employers, those that arise from tort law and those that arise from contract law.
Under agency law (tort law) there are three duties that an employee owes the employer:
1. Duty of loyalty - the obligation to act only in the interest of one's employer and not to compete with one's employer. Even if one is working on one's own project at home in the evening using one's own computer and equipment, the project may constitute a breech of loyalty if it competes in the same line of business as that of the employer.
2. Duty of obedience - the obligation to obey all reasonable orders of one's employer. An act of insubordination is a violation of this duty.
3. Duty of care - lack of performance is a violation of this duty.
Under contract law, there are confidentiality agreements and restrictive covenants.
1. Confidentiality agreements - two restrictions are non-use and non-disclosure. A thorough agreement should have both. An example of a confidentiality breach might be disclosing the identity of the former employer's customers to the new employer. There are three levels of confidentiality. The lowest level is public domain information, followed by confidential information, and finally by trade secrets, the highest of the three.
2. Restrictive covenants - four types of restrictive covenants are non-competition, non-disparagement, non-interference, and non-solicitation.
The following outlines the four types restrictive covenants:
A. Non-Competition agreements - can center on geography, customers, or knowledge. A firm cannot stop another firm from competing with it without a valid non-competition agreement. Two types of circumstances when non-compete agreements arise are transactional settings and employer-employee situations.
i. transactional settings - such as sale of a business. For example, is a physician sells his/her practice, a non-competition agreement might prevent the same physician from opening a new practice within a five mile radius. Courts will consider four factors when enforcing non-competition agreements in the sale of a business:
a) type of business
b) client base, size, and geography
c) impact if the non-competition agreement were extended
d) how long the agreement is to be enforced
ii. employer-employee situations - this is different from transactional settings in that the employer and employee are not on a level playing field.
Non-competition agreements are blatant restrictions on trade and are therefore difficult to enforce. However, courts are more willing to enforce those associated with transactional settings than those associated with employer-employee relationships. However, even if an employer knows that an agreement is overly restrictive and unenforceable, he/she may have employees sign it in order to make them think twice before trying to compete. A court will look at the following points when deciding whether to enforce a non-competition agreement:
a) that the agreement is reasonably limited in scope such as duration, geography, client base, and technology.
b) that the agreement is narrowly tailored to the interests of the employer, such as customer lists, trade secrets, goodwill, or extraordinary skills.
c) that the agreement is supported by valid consideration. The agreement must be the product of some bargain. When people do not give something up in exchange for something else, there is unlikely to be intention to enforce it. If a company requests that present employees sign a non-compete, the employer is giving nothing in exchange for it. This situation also applies to employees who show up the first day on the job and are requested to sign a non-compete. In order to make it enforceable, employers may specify in the offer letter that the employment is contingent on the signing of the non-competition agreement, in which case there is valid consideration.
d) that the agreement is not harmful to the public or the employee. For example, in an area that has a shortage of providers of an essential service, a court is much less likely to enforce a non-competition agreement related to that service.
A court may change an item in a non-competition agreement to a value that is more reasonable. For example, the court may shorten the duration of the agreement. Such changes are referred to a "blue penciling". The court must balance the interests of employers, such as protection against damage caused by competition, with the interests of the employees, such as the ability to earn a living. Some states have statutes specifying things that are not enforceable. But an injunction in one state does not necessarily prevent one from competing in another state.
B. Non-Disparagement agreement - prevents the employee from talking negatively about the employer.
C. Non-Interference agreement - prevents the employee from interfering with certain relationships:
- vendor/supplier
- referral patterns
- customers
D. Non-solicitation agreement
Non-solicitation agreements may prevent:
· solicitation of employees to attempt to steal them (but the employee may seek out your firm unless otherwise prevented)
· solicitation of customers
Under general tort claims, there are:
- wrongful conversion (theft) of trade secrets - there have been cases in which even though non-competes had not been signed, companies have been able to get a TRO against employees who were going to a competing firm when it was inevitable that trade secrets would have been disclosed. Under the inevitable disclosure doctrine, an employee may be prevented from performing work in competition with a former employer if a court decides that he will inevitably disclose trade secrets belonging to the former employer.
- tortuous interference with contractual relationships
Ten issues to consider when hiring a competitor's employees:
1. What the employee had been doing at the former employer - are there some potential activities in the new role that should be off limits?
2. The nature of the business - how crucial it is to be first to market, is the market in a particularly highly competitive phase, etc.
3. Whether the companies really are competing - even though they may be in the same industry, if there is little product overlap then the risk of transferring trade secrets is lower.
4. The degree of competition - even if there is product overlap, a move from a weak player to a strong player may not be a problem, unless the weaker player has just made some sort of a breakthrough.
5. Whether the employee had an in-depth knowledge of trade secrets or just general exposure.
6. Whether the former employer has been able to achieve something that the new employer has tried unsuccessfully to achieve.
7. Whether the former employer took adequate precautions to protect the trade secrets in question - otherwise they might not actually be trade secrets.
8. The amount of discretion that the employee will have - if he or she simply is implementing a pre-existing plan with little ability to change it, there may be little risk of doing damage.
9. Whether the employee will be working with former colleagues at the new employer - if an entire team is assembled and this team once had knowledge of trade secrets at the former employer, there is greater risk of disclosure of those secrets.
10. Whether the employee will receive a substantial increase in salary at the new employer - if so, this could be viewed as a premium for the trade secrets.
Employment Law Cases
Case: Business Intelligence Services, Inc. v. Carole Hudson
Facts
Carole Hudson was an employee of Business Intelligence Services (BIS). In August of 1983, Ms. Hudson received an employment offer from Management Technologies, Inc. (MTI), a competing firm. About one-third of MTI's employees were former employees of BIS. Business Intelligence Services (BIS) sought an injunction to prevent Ms. Hudson from working for MTI. Ms. Hudson believed that she had signed an employment contract with BIS in June 1983, but later could not produce a copy of it. During the summer of 1983, Ms. Hudson had received a promotion at BIS. On September 9, 1983, prior to Ms. Hudson's resignation from BIS, Ms. Hudson's supervisor at BIS told her that there was no employment contract on file for her and that such a contract was required. The secretary of BIS's president approached Ms. Hudson with a contract that she said she had retyped. Without reading the contract, Ms. Hudson signed it. The contract had a non-compete clause in it prohibiting Ms. Hudson from doing business with any of BIS's clients for a period 12 months after termination of her employment.
On December 29, 1983, Ms. Hudson resigned from BIS. BIS noted the non-competition clause, and Ms. Hudson expressed her view that the contract that she had signed in June had no such clause. There was no evidence that Ms. Hudson would be unable to gain employment for the 12 month non-compete duration.
Issue
The issue in this case is whether the non-competition clause was enforcable. First, it may have been misrepresented since it had been presented to Ms. Hudson as a retyped version of the original. Second, since the new contract was presented after the commencement of employment with BIS, there is a question of whether consideration was given.
Holding
The non-competition clause is enforcable, and its one-year duration is reasonable.
Reasoning
In the presentation of the employment contract on September 9, while it may have been misrepresented, there is no evidence of intention to deceive. When one signs something, one is bound by its terms so one should know what is in it. While continued employment does not constitute valid consideration, Ms. Hudson's promotion does. Furthermore, BIS's specific knowledge of clients' systems are protectible as a trade secret.
The remedy in this case was an equitable remedy since BIS would suffer irreparable harm and actual damages would be difficult to quantify. The court issued a preliminary injunction to prevent Ms. Hudson from commencing employment at MTI.
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Case: Reed, Roberts Associates, Inc., v. John J. Strauman
Facts
Reed, Roberts track the employment laws in 50 states and advises companies doing business in those states. John Strauman was a vice-president of Reed, Roberts who had signed a restrictive covenant indicating that he would not solicit any of the firm's clients for three years after the termination of he employment. After 11 years with Reed, Roberts, Mr. Strauman resigned and formed a company called Curator Associates, Inc, which was located in the same city as Reed, Roberts and which was in direct competition with Reed, Roberts.
Issue
Enforceability of non-competition and non-solicitation.
Holding
The initial court ruled that the non-solicitation clause was enforceable but that the non-competition clause was not. However, the court of appeal ruled that neither was enforceable.
Reasoning
The lower court reasoned that the non-competition clause was not enforceable because it interfered with Mr. Strauman's right to earn a living, but that the non-solicitation clause was enforceable because it would be unjust for Mr. Strauman to utilize his knowledge of Reed, Roberts' internal operations to solicit its clients. The court of appeal reasoned that the solicitation of customers usually was done through a public directory such as Dun and Bradstreet's Million Dollar Directory, so this information did not constitute trade secrets.
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Case: Structural Dynamics Research Corporation v. Engineering Mechanics Research Corporation
Facts
Structural Dynamics Research Corportation (SDRC) and Engineering Mechanics Research Corporation (EMRC) both are in the business of structural analysis and testing. Kothawala, Surana, and Hildebrand were former employees of SDRC, where they had signed confidentiality agreements. Kothawala and Surana had developed an isoparametric computer program in their roles at SDRC. Kothawala left SDRC to establish EMRC and the other two followed him shortly thereafter. While at SDRC, Kothawala and Hildebrand had sent to Ford a letter that criticized SDRC with the intent to transfer the Ford business to their new company once they left. Furthermore, parts of EMRC's computer program code were found to be identical to those of SDRC's.
Issue
Breach of trust, breach of contractual duty not to use or disclose confidential information, and unfair competion.
Holding
The court did not enforce the non-competition clause. The former employees were found liable for SDRC's loss of profits from Ford due to Kothalwala's and Hildebrand's disparaging SDRC's ability to complete the project. Due to unauthorized use of SDRC's confidential information, EMRC was liable to SDRC in the amount of 15% of its sales for the next three years, and $45,000 in damages were to be paid to SDRC.
Reasoning
The contract was entered into in
Business Legal Structures
Two issues frequently faced by start-ups are that of intellectual property and the legal structure of the business. There exists a number of different business structures that differ in several important aspects. Some of the more common business structures are:
- sole proprietorship
- general partnership
- limited partnership
- limited liability partnership
- corporation (including S corporations)
- professional associations
- limited liability companies
- business trusts
- professional corporations
There are six common issues that distinguish the different business forms:
- taxation
- liability
- risk and control
- continuity of existence
- transferability
- expense and formality
Taxation and risk and control are the more significant issues. In addition to these common issues, there also are issues specific to each form.
A one-person company generally has only three choices of business form: sole proprietorship, corporation, or a limited liability company. Multiple people typically have the additional options of general partnership, limited partnership, or a limited liability company.
Liability is a risk that one exposes oneself to when starting a business. Two types of risk are tort risk and contract risk. A tort is an intentional or unintentional harm to the person or property of another. Some examples of tort risk are worker injury, product liability, automobile liability, and general liability, such as when somebody falls on a wet floor. Examples of contract risk are financing risk and risk with vendors and customers.
Tort risk can be protected against by using insurance. 99% of businesses can get an insurance policy against all tort risks. Excess insurance beyond standard liability limits often is not needed. For example, in medicine most people will settle claims at policy limits, because otherwise too many activists would protest if physician's personal assets could be easily taken.
Liabilities associated with contract risk can be limited in the contract itself. For example, software user agreements may have a general liability limitation equal to the price paid for the software.
Traditionally, there was a tradeoff between liability and taxation. However, S corporations and LLC's have changed that tradeoff so that a company can have limited liability and pass-through taxation.
Sole Proprietorship
As the simplest form of business legal structure, the sole proprietorship is viewed as being one and the same as its owner. The sole proprietor incurs little expense in setting up this form of business, and it is the most common structure among small businesses.
General Partnership
The general partnership is an association between two or more people in business seeking a profit. General partnerships have pass-through taxation and the owners are personally liable for the debts of the business. General partnerships can be formed with little formality, but because more than one person is involved it is wise to have a written partnership agreement stipulating the terms of the partnership.
Limited Partnership (LP)
The limited partnership comprises general partners who run the business and are exposed to personal liability, and limited partners who invest in the business and have only their invested capital at risk. Limited partnerships are especially useful for raising capital since they permit investors to participate financially in the business without incurring personal liability.
Limited Liability Partnership (LLP)
The limited liability partnership is similar to a limited partnership except that all partners in an LLP enjoy limited liability. Limited liability partnerships are common among professionals such as attorneys and accountants, who are not allowed to use corporations to limit their liability. Limited liability partnerships offer both the pass-through taxation of a partnership and the liability protection of a corporation.
Corporation
The corporation is the most common form of business entity among larger companies. Unlike sole proprietorships and partnerships, corporations are separate and distinct from their owners in the eyes of the law. As a separate entity, corporations have several distinguishing characteristics including limited liability, easy transferability of shares, and perpetual existance. Corporations also have centralized management who may be different persons from the actual owners.
Limited Liability Company (LLC)
Venture capitalists do not like the flow-through taxation associated with LLC's. However, in many cases an LLC is better than an S corporation for taxes because there are fewer hurdles and income can be allocated more flexibly.
The Uniform Commercial Code
Businesses are formed under state laws and are governed by the Uniform Commercial Code (UCC), which made business laws similar in all states. Before the UCC, businesses had to know and deal with the different laws in all of the states in which they operated. Note however, that
The Sole Proprietorship
The sole proprietorship is the most common form of business structure for small companies. It is viewed as being one and the same as its owner. This characteristic has the advantage of simplicity but also has the disadvantage of personal liability.
Taxation
A sole proprietorship has pass-through taxation. The business itself does not file a tax return; rather, the income passes through and is reported on the owner's personal tax return.
Liability
The owner of a sole proprietorship has unlimited personal liability. However, with insurance for tort risk and contractual limitations for contract risk, the sole proprietor can insure against most risks and operate with near the same level of comfort as the owners of a corporation.
Continuity of existence
A sole proprietorship exists only as long as the owner is alive or until the owner decides to close the business.
Risk and Control
The control of a sole proprietorship belongs entirely to the owner, who also assumes the full risk of the business.
Transferability
Transferring one's interest in a sole proprietorship is very easy - one simply prepares an asset purchase agreement and sells the assets. The assets of a sole proprietorship are transferred with the estate of the owner upon death. To die testate means that there is a valid will; intestate means that there is no valid will and the intestate succession laws will determine the allocation of assets among heirs. These laws are logical, but it is better to use a will to specify one's wishes for the transfer of sole proprietor assets.
Expense and formality
The sole proprietorship is the simplest way of doing business. The costs of formation are very low and there is very little formality required. If the name of the business is different from the name of the owner, the sole proprietorship must be registered with the state. If the owner's name is used, it will be in the form of firstname lastname or simply lastname.
The General Partnership
A general partnership (or simply partnership) is an association of two or more people carrying on a business with the goal of earning a profit. A partnership is viewed as being one and the same as its owners. There is little formality involved in creating a partnership. In fact, if someone can establish that you are in business with somebody else, then there is a general partnership. The intention or lack thereof of having a formal partnership is not important.
Existence of a Partnership
Rules for determining the existence of a partnership are outlined in Part II of the Uniform Partnership Act (UPA). Some of these rules are summarized as follows:
1. Joint tenancy, common property, part ownership, etc. does not by itself establish a partnership, regardless of whether the owners of the property share any profits from it. Three ways to jointly own property are:
A. Tenants in common - when one dies, one's portion of the partnership is transferred to one's heirs.
B. Joint tenancy - right of survivorship - when one dies, the entire interest goes to the other person.
C. Tenancy by entirety - for example, a husband and wife. Each tenant owns by whole and by part. If a third party has a claim against the husband, the claimant cannot go after the property since it belongs wholly to the wife as well. For this reason, banks often require both the husband and the wife to sign a loan.
2. Sharing of gross returns from jointly held property also does not by itself establish a partnership.
3. The receipt of a share of profits from a business is evidence of being a partner of that business, unless the profits were received as payment on a debt, interest, wages, rent, etc.
A person may be considered a partner even if not formally included in the partnership. This is known as partnership by estoppel. "Estoppel" means that one is not permitted to deny. In the context of partnerships, it means that a person cannot deny being a partner if he permits the partnership use his name. Take for example, a situation in which partner A and partner B start a business and offer non-partner C a profit interest in the company if they can use C's name in the business. If a bank lends money to the partnership and the partnership becomes insolvent, C would be considered a partner and could be held liable.
Partnership Taxation
Like a sole proprietorship, a partnership has only one level of taxation. A partnership is a tax-reporting entity, not a tax-paying entity. Profits pass through to the owners and are divided in accordance with what is specified in the partnership agreement. There are no restrictions on how profits are allocated among partners as long as there is economic reason, so there is latitude in allocating income according to which partners have the best tax rates.
Liability
While pass-through taxation is an advantage, owners of a partnership have unlimited personal liability. In general, each partner in a partnership is jointly liable for the partnership's obligations. Joint liability means that the partners can be sued as a group. Several liability means that the partners are individually liable. In some states, each partner is both jointly and severally liable for the damages resulting from the wrongdoing of other partners, and for the debts and obligations of the partnership.
Three rules for liability in a partnership are:
- Every partner is liable for his or her own actions.
- Every partner is liable for the actions of the other partners.
- Every partner is liable for the actions of the employees of the business.
As an example to illustrate liability in a partnership, suppose there is a partnership formed by partners A, B, and C. If partner A accidentally runs over somebody while driving on a personal trip to the grocery store one weekend, then A alone has unlimited personal liability. If partner A accidentally runs over somebody while making a delivery for the partnership, then A still has unlimited personal liability, but all three partners would be jointly and severally liable. If the victim wins a judgement of $1 million against the partnership, and only partner B has the money, then B would have to pay the judgement. Partner B could assert a right of contribution against partner A, but if A has no money it would not be worth the effort. If an employee of the partnership, employee E, accidentally runs over somebody during the course of work, then the partnership is liable since the employer is responsible for the actions of an employee within the scope of business. If the accident happened while the employee stopped for something personal, then the employer would not be responsible (frolic and detour).
Risk and Control
Absent an agreement to the contrary, UPA gives partners equal voting rights, even if they contributed different amounts of capital. Squeeze-outs are a common issue in partnerships.
Expense and formality
As in the case of a sole proprietorship, if the partnership chooses a ficticious name (different from the names of the partners), it is required to file that name with the state.
Fiduciary Duty in a Partnership
Partners owe both a contractual duty and a fiduciary duty to one another. According to Black's Law Dictionary, a fiduciary duty is the duty to act for someone else's benefit while subordinating one's personal interests to those of the other person. These days however, many operating agreements waive the fiduciary duty so that one can pursue other opportunities that may come along.
Case: Meinhard v. Salmon
Facts
Salmon wanted to lease some property in
Issue
Meinhard claimed that Salmon had a fiduciary duty to provide him the opportunity to participate in the deal.
Holding
The court ruled in favor of Meinhard.
Reasoning
The new deal was an extension of the old one. While Salmon did not act in bad faith, he had a fiduciary duty to Meinhard.
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As one person put it, "a partnership is just like a marriage."
Issues to Address when Forming a Partnership
To reduce the chances of disputes among the partners, a written partnership agreement always should be drawn up before going into business as a partnership.
The Revised Uniform Partnership Act (RUPA) was issued in 1994. It is a revision of the original Uniform Partnership Act that dates back to 1914. UPA is interstitial; it fills in the gaps in the specific partnership agreement.
Issues to address in forming a general partnership:
· Amount of capital contributed by each person, and if more is needed at a later date, who contributes it, and any limitations to someone's maximum contribution.
· Rights and responsibilities of each partner.
· Division of profits among the partners.
· Distribution of assets upon dissolution of the company. If one partner wakes up one day and wants out, the partnership dissolves. But liquidation would destroy the value of the business, so the partnership agreement should provide rules for a partner's exit. One partner can transfer a profit interest to an external party, but not control. Some options for distribution of assets include:
o Right of first refusal - a provision that requires the departing partner to allow the remaining partners to buy his or her share of the business at the same price of a bona fide external offer.
o Right of first offer - since the time delay associated with giving existing partners the right of first refusal may discourage external parties' interest in bidding, the right of first offer may be used instead. The right of first offer is a provision that requires the departing partner to offer to sell his or her share of the business to the other partners before offering it externally.
o Dutch auction - a provision in which one partner offers to sell to the other partner at a particular price. If the other partner refuses, the first partner must buy the other partners share at that price. This arrangement provides strong incentive for a fair asking price. Note that the term "Dutch auction" has other meanings as well - it also refers to both a descending price auction and to an auction in which several identical items are auctioned and all successful bidders pay the either the price of the lowest successful bidder or their bid prices, depending on the specific auction rules.
o Third party arbitrator - an outside party sets the price.
Limited Partnership
A limited partnership (LP) consists of two or more persons, with at least one general partner and one limited partner. While a general partner in an LP has unlimited personal liability, a limited partner's liability is limited to the amount of his or her investment in the company. LP's are creatures of statute since they must file with the state to form them. Because of the limited liability of limited partnerships, they often are used as vehicles for raising capital. The limited partnership is a separate entity and files taxes as a separate entity.
The statute that provided for the formation of limited partnerships was the Uniform Limited Partnership Act (ULPA), which dates back to 1916. In 1976, ULPA was revised into the Revised Uniform Limited Partnership Act (RULPA), which was amended in 1985 to address the issue of limited partners' taking control.
RULPA states that a limited partner shall not be liable as a general partner unless he or she takes control of the business. However, a limited partner is not considered to control the business if he or she is a member of the board of directors.
Because the general partner is exposed to unlimited personal liability, LP's sometimes are set up so that the general partner is a corporation or an LLC.
Distinctions Between Limited Partnerships and General Partnerships
Three distinctions between limited partnerships and general partnerships are:
1. LP's are created by statute, not by intentions of the partners.
2. Ability to override the partnership agreement.
3. Tax treatment - a limited partnership normally has pass-through taxation, but must meet certain criteria to avoid being taxed as a corporation.
Taxation
As in a general partnership, income can be allocated each year among the partners in a way that minimizes taxes. If the limited partnership meets a minimum number of criteria related to limited liability, centralized management, duration, and transferability of ownership, it can enjoy the benefits of pass-through taxation; otherwise it will be taxed as a corporation.
Transferability
The limited partner interest is considered a security by law. It can be transferred to a third party, but general partners and limited partners have the right of first refusal. Because of its nature as a security, there is an advantage to targeting "sophisticated" or "accredited" investors, defined as those having a net worth greater than $1 million or having an income greater than $200 thousand for the past two years. Disclosure laws are not as rigid for such investors.
Two issues commonly faced by limited partnerships are defective filing and a limited partner's taking control.
A Case of Not Filing for Renewal
A potential problem with statutory entities is that if one forgets to file a renewal, one may lose limited liability without knowing it.
Case: Gilman Paint & Varnish Co. v. Legum
Facts
The Tovell Construction Company was a limited partnership that was formed in 1942 for a predetermined duration of two years. C. Eugene Tovell and Walter J. Levy were general partners each of whom contributed $25,000 in capital, and Legum was a limited partner who contributed $150,000. Legum's share of the net profits was to be 33 1/3 percent. Gilman Paint & Varnish Co. sued Legum, together with Tovell and Levy, severally and as partners. In 1944 the partners signed a two year extension, but did not record it until 1948. Therefore, at the time of the sale of the merchandise, there was nothing on record indicating the existence of the partnership. In early 1948, the partnership defaulted, and Legum was sued for the amount owed.
Issue
Since the limited partnership no longer existed at the time of the sale, the issue is whether Legum really was a general partner and therefore whether he had unlimited personal liability.
Holding
Legum cannot be held as a general partner of the Tovell Construction Company. Furthermore, he did not have to give up his share of the profits in the business in order to not be held personally liable.
Reasoning
Section 11 of ULPA addresses situations in which a person erroneously believes himself to be a limited partner. If one gives up one's interest in the company upon learning of being a general partner, then the person is relieved of the obligation of a general partner. Section 11 of ULPA also states that one does not have to repay past profits as long as the profits do not exceed those that would have been received as a limited partner.
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A Case of Limited Partners' Losing their Limited Liability
Case: Holzman v. de Escamilla
Facts
Hacienda Farms Limited was organized as a limited partnership in early 1943. Ricardo de Escamilla was the general partner and James L. Russell and H.W. Andrews were limited partners. Russell and Andrews advised Escamilla about which crops to plant and co-signed checks. They even could write checks without the need for Escamilla's signature. They also fired the general partner and hired somebody to replace him.
The partnership entered bankruptcy in December 1943. Russell and Andrews claimed that they had limited liability. The plaintiff maintained that they had taken control of the business, performing managerial acts, and therefore had the liability of a general partner.
Issue
The issue is whether Russell and Andrews active participation in the business made them lose the personal liability protection of limited partners.
Holding
Russell and Andrews were held liable as general partners.
Reasoning
Because they had the absolute power to withdraw all partnership funds from the bank account and could fire the manager, they had full control of the business and had become liable as general partners.
The Corporation
The corporation is the most sophisticated form of business entity and the most common among large companies. The corporate business form was well-developed under Roman law. In the second and third centuries, the corporate form was used by the early Christian church to hold and transfer church property, for example, for transferring control of parish assets to the new bishop when the previous bishop died. The corporate form was brought to the American colonies by the British.
When to Incorporate
A venture usually does not need to incorporate in its very early stages. The need for incorporation often arises from a specific event such as:
· The business begins to sell a product, opening up potential liability.
· The business seeks external financing, necessitating the need for a formal legal structure.
· Some other specific reason develops.
From a venture capitalist's point of view, C corporations are the preferred choice of business form because the VC partnership does not want to see the pass-through income. For entrepreneurs without VC funding, limited liability companies are the preferred choice since losses in the first few years can pass-through for personal tax deductions.
Forming a Corporation
To form a corporation, an incorporator (anybody can act as one, e.g. the secretary of a lawyer) performs a name check to determine whether the proposed corporate name is available in the state of incorporation. However, the right to use the name is in the domain of trademark law. The incorporator then files the articles of incorporation. Most large corporations are incorporated in
The articles of incorporation include:
1. The name of the corporation, which must be followed by a corporate indicator such as "Corporation", or "Ltd."
2. The address (not a post office box) of the corporation's registered office and the name of the registered agent at that office. The registered agent is the person to be served if the corporation is sued. This is an office for legal purposes and does not have to be the corporation's business office.
3. The length of time that the corporation is to exist. This duration can be perpetual or renewable.
4. The capital structure such as common stock, preferred stock, the rights and responsibilities of each, and how much of each. One often authorizes about 20 million shares of common stock and 5 million shares of preferred stock. However, many closely-held small corporations that do not require outside investors may have only common stock and may limit the authorized shares to only a few thousand in order to minimize franchise taxes, depending on the state.
5. The name and address of the incorporator.
Up to this point in the incorporation process, one has spent no more than a few hundred dollars in fees for filing the articles of incorporation. The incorporator then elects a board of directors and goes away as the board of directors takes over. The directors then issue shares and elect the officers.
Taxation
For a corporation organized under subchapter C of the 1986 IRS code (known as a C-corp), the federal tax rate ranges from a minimum of 15% to a maximum of 35%, depending on the corporation's level of taxable income. All but the smallest corporations are taxed in the 34% - 35% range at the federal level. The state tax rate varies.
Double taxation may be an issue with C corporations since profits paid out as dividends are taxed a second time at the personal level. To reduce the tax burden, the company can include debt in its capital structure, but at a certain level of leverage the IRS will reclassify the debt as equity. A more common way of reducing the tax burden is to pay year-end bonuses so that the corporate income is reduced to near zero. However, there is a limit to what the IRS considers reasonable compensation, at which point further amounts are considered to be non-deductible.
Another way to reduce the tax burden is to form a general partnership or a limited liability company that owns the equipment used in the business. The rental fees for the equipment can be used to channel income.
S Corporation
For a corporation organized under subchapter S of the Internal Revenue Code (S stands for small business corporation), there is pass-through taxation. An S corporation can be formed by making a subchapter S election when forming a C corporation. This distinction is at the federal level, but some states recognize it as well. The subchapter S election affects the corporation only from a taxation viewpoint. The income, gains, losses, and deductions are passed through in proportion to one's share of ownership in the S corporation.
The subchapter S election has some additional requirements:
1. The S corporation must be a domestic corporation.
2. The maximum number of shareholders is 75. Before 1997 this limit was 35. There are ways around this limitation, for example, by forming two S corporations that form a joint venture.
3. The shareholders of an S corporation must be individuals or certain estates and trusts.
4. The shareholders of an S corporation must not be non-resident aliens.
5. An S corporation may not have more than one class of stock, for example, common stock. However, there can be two types of common stock - voting and non-voting. In some cases, options and warrants may count as a second class of stock. Debt is not considered a second class of stock unless it is classified as equity. There are three requirements for debt to be acceptable for subchapter S election:
- Its interest is not tied to profits.
- The debt is not convertible.
- The creditor must be an individual.
6. The corporation must make the S election within 75 days of formation, otherwise it will be a C corporation for the first year, and an S corporation thereafter.
If the exit strategy is to be acquired, for a small non-dot com an S corporation is a better choice than a C corporation. C corporations require a higher selling price to make up for the tax differences to the owners. A corporation can change from a C corporation to an S corporation fairly easily, but it is much more difficult to change from an S to a C corporation.
State of
The corporation is an entity created by state law, and laws vary from state-to-state. Selecting the state of incorporation is an important decision for a business. Traditionally,
Incorporation Documents
There are several key documents in a corporation. The articles/certificate of incorporation are analogous to a nation's constitution. The bylaws are analogous to a nation's statutes. The organizational minutes evidence a meeting. After those, the key documents of concern are the shareholders agreement and employment agreement.
The shareholders agreement is related to risk and control issues. It regulates how shares are transferred, for example, if a shareholder dies. It also specifies how a shareholder can get out.
Preserving Limited Liability
An important advantage of the corporation as a business form is that shareholders are not personally liable for the debts incurred by the corporation. However, this protection is not ironclad. Individuals can be held liable when it can be shown that the incorporation process was not performed properly (defective incorporation), when one personally signs a contract without explicitly stating that it is on behalf of the corporation, and when a court decides to pierce the corporate veil and remove the limited liability protection.
Reducing Potential Personal Liability Associated with Sitting on the Board of Directors
1. Have an indemnification - an indemnification agreement creates an exemption from incurred liabilities. One can guard against personal liability by getting the company to agree to pay for legal defense and to reimburse any damages.
2. Have a contract that specifies the indemnification.
3. Have director and officer (D&O) insurance.
Corporate
Case: Klinicki v. Lundgren
Facts
In 1977, Klinicki and Lundgren incorporated Berlinair, Inc. Lundgren served as president and a director; Klinicki was a vice-president and a director. Lundgren and Klinicki, as representatives of Berlinair, met with a consortium of travel agents about a potentially lucrative business opportunity. Without telling Klinicki, Lundgren incorporated Air Berlin Charter Company as the sole owner in order to take advantage of the opportunity. Air Berlin Charter Company was granted the contract. Lundgren defended himself by arguing that Berlinair did not have sufficient financial resources to pursue the opportunity.
Issues
The issues are corporate opportunity and fiduciary duty.
Holding
Lundgren misappropriated the lucrative contract.
Reasoning
Lundgren should have presented the opportunity to Berlinair's board of directors and shareholders. Had they voted against pursuing the opportunity, Lundgren would have been free to pursue it.
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Stock and Debt
When forming a corporation, there are three things that must be divided: earnings, assets, and management.
The authorized stock is the total number of shares that the articles permit to be issued. For example, a Delaware C corporation might issue 15 million shares of common stock and 5 million shares of preferred. Of this, the founders may own one million shares and the angel investors 300,000 shares. Too many authorized shares may result in higher taxes since some states tax a corporation on the number of shares. (
Common stock has voting rights and a residual claim on assets and earnings. Preferred stock can vote only under certain circumstances, for example, if its dividends are not paid or if there is to be a change of charter; the voting rights associated with a change of charter depend on the shareholder agreement.
There are three types of debt:
1. Notes, of duration less than 10 years, non-secured.
2. Debentures, of duration greater than 10 years, non-secured.
3. Bonds, of duration greater than 10 years, secured. Secured debt entitles the debt holders to specific assets in case of default.
Stock Options
Equity compensation plans often use stock options (actually called warrants since they are issued by the company). There are two types of stock options:
1. Incentive Stock Options (ISO) - these options are given to employees and provide them the right to purchase stock at its fair market value on the date the options were granted. Such options are not taxable upon exercise. An employee can lose such options if terminated for cause. An employee may want to consider negotiating a 30 day termination notice and an "opportunity to cure." If leaving voluntarily, options normally can be exercised within 60 days.
2. Non-qualified options - exercising such options triggers a tax liability.
Piercing the Corporate Veil
How to Preserve Limited Liability
Preservation of limited liability is an important issue specific to corporations. The corporate protection of limited liability can be lost through:
- Piercing of the corporate veil
- Defective incorporation
- Improper signing of documents.
Piercing the Corporation Veil
A court may pierce through the veil of liability protection if the corporation does not follow proper corporate formalities, if it is undercapitalized, or if it can be shown that it is a sham that was set up to defraud.
If the corporate formalities are not followed, the corporation may be deemed to not be functioning as a corporation, but rather, as the alter ego of the owners. To prevent the corporate veil from being pierced, it is important to keep minutes of the board meetings and to not co-mingle bank accounts. These measures help to ensure that the corporation will be treated as a separate entity should it be sued.
Case: Edwards Company, Inc. v. Monogram Industries, Inc.
Facts
In 1977, Monogram Industries, Inc. acquired Entronic Corporation, a company that produced smoke detectors. Monogram made the puchase through a wholly-owned subsidiary called Monotronics, itself a corporation. Monogram owned 100% of Monotronics' stock. Monotronics then formed the Entronic Company, a limited partnership in which Monotronics was the only general partner. All went well until 1978 when General Electric began dumping smoke detectors on the market. A company called Edwards had extended about $350,000 of trade credit to Entronic, which Entronic was unable to pay, resulting in the liability of the general partner Monotronics. However, Monotronics had only about $10,000 in total assets at the time, so Edwards sued Monogram Industries to recover the debt, attempting to pierce the corporate veil of Monotronics.
Issue
Edwards claimed that Monotronics had the same board of directors, same office, same payroll, and the same telephone as Monogram Industries, and therefore Monotronics was simply a piece of paper in Monogram's file cabinet.
Holding
The court ruled that Edwards could not pierce the corporate veil. Monogram was not liable for the debt of Monotronics.
Reasoning
The court described a very clear test to determine whether one can pierce the corporate veil. In order to pierce the corporate veil in contract cases, both of the following must be shown:
- There must be fraud or injustice, and
- There must be a lack of separate existence.
The court found no evidence of either of these. There was no evidence of not abiding by corporate formalities, no evidence of co-mingling of money (alter ego claim), and no evidence of under-capitalization. Edwards had not performed adequate due diligence. It used outdated Dun and Bradstreet reports in its research and did not really understand which entity it was doing business with.
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Besides cases involving the piercing of the corporate veil, individuals may be held personally liable for a corporation's debt in some cases of defective incorporation and improper signing of documents.
Defective Incorporation
Suppose that a person forms a corporation and convinces two other people to invest. If the corporation later gets sued and it is discovered that the corporation had not been formed properly, the investors may not have limited liability due to defective incorporation.
Individuals may be held personally liable if the corporation is not set up properly but proceeds to do business. In such cases of defective incorporation, one can escape personal liability under certain conditions. For example, if a good-faith effort was made to incorporate and a substantial portion of the incorporation laws were followed, limited liability protection may be granted.
Signing of Documents
When signing documents on behalf of a corporation, both the name of the corporation and the signer's representative position in the corporation must be stated.
For example:
By: John Doe's signature
Name: John Doe
Title: President
Case: Wurzburg Brothers, Inc. v. James Coleman
Facts
James Coleman is the president of Coleman American Moving Services, Inc., a publicly owned
Issue
The issue here is whether the corporate instrument was properly signed.
Holding
The court ruled that Mr. Coleman was personally liable for the debt.
Reasoning
Mr. Coleman did not follow the proper procedure for signing corporate instruments in a representative capacity.
Where to Incorporate
Selecting a State of
The internal affairs of a corporation are governed by the laws of the state in which it is formed. A corporation does not have to have an office or do business in the state in which it is incorporated; it need only have a registered agent in that state. There are companies such as CT Corporation System that will act as a registered agent in the state of incorporation.
Advantage of Incorporating in One's Own State
If the company does not plan to obtain venture capital funding, it may be best to incorporate in the state in which the company plans to do business. Doing so has the following advantages:
- Local attorneys are familiar with the local law
- One can have an intrastate securities law exemption.
- There is the convenience of geographical proximity.
- The corporation does not need to register as a "foreign" corporation in the state of operation if it is incorporated there.
Name Availability
The selected name must be available in the state of incorporation. In choosing a corporate name, one needs a name that can be used in every state in which the corporation will do business. It is best to coin a name that is not a common word in the language. "Exxon" and "Pentium" are examples of such words.
Issues to Consider when Selecting a State
Some of these issues may be important to your corporation. In any case, they can serve as a starting point for questions to ask.
1. How many incorporators are required by the state, and whether the incorporator itself can be a corporation.
2. The minimum number of people required to form the corporation.
3. The minimum capital requirement, if any.
4. The state's fees for filing the articles of incorporation.
5. The state's annual corporate franchise tax.
6. The state's corporate income tax and whether earnings from operations outside the state are taxable. The State of
7. Whether the corporation is allowed to keep its books and records outside the state.
8. The state's court system's reputation of fairness in business cases.
9. Whether the corporation is allowed to have its principal place of business outside the state.
10. Whether there is a state inheritance tax on non-resident shareholders.
11. Disclosure/privacy - whether the state requires public disclosure of the names of shareholders.
12. Whether the state requires a corporate bank account in that state (
Nevada Corporation
(Compared to
Historically,
1. Taxes on corporate earnings:
2. Annual franchise tax:
3. Annual disclosure:
4. Protection of officers and directors:
5. Shareholder disclosure:
6. Disclosure to IRS:
There is a flip side to some of
Regardless of the state in which your business incorporates, the state in which it is operating probably requires it to register as foreign corporation in that state. In addition to registration fees, the corporation typically would be subject to the same types of reporting and taxes as would any corporation in that state. If a corporation does not register as a foreign corporation in a state, it may not be allowed to bring action in the court system of that state, and may be subject to the taxes and fees that it would have paid had it been registered. Fines also may be imposed. Because of the requirement to register as a foreign corporation, most of the anticipated advantages of incorporating in a state that offers more favorable laws might not be realized.
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