Marketing, Law, and Ethics

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learning objectives After studying this chapter, you will be able to: LO9- 1

Discuss the various legal forms of business to determine the best design for a proposed new business.

LO9- 2

Explain the basics of contracts.

LO9- 3

Define the role of leases in the legal formation of the new business.

LO9- 4

List how laws, rules, and regulations benefit new businesses.

LO9- 5

Explain the importance of copyrights, trademarks, and patents to a new business.

LO9- 6

Define the role that insurance plays in the risk portfolio of the new business.

LO9- Discuss how to develop an effective board of advisors or board of directors.

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7

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Establishing the Legal Foundation

WEEDMAPS: THE YELP OF MARIJUANA BUYING

How do you take something that is considered illegal in much of the United States and make a legal business out of it? Regardless of one’s opinion on the subject, legal marijuana sales exist in the United States. As of 2014, 21 states as well as Washington, DC, allowed for the purchase of medical marijuana, whereas two states, Colorado and Washington, allowed for any adult to purchase marijuana for recreational use. Despite being legal in these settings, running a business in this industry is still a legal minefield.

According to the federal government, marijuana is a Schedule 1 narcotic with no accepted medial value. In addition, there are thousands of people in jail for past possession of the product. Add to that, it is still highly regulated even in states where it has some form of legality. The Marijuana Enforcement Division in Colorado issued a 230-page document prescribing how it must be advertised, sold, and distributed in the state. At this point, the federal government has decided not to pursue their established enforcement actions in those states where it is legal; however, it is unknown how long that decision will last. Any business enabling the sale of an illegal substance is subject to seizure and jail time for the owners.

Weedmaps was founded by Justin Hartfield and Keith Hoerling in 2008 and navigates this legal minefield as it provides menus and pricing of legal marijuana dispensaries across the United States. The firm makes money not by charging visitors to the website but by charging the business owners who list there. Weedmaps helps customers find legal marijuana suppliers and also helps the firms that list with them manage their products. Hartfield says the site is tracking half a million products in real time, “not just strains but also edibles, lotions, tinctures, salves, balms, clothing, bongs, and vaporizers. Anything a dispensary sells is on our weed menu.” Today, the firm has over $18 million in annual revenue with more than 2 million visitors a month to the website.

Like all businesses, the firm makes efforts to reach out and connect with its customers. As one aspect of this marketing effort, the firm hosts social events for the users of medical marijuana to meet each other. Another aspect of this connection to customers is its association with NORML (a lobbying group seeking to legalize marijuana), which is an official partner of Weedmaps. In part, this partnership reflects the view that Hoerling and Hartsfield have of Weedmaps as playing not only a role to make a profit but as supporting

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the community that smokes marijuana. This view of the community can also be seen in Hartsfield’s founding of the first venture capital fund (Ghost Group) focused on funding emerging companies in the legal medical sectors.

There are legal constraints on every business. Some are just more intense than others.

Questions 1. Does this change the definition of a “drug-free” workplace in Colorado? 2. What type of legal organization would you consider if you were running this business? Why? 3. What insurance issues concern you about this business?

Sources: B. Eha, “High Hopes and Blunt Truths for the $2.3 Billion Legal Marijuana Market,” Entrepreneur, January 13, 2014, www.entrepreneur.com/article/230772-1; T. Hughes, “Legal Pot Becomes a Touchy Work-place Issue,” USA Today, April 7 2014, www.usatoday.com/story/news/nation/2014/04/07/marijuana-pot-workplace-employers-hiring-jobs/7272467/; B. Weiss, “Thank You for Smoking Marijuana,” Wall Street Journal, March 14, 2014, http://online.wsj.com/news/articles/sb10001424052702303630904579419033028056534

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Legal issues are critical for any new business to consider. Even though we present issues sequentially in this text, you should recognize that often things happen simultaneously. Thus, legal issues may occur at the same time as some of the financial issues discussed earlier in the book and, in fact, may impact your financial decisions. In addition, the information in this chapter is not meant to be definitive or exhaustive of all the legal concerns related to starting a new business. The material is factually correct; however, we strongly believe that you should hire a qualified attorney to assist you in building the foundation of the new business. The laws in each state vary, and the consequences are often serious enough that you will want to ensure you have a full and complete understanding of the legal issues related to the business.

In the previous chapters we have set out a means for you to develop the type of business you want to create, determine its strategy and/or mission, and perform a detailed analysis of the potential cash flow position for the new firm. However, prior to the beginning of any actual operations, the founder must ensure that the proper legal foundation for the business is established.

Mature economies are based upon laws.* To fully appreciate the reliance in the United States on the legal institutions, one need only compare the United States to China.1 There is a legal system in China, but in most cases this system is one that is evolving. Often the laws are on the books in China but will be enforced only sporadically or in an inconsistent manner. How those laws are enforced and the penalties for violations of those laws will vary widely across the country. Whether laws and their enforcement are the concern of the central government, province, or city is often unclear; instead, there are competing authorities who may interpret what is to be done very differently. To work in this environment, a business survives by developing good relationships with administrators, regulators, and/or the police. It will be the relationship between these individuals and the entrepreneur that determines if the laws are enforced and, if so, how they are enforced. The relationship between a businessperson and government officials may originate from a variety of sources, such as being related by blood or marriage, going to school together, or making a payoff, but without such relationships the new businessperson will most certainly find that he has significant legal problems.2

In contrast, the laws of the United States, and many other mature economies, are relatively clear, reasonably well enforced, and the amount of corruption relatively low. As a result, legal conflicts are decided based on the facts, not on who you know. This does not mean that the legal system in a nation such as the United States is not a source of irritation for businesspeople. For example, obtaining a license to sell alcohol at your premises involves approval from numerous independent authorities—local, state, and federal (the federal agency is the ATF—the Bureau of Alcohol, Tobacco, Firearms, and Explosives).

Although they are frustrating, entrepreneurs must realize that legal structures in society are critical for businesses. The abilities to collect money owed, to trust that contracts will be honored, to operate without fear of being arbitrarily shut down, and to prevent ruinous interventions by the government are all the result of laws. Indeed, in a developing country, or in one recently ravaged by war, one of the first major steps in building the nation’s economy is to establish the police and the courts so that basic business can be transacted.

__________ *The law present in a country is referred to as an institution. Other issues such as culture and ways that a given profession may conduct business are also institutions. These institutions shape the way business is conducted in subtle and pervasive manners. To fully understand how business is conducted in a given area, such institutions must be understood.

Our view is that new businesspeople need to acknowledge the central role and importance of the legal system, recognize how it will impact their

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business lives, and be prepared to compete in that arena. The businessperson cannot ignore legal issues. As a result, entrepreneurs need to recognize that it is likely they will at some time go to court to resolve disputes. If, on the other hand, a supplier or customer did not live up to an agreement in China, the entrepreneur might go see a powerful person who would mediate the dispute between the two parties using his personal judgment and experience as a guide. If the entrepreneur’s relationship with that mediator was poor or if the other party had very strong ties to the mediator, the entrepreneur would likely lose. In the United States, the entrepreneur has the ability to use the court system for a legal remedy that is bound by precedent and the Uniform Commercial Code. The nature of business is that there will be disagreements, and as a result, you as an entrepreneur are likely at some point to be in court. Although this may not be the ideal path to arbitration, it is better than the alternative of having no legal system, or a weak one.

The Friends’ Home Health Care founders had determined the type, mission, and fundamental positioning of their new business idea. However, before they began operations they felt that this business idea might need another investor or two. The resources from these investors would allow them to position the business to grow faster. Betty and Joan started their discussion with several local bank managers and loan officers regarding their initial financing, but were stumped in the process when they were asked “what type of business” they had. Initially they thought this question referred to their positioning or plan for success, but they quickly found out that the financiers were asking about what legal form of business the entrepreneurs would choose.

Having given this topic very little thought, the partners were not sure they understood the different forms of business they could pursue, but they also did not have much time to worry about such issues (or so they thought). They wanted everything to be fair and even between the founders and the new investors, so, with very little thought, they announced that they were going to form a “partnership.” They mistakenly believed that this form of business would indicate their commitment to the business and their desire to have investors involved in the business. After all, in law firms and accounting firms, being made a partner is considered the highest honor and confers upon the partner rights to the profits of the firm.

The founders had made great progress in developing their business plan, and their next step was to approach the person they expected to be their key financial investor. This individual was a very successful entrepreneur that one of the founders had loosely known since childhood. Over the years he had started and run a variety of retail businesses. Although the investor had not had a business in the health care industry, he was interested in the idea and was familiar with the business domain as his mother had just recently passed away after a long period of home care. His prior success in business led the founders to also believe he could provide great insight to them on running the business and therefore would be an ideal investor.

The founders met with this investor and made a presentation of their business idea. It had taken two weeks to get on his calendar and the meeting was going to be quite brief. He was intrigued by the business idea and by their “numbers.” He then asked them what type of business entity they had formed, and Betty and Joan responded that they had formed a “partnership.” The potential investor fell silent. After what seemed like an eternity to the Friends’ founders, he responded that he would not invest in a partnership because of the personal liability and problems associated with the lack of liquidity. He finished up with a few polite comments, wished them the best of luck—and the meeting was over.

Betty and Joan were shocked, but in analyzing the meeting afterward, they realized that the type of business they intended to form was of significant interest to potential investors, bankers, and perhaps themselves. They realized that the legal foundation for their business needed to be reconsidered as it was a more central issue than they originally believed. The opportunity to obtain any investment from the ideal investor with whom they had just met was probably lost forever owing to the lack of an adequate legal foundation. They were now determined to investigate the legal issues in more detail before they went forward any further.

QUESTIONS 1. How would you describe the liability issues that concerned the potential investor? 2. Do these concerns seem relevant? How would you address them?

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An important part of operating a business is having a fundamental understanding of the basics of commercial law and the potential remedies when there is a dispute. The establishment of a basic legal foundation will help the entrepreneur navigate the legal environment much more easily.

Significant time and effort can be saved in the long run with some careful thought at the founding of a new venture about legal issues. This chapter will examine a number of legal issues that impact the founding of the new business, including:

  The forms of business   Contracts   Leases   Regulations, including licensing requirements   Copyrights, trademarks, and patents   Insurance   Board of advisors or directors

sole proprietorship The simplest form of business organization, characterized by the fact that the person who owns the business and the business itself are treated as the same entity.

Various Legal Forms of Business to Determine the Best Design for a Proposed New Business LO9-1 Discuss the various legal forms of business to determine the best design for a proposed new business.

There are three basic types of legal business organization: sole proprietorship, partnership (including both general and limited liability), and corporation (C, S, and limited liability company). Each of these will be examined below.

Sole Proprietorship A sole proprietorship is the simplest form of business to establish, as the person who owns it and the business itself are treated as the same entity. Driven by the belief that new business is good for the economy and should be encouraged, most communities have made the process for obtaining a sole proprietorship license quite simple although there can be distinct differences between communities that will affect the rate of sole proprietorships formation.3 A quick trip to the local courthouse or public administration building, filling out a simple form, and paying a small fee is usually all that is required to establish a sole proprietorship. More and more communities are making this process even simpler with a complete online process. All of the business income and losses for a sole proprietorship are treated as part of the individual’s overall income and are reportable on schedule C of your 1040 tax form. Absent other licenses that may be required to operate your business (a topic we will cover in more detail later in this chapter), the establishment of a sole proprietorship allows an individual to legally transact business.

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Many single-person businesses are set up as sole proprietorships.

The major benefit of this form of business is that it is very easy to form and easy to dissolve. There is virtually no separation between the founder and the business. There are strict rules regarding record keeping, and it is important that the founder maintain a firewall between personal and

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business expenses since the government does not want to pay for the daily living costs of the entrepreneur. However, the entrepreneur may be able to deduct relevant business expenses from the business income.

The drawbacks to this type of business are numerous, and for business-people who develop a substantial business, these drawbacks will outweigh the ease of establishment. The first disadvantage is that a business that involves more than a single founder cannot be a sole proprietorship. Friends’, by its very nature of having been founded by two individuals, could not be a sole proprietorship unless the founders placed 100 percent of the authority with a single individual, and the other founder was considered an employee (not a very attractive prospect to the founder treated as an employee). The law does not recognize other equity investors in this type of business. This limitation is a significant drawback for the growth potential of a new business, not only from an initial investment perspective, but also because as the business develops it may need additional outside investment, which a founder may get in exchange for part ownership of the business. Such investment would be virtually impossible in this legal form. This inability to have additional owners also means that equity incentives to attract top employees and executives are not possible as you could not give them any ownership as part of their compensation. This leaves the founder with two options: either obtain all new monies as personal debt or go through the process of changing the legal form to a more robust one as the firm grows.

A second significant disadvantage of a sole proprietorship is the liability for the owners associated with it. In the sole proprietorship all of the liabilities of the sole proprietorship are the direct responsibility of the owner of the business. Thus, a debt for the firm is a personal debt for the business owner. The result is that if the business does something relatively risky, such as trading commodities, or even something mundane, like taking delivery of a substantial level of inventory that ultimately cannot be sold, then those debts of the business are treated as debts of the owner.

A third issue is one of legitimacy with suppliers and customers. Owing to the fact that this legal form is so easy to dissolve, suppliers typically require personal guarantees for the debts of the firm from the founder of the business. The result is that the value of the business is limited since it is so tightly tied to the founder. If the founder should seek to sell the business it can be difficult to accomplish.

Thus, a sole proprietorship is very popular among individuals who: 1. Are unsure of their business idea and just want to see what might happen (if the business proves successful these individuals

often re-form the business later, using another business form). 2. Have a very small business where the time limitations of the founder will keep the business from growing significantly. 3. Have a business where the costs of equipment are low and therefore so are the risks. For example, a new business that

embroiders names on shirts and hats can have relatively low costs and low risks.

Partnerships A more complex business form is a partnership. There are two broad categories of partnerships: general and limited. The two differ significantly from each other and will be reviewed separately.

partnership

A type of business formed between individuals directly. It includes both general and limited varieties.

General Partnership. If two or more people are involved in the founding of an organization, they can form a partnership. Similar to the founding of a sole proprietorship, the means of forming a basic partnership is relatively simple; however, it does involve an extra step beyond that of a sole proprietorship. When filing for a partnership, most local communities

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require a partnership agreement. Although there are no set requirements that such an agreement must take, these agreements generally specify who is involved; what each party is expected to contribute to the founding of the firm (whether it be cash, services, or property); how profits, losses, and draws by the partners are to be treated; how one partner can buy out the other(s) if that individual decides to leave; how new partners are brought into the partnership; and how disputes are to be settled.

draw A distribution of funds from the business. It is usually in the form of a cash dispersion in advance of salary, bonus, expected year-end distribution, and the like.

We periodically hear from potential partners that they simply do not need such items to be specified. These individuals may have known each other for years and feel very comfortable with each other, so that they trust each other and are ready to tie up their combined financial wealth. As a consequence these individuals do not take the time to develop a rich and full partnership agreement. However, recall what we stressed at the beginning of this chapter. This is a legalistic society, and a business is fundamentally a financial transaction, which should be treated as such. The time to prevent problems is early in the relationship, prior to any conflict (which, by the way, is inevitable in any interaction between two or more people). We recommend the early establishment of clear and legally binding dimensions of the partnership. Thus, our advice is to get assistance from your accountant or lawyer in drawing up such an agreement. The time spent up front on an agreement will save hours and hours of frustration and conflict later.

To illustrate the importance of this process, we will describe a partnership we worked with that had been formed to develop a landscaping business. The business developed quite well for several years and grew to where the firm had more than 50 employees and annual revenues in excess of several million dollars. When the partners began, both were married, had known each other for years both personally and professionally, and attended the same church. One partner worked in the field operations while the other handled new business development for the company and managed the office operations. The wife of the partner who worked in the field was the in-house accountant for the business. Unfortunately, after several years it became clear that there was an affair between the partner working in the office and the wife of the other partner who was also working in the office. During the next few months, both partners filed for divorce and the pair having the affair moved in together. The rift in the business became obvious to customers, suppliers, and the employees of the business to the point that the business was on the verge of collapse.

The two partners had developed a short partnership agreement when they formed the business, but it was based on one they found online for free, and they had simply deleted passages that they did not want to address. At the time the two were best friends and believed that they did not need an extensive agreement. The document the two partners had generated was not clear on how they would split the business if either partner wished to terminate the agreement without the agreement of the other partner. The result was that the case ended up in court, connected to two messy divorces. Of course, the business continued to suffer. Employees left, customers chose other landscaping companies, and suppliers changed their credit terms for the business because they were concerned about the dissolution of the business. The result was a costly battle for both parties, with the field partner retaining the business and the office partner receiving a cash payment. Unfortunately for the partner who got the business, there was not a noncompete clause in the partnership or termination agreement. Once the legal case was over, the partner that left with the cash payment set up a new business in the same area and sought out customers from the previous partnership.

In general, breaking the partnership among partners has a negative impact on new businesses.4 However, in the case of the landscaping business, a better-constructed partnership agreement could have allowed for a fair and

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less costly dissolution of the partnership. Plus it could have protected the existing company from the partner who left and set up a competing business.

If a partnership agreement is not developed and signed, the partnership will be governed by either the Uniform Partnership Act or the Revised Uniform Partnership Act. These partnership laws were developed as suggested formats and adopted by each state. Thus, although there is some variation among the states, they are nonetheless a relatively effective means to handle the basics of partnership. Although the laws vary somewhat from state to state, certain standards are in place in the absence of a pre-formation agreement. The rules in the acts are reasonable, but they rarely match exactly what most individuals would prefer for their business. For example, in these acts all assets are treated as equal for the partners. However, we find that rarely is there a true 50–50 partnership. Inevitably, one or more partners contribute more capital or take more of a role in running the business than the other(s). Given this situation, new-business owners would likely want to write a partnership agreement that recognized the larger contribution and perhaps provided a larger ownership stake. Similarly, issues like noncompete agreements are not covered in these acts.

A general partnership shares some of the characteristics of the sole proprietorship. The owners report their shares of losses or profits on their own personal income tax returns in proportion to their interest in the firm. Business expenses have some flow- through to personal tax forms, but the restrictions are significant. General partnerships require little more in the way of formal paperwork than sole proprietorships and dissolution can be quite easy, although it does require a formal record with the local authorities.

Some of the drawbacks of general partnerships are the same as they are for sole proprietorships. The issue of liability is usually a bit more of an issue than it is for a sole proprietorship. Partners are generally held to be jointly liable for all debts incurred by the partnership. This means that a debt agreed to by your partner for the business becomes your total responsibility if the partner fails to meet her obligations. Each partner is assumed to be involved with all decisions, which translates into a fiduciary relationship between partners. In other words, partners have the responsibility to watch out for the best interests of the other partners.

Whereas a sole proprietorship virtually eliminates the firm’s ability to bring in new equity investment, a general partnership opens this door just a bit. To accept new equity investment in a partnership, each established partner must surrender a portion of her ownership position. This is usually a process in which the new “partner” buys out a portion of each of the existing partners in a transaction that also adds some financial muscle to the organization. A new partnership agreement is required each time this process occurs, and there are limits in some communities as to the number of partners a business may have.

Limited Partnership. Some of the drawbacks to a general partnership encouraged the development of another type of partnership: a limited liability partnership (LLP). An LLP still has at least two individuals who are partners in a venture (although technically, one person can form an LLP and declare a full pass-through of all income on his or her federal taxes); however, there are two classes of partners in such a venture. The first is a general partner. The general partner is considered the manager of the firm and, as such, has unlimited liability for any debts or judgments against the firm. In contrast, the other partners are considered to be passive investors, and as such, their liability is limited to their investment in the business. The other partners are called limited partners and can work for the firm, but may not be active in the management of the organization. The only requirement of an LLP is that at least one partner is considered to be a general partner. Otherwise, the positives and negatives discussed in the previous section for general partnerships also apply to LLPs.

LLP

A limited liability partnership.

general partner

In an LLP, the individual considered the manager of the firm, who, as such, has unlimited liability for any debts or judgments against the firm.

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Corporations The result of forming a sole proprietorship or a general partnership is that the business debts flow directly to the owner(s), meaning that all owners are responsible for any debts of the firm that arise. Thus, owners can have their life savings disappear if the business goes bankrupt. The critical issues of personal liability and the desire to limit exposure to the original equity investment led to the development of other forms of organization. A corporation addresses both drawbacks by viewing the business not as synonymous with the individual but as a separate entity.5 If a corporation suffers substantial losses, the founder(s) will lose only his investment in the business.

AT&T’s corporate headquarters in San Antonio, TX. What are the advantages of working for a corporation?

There are a variety of corporations that the U.S. legal system has developed, and we will address the three most common forms. Historically, a new business formed a simple protected corporate form known as a Subchapter S Corporation, while a business that was larger, or one that was developing into a large business, formed as a Subchapter C Corporation. These corporation types take their names from subchapters in the Internal Revenue Code. However, today another form of corporation, the Limited Liability Corporation (LLC), has become a predominant business form in the United States. We discuss S, C, and LLC corporations in greater depth next.

Subchapter S Corporation An organizational form that treats the firm as an entity separate from the individuals. This allows the owners to treat the income as they would if the firm were a sole proprietorship or a partnership. It has limitations in the number and type of shareholders.

Subchapter S Corporation. As with all corporate forms, the Subchapter S has the benefit of protecting the owners by treating the firm as a separate entity. Thus, the liability is generally limited to any investment the owners might have in the organization. However, a Subchapter S allows the owners to treat the income of the firm as they would if the firm were a sole proprietorship or a partnership. Thus, the owners report their income or losses on their own personal income tax returns. The business must file informational tax returns that report each shareholder’s portion of the business that allows the IRS to ensure the owners of the corporation are reporting their income.

The benefits of a Subchapter S can be summarized as follows: 1. Limited liability for owners of the corporation. 2. The potential to consolidate financial statements of business and personal income for the tax benefit of the owners. 3. Relatively easy formation compared with a Subchapter C Corporation. 4. Legitimacy in the market as a more established form of business (the right to put “Inc.” after your business name). However, there are negatives to this form of business as well. Although the effort to form this type of organization is

substantially easier than that involved in forming a Subchapter C Corporation, it is nonetheless quite cumbersome and expensive when compared to either a sole proprietorship or a general partnership form. We strongly recommend that an entrepreneur who wishes to form a Subchapter S Corporation get an experienced professional (lawyer or accountant) to process the paperwork. A second consideration is the limitation to the number of shareholders in this type of organization. Historically, a Subchapter S Corporation has had a numerical limit to the number of shareholders. Currently that limit is set at a maximum of 75 shareholders.

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This limitation is fine for a closely held or family corporation but is a significant limitation to a rapidly growing organization or one that has any thought of going public in the future.

Subchapter C Corporation. Subchapter C solves some of the issues raised regarding Subchapter S Corporations, while creating others. Subchapter C Corporations also have limited liability for the owners, but the corporation pays an income tax.6 This leads to the situation where the corporation pays a tax on its profits. Then those profits after taxes can be paid as dividends to the owners. However, the owners will have to pay taxes on their personal tax returns for the income distributed as dividends by the Subchapter C Corporation. This is the double taxation situation that is often discussed in the United States.

New York Stock Exchange

It is possible for the developing new-business owners to mitigate the double taxation cost. The owners are also considered employees of the Subchapter C Corporation and as such are paid salaries and bonuses. The costs of these salaries and bonuses can be viewed as costs to the business. Thus, the owners can pay themselves virtually all of the profits each year, so that little actual profit is reported by the corporation, and therefore, little corporate tax is owed. Profits that are not paid out for such items as salaries, bonuses, and/or dividends are then retained by the corporation for future expansion. A Subchapter C Corporation also has the advantage that fringe benefits that are paid out are not treated as income for employees. Thus, owners can have their health insurance and other benefits paid by the corporation, which then expenses each of these as a cost of business.

Subchapter C Corporation

An organizational form that treats the firm as a unique entity responsible for its own taxes. There are no limitations to shareholder participation and the “owners” are protected beyond their equity investment.

An important feature of a Subchapter C Corporation is that there are no limits to the number of shareholders that the organization may obtain. The only real limit is the number of authorized and distributed shares in the organization. Shares in the firm must have an initial value at which they are offered, a “par” value. Thus, the corporation has a floor value that is equal to the par value times the number of shares distributed, and this translates into the shareholder equity of the firm. We recommend that the par value be set very low so that the new company can authorize a very large number of shares (millions or even tens of millions). In both Subchapter C and S Corporations, authorizing more shares, holding annual board meetings, and reporting standards to local, state, and federal authorities are among the issues that must be formally addressed by the corporation. The result is that a corporation has higher administrative costs than is typically seen in a sole proprietorship or a general partnership. For example, a

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Subchapter C Corporation requires a rather detailed corporate charter; software packages are available to guide the new businessperson through the process.

The entrepreneur forming either a Subchapter S or a Subchapter C Corporation will have to have the following: 1. A corporate name—the new organization cannot choose a name that is considered a replication of another company’s name.

Patent and trademark attorneys offer services that include detailed searches of company names (and allow business owners some level of comfort with their choice) all the way to obtaining a nationwide trademark on the name.

2. Location of the corporate headquarters—for a new business this is generally the same as the business address. 3. General nature of the business—specified for the filing. 4. Names, addresses, and titles—of all corporate founders and initial investors.

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5. A so-called time horizon for the firm’s existence—for all intents, this is usually “in perpetuity.” 6. Authorized stock and capital—the par value times the number of shares issued is considered the initial capital

of the organization. Some states require the company to have that amount on deposit in a business account with a bank. 7. By-laws of the organization—the basic rules that will govern activity in the new company.

Limited Liability Corporation. In recent years the LLC has become one of the most popular forms of incorporation for new businesses.7 This business form is still relatively new; for example, it was only in 1994 that California passed a law to allow such entities. The limited liability company has many similarities with the Subchapter S Corporation. There is the limited liability feature, which exposes each shareholder only to the amount of their investment. However, the LLC allows the new venture to have more investors, and it allows other corporations to hold stock in the company (a feature not available to Subchapter S Corporations).8 An LLC may have as few as one individual listed as an officer of the company, referred to as a “member” of the corporation. The LLC is similar to a Subchapter C Corporation in that all of the information required is the same but is unlike a Subchapter C Corporation in that profits from the organization can be handled flexibly. The owners are allowed to flow the profits through to their personal returns to avoid double taxation, which occurs with a Subchapter C Corporation. Furthermore, there is substantial flexibility (unlike with a partnership) regarding the amount of income that is designated for each individual. It does not have to be in proportion to that owner’s holdings.

LLC A limited liability corporation (LLC).

The cost of formation of the LLC is very low as this type of organization is formed by simply submitting the paperwork to the state government and having a charter issued prior to beginning operations. State governments establish how this business entity is formed and a few states, such as New York, also require that the founder of the new business publish notice of forming the LLC in the local newspaper. Some states limit their use and will not allow professionals such as accountants and lawyers to form such business entities. As we have stated before, professional advice in regard to what is appropriate within your state is money well spent.

EXERCISE 1 1. What form of business do you believe will be the best for your new venture? Why? 2. Looking five years down the road, what form of business will be best if you meet all of your forecasts? If there is a difference

in your conclusion, why would that be so?

Basics of Contracts LO9-2 Explain the basics of contracts.

Beyond the legal form of the new organization, there are a number of other legal issues that entrepreneurs should consider prior to beginning operations. A contract is an agreement between two parties to perform certain activities for some consideration. A contract does not have to be written, but it should be consistent with the theme presented in this chapter; we strongly recommend that the entrepreneur employ formal written contracts whenever there is an agreement with another party.

contract An agreement between two parties to perform certain activities for some consideration.

As with our other recommendations, we strongly suggest the use of an attorney in the creation of any legal agreement. In general, a contract should include several items that are reasonably straightforward, following on the next page:

1. Who the parties are in the contract. This preamble describes briefly who the parties are so that it is clear who is involved and in what manner.

2. What each party agrees to do and for what consideration (i.e., their cost, pay, product received, etc.). 3. When the transaction is to take place. 4. The timing of payment, if other than immediately.

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5. When the activity is to take place and how long the contract is in place. 6. Warranties. 7. How the contract can be terminated. There may be damages specified. 8. Whether the contract can be transferred. 9. If the firms are in different states, which state’s law applies?

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ETHICAL CHALLENGE Peter Roberts was a clerk for a Sears, Roebuck and Company store in Gardner, Massachusetts, in the 1960s. In 1964, when he was only 18 years old, Roberts invented the quick-release socket wrench. He presented the idea to Sears’s managers and waited to hear back from them while they did market studies and considered the manufacturing implications. Peter was offered $10,000 for his invention, which was a sizable sum of money for a teenager in the mid-1960s. Sears told him that they saw only limited sales for the product but wanted to reward his ingenuity and also keep the rights to sell the tool. Unbeknownst to Roberts, Sears’s market studies had suggested that the market would love the tool and the company had made plans to sell 50,000 per week. Roberts sued Sears and after more than two decades was awarded over $8 million. He later settled with Sears for an undisclosed sum of money.

QUESTIONS 1. Would you fight a legal case for more than 20 years? 2. Do you think it was ethically wrong for Sears to tell Roberts that his invention was not very valuable when in fact it

appeared to be a significant new product? 3. Since both parties would like to benefit from a new invention, how should each approach a situation like this one?

Role of Leases in the Legal Formation of the New Business LO9-3 Define the role of leases in the legal formation of the new business.

One of the most significant contracts that a new business is initially involved in is the lease where the business will operate. Lease contracts may be of any term length that is agreeable between the parties. Whatever the length of the lease, there are several issues that the new business owner should consider:

1. What exactly is the new business owner leasing? Beyond the basic address and exclusive access to the premises, leases should address utilities; access to parking (either exclusive or shared); responsibility for the external premises (including lawn care, painting, etc.); structural repairs/improvements; approval of leasehold improvements; and responsibility for permanently installed equipment (heating/air conditioning, plumbing, electrical, etc.).

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2. Can the business owner renew the lease? The lease should specify how long it is in effect and if there is the opportunity to renew the lease. Such renewability is not critical in all leases, but the entrepreneur needs to evaluate such details in light of their business. The initial space that is leased may not be critical for some types of businesses, such as an Internet-based business where no customers will be coming in on a daily basis. For these businesses, the website and telephone are far more important issues. However, if you have a bakery that makes specialty cakes, your customers grow accustomed to where you are located. If you have to move such a retail-based business, there are significant limitations to maintaining a customer base.

3. Who is responsible for improvements? Who has responsibility and authority for physical plant improvements? A lease that includes the responsibility for making improvements to the facility should be accompanied by a lower lease payment. One entrepreneur bought an existing hair salon and negotiated what she believed was a reasonable lease with the landlord. During the first summer that she occupied the building, the air conditioner stopped working, and the lessee found out that she was responsible for replacing the air-conditioning unit; however, the landlord had the exclusive right to approve the unit. The landlord wanted a top-of-the-line unit to replace the old unit, while the lessee just wanted to install a functional mid-priced unit. The decision had to be made quickly, as it was midsummer in the southwest United States, with temperatures over 100 degrees. The owner of the business had no choice but to put in the unit the landlord wanted. The unit and the related improvements cost more than $25,000.

4. Who has responsibility for maintenance and other facilities issues? Who has responsibility for issues such as the utilities, landscaping, janitorial costs, trash removal, parking lot maintenance and security, window washing, and real estate taxes? Can you place the signage you want, or are there restrictions?

5. Who has to carry the liability insurance and at what level? Many leases require the tenants to carry insurance not only for themselves but also to cover any liability of the landlord. Insurance can be expensive, and it merits particular attention to be clear who has what responsibility for insurance.

6. Can your landlord enter your place of business? Most leases give the landlord some rights to enter your business to inspect it. The landlord wants to make sure you are taking care of the rental location and that nothing illegal is occurring. However, it can feel like an invasion if the landlord can come into your business whenever he or she desires.

7. If there are problems, what are the procedures for addressing and resolving them? If you cannot use all of your space and have a financial need, can you sublet some of your leased space to others? Many leases prohibit such subleasing. Most leases also do not allow you to cancel the lease unless you meet the specified conditions in the lease. To illustrate, recently a developing business was looking for a location for a new retail store. There appeared to be a number of good opportunities in the area where there were multiple buildings with empty space. Unfortunately, the business owners found that one space they really liked was already leased by a

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business that no longer existed. The lease had been written with the personal guarantee of the business founder. Most states do not allow a landlord to charge two individuals for rent on the same space. Interestingly, the landlords chose to leave the space empty and collect full rent for the remainder of the old lease rather than rent the space to the new start-up at a lower rate. The individual who had personally guaranteed the lease before going out of business could only get out of the lease by filing personal bankruptcy, which he was not willing to do. If there are other problems and disagreements between the landlord and the business owner, how will these be solved— mediation, arbitration, or other means? If there are problems, can you withhold your rent?

Leases help protect long-term businesses.

EXERCISE 2 1. Put together a list of all the items you think are critical to discuss with your potential landlord. 2. What are the three or four most important items? Write down your minimal acceptable negotiation position for each.

Hopefully you can see that a lease is multidimensional and should be carefully crafted before signing. Consistent with our belief stressed in this chapter, new business owners can prevent many problems by ensuring that legal issues are thoroughly investigated and that they employ experts where needed.

How Laws, Rules, and Regulations Benefit New Businesses LO9-4 List how laws, rules, and regulations benefit new businesses.

New businesses generally deal with fewer regulations than do established larger businesses. Many regulations enacted by the federal government do not apply to businesses with fewer than 50 employees (this number varies with the regulation). Some industries are highly regulated regardless of size, whereas others are only loosely regulated even for the large, well-established organizations. If a new business deals with toxic waste such as asbestos, it can expect to have to file extensive registration documentation and be subject to significant regulation immediately, regardless of the size of the firm. Thus, regulation-related issues need to be carefully considered as the business is developed. This same issue will also apply in industries involving alcohol, medical-related industries, and military-related businesses. However, at the other extreme, an Internet business that sells retail goods faces only minimal regulation.

There are some basic regulations that cut across the spectrum of businesses. Virtually all businesses must have an Employer Identification Number for tax purposes. Additionally, a business with employees will be required to calculate and deduct various taxes for federal, state, and, in some cases, local authorities. The payroll requirements are specific and well developed. Fortunately, an entrepreneur can simply purchase a canned package for doing payroll and should be able to meet all of these various requirements.

Some states, such as California, have far more expansive laws governing business practices. Although environmental regulations at the federal level are typically designated for large businesses, in some areas the states will also apply those laws to all businesses. Similarly, specific cities may have unique sets of special regulations. A city such as New York has extensive additional regulations for all businesses. A restaurant in New York City has to post information on the calories and fat content in all of its products, and any food that is deep fried must use very specific types of oil.

Obviously, the special rules and regulations for your industry and location should be explored before you start your business to ensure that you

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are meeting all requirements. Excellent sources of information regarding regulatory requirements are the Small Business Assistance Center (run by the Small Business Administration) in your area, the state or local department of economic development, and the local chamber of commerce. More and more government agencies are developing websites to provide all this information and, in some cases, even allow for online submission of materials. All states and cities are critically aware of the role new businesses play in their economic viability. The result has been the establishment of offices to help new businesses to navigate these laws and regulations.

Do you think the food regulations including health inspections, display of health code grades, liquor licensing, calorie information, and ADA certifications are fair to new business owners?

One set of regulations that bears particular mention is the Americans with Disabilities Act (ADA). This law applies fully to any firm with more than 15 employees and in some communities has been applied to all businesses.9 The law requires that there be no discrimination in the hiring, management, or dismissal of employees with disabilities. If the firm has someone with a covered disability, the business must make reasonable accommodation for that individual. Additionally, virtually all retail and most office businesses must make their places of business accessible to people with physical disabilities. The requirements of the ADA have spawned lawsuits in every region of the country. So many aspects of the law are still being litigated that specific requirements associated with the law can be hard for a business to pin down. The requirements of the law can also change after the new business has opened.10 The result is that this area of the law must be constantly monitored by the new business owner.

ADA Americans with Disabilities Act—specifies protections in business for those with disabilities.

Licensing Related to the topic of regulation are the licenses that the business must obtain to operate. A license can be as simple as a business license that is used by communities to track business performance (and thereby tax income), or it may be specifically related to the fundamental operations of the business. Examples of licenses and permits include the following:

1. Business license. 2. Local ABC (Alcoholic Beverage Control) liquor license. 3. Occupancy permits. 4. Federal liquor license (Bureau of Alcohol, Tobacco, Firearms, and Explosives). 5. Business license (from the local city and county authorities). 6. Sign permits. 7. OSHA permits for food handling. 8. Fire safety permit. The above list is illustrative and does not represent all the licenses that a business will likely need. However, looking at this list a

few things should be noted. At a minimum, most businesses must acquire a license to do business in the county or city in which they will be operating. This type of license is quite simple to obtain, as it normally requires only that one of the principals of the business fill out a form (more and more often online), pay a set fee (usually less than $100 and often quite a bit less), and agree to report basic information about the business’s performance on a set schedule. The business will be required to pay a business license tax each year; the tax is often based on company sales. While completing this procedure, we suggest that the new businessperson search for other

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licenses that might be required for the operation. Because lack of knowledge is no excuse for failing to have the proper licenses, we always recommend talking with current business owners and/or local authorities concerning the procedures and licenses required in each locale. For those firms who are facing more challenging licensing, such as one that involves disposing of hazardous waste or serving alcohol, it is best to visit with a lawyer.

Importance of Copyrights, Trademarks, and Patents to a New Business LO9-5 Explain the importance of copyrights, trademarks, and patents to a new business.

A topic that merits brief mention is intellectual property protection through copyrights, trademarks, and patents. A copyright can be claimed on creative materials generated, such as books, magazines, advertising copy, music, artwork, or virtually any other creative product, whether published or unpublished. In the United States, a copyright is assumed to apply to anything that is your own original work (whether that original work itself is filed with the U.S. government or not). The copyright is valid for the life of the author plus 70 years.

copyright

The legal means to protect intellectual property. It grants ownership on creative materials generated, such as books, magazines, advertising copy, music, artwork, or virtually any other creative product, whether published or unpublished.

A trademark is legal protection of the intellectual property that is associated with a specific business. This may be the name of the firm, a symbol representing the firm, or the names of its products. Most large companies have trademarked their company name, symbols, and tag lines.

trademark

Claim of intellectual property that is associated with a specific business. This may be the name of the firm, a symbol representing the firm, or the names of its products.

You may not use a product’s name such as Sprite, as it is the trademark of a specific product for the Coca-Cola Company. Although not as universally recognized as a copyright, a trademark is assumed in place once a firm begins to use the symbol or name. However, a firm can and probably should register its use to ensure the protection of the trademark. A new business is well served to perform a search to ensure that it is not violating a trademark. A firm that is violating a trademark can be sued and is required not only to pay damages, but also may be forced to change its name. A trademark is valid for 10 years and can be renewed as long as the firm or product is active.

The last intellectual property protection is the most complex and expensive. A patent covers a specific innovation. A patent is good for 20 years from the point that it is filed, fees are paid, and it is accepted by the U.S. Patent and Trademark Office for processing. Recent changes to the patent regulations have meant that patent protection is being granted on a “first to file” basis rather than a “first to invent” basis. This might have significant impacts on the timing of efforts by new businesses.11 Patents are expensive to obtain and expensive to maintain, so they should be used only in the case where obtaining the patent is part of the sustainable competitive advantage of the organization.

patent

Claim of intellectual property that covers a specific innovation.

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Coca-Cola names “Share a Coke,” the promotion for summer of 2014.

There are three types of patents: Utility, Design, and Plant. A Utility patent is for a new process, machine, article of manufacture, or composition of matter, or any new and useful improvement of those. A Design patent is for a new, original, and ornamental design for an article of manufacture. Finally, a Plant patent is for someone who invents or discovers and asexually reproduces any distinct and new variety of plant.12

A patent can be a potent entry barrier for a business, as it prevents direct imitation for that period of time. Unfortunately, close copies may skirt the patent laws, so a patent should be but one avenue of competitive protection.

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For businesses that founders hope will expand internationally, one issue to recognize is that copyright, trademarks, and patents filed in the United States only apply in the United States. If the firm moves to expand abroad, the entrepreneur will have to file each of those documents in each of the markets in which they plan to sell.

Role That Insurance Plays in the Risk Portfolio of the New Business LO9-6 Define the role that insurance plays in the risk portfolio of the new business.

A topic related to the legal concerns of all types of business is insurance. One of the key concerns that should have been clear in the discussion of the form of organization is that the new business chooses the level of liability it is willing to risk. One means to limit liability concerns is through the effective application of insurance.

There are several basic types of insurance, but a key one is a firm’s property insurance. Property insurance covers the building, fixtures, and inventory in all of the buildings in which the business has a function. One key concern is whether the insurance covers replacement cost or only current value. Much like owning an older car, you may have equipment that has only limited value in a resale market but is very expensive to replace if you have to buy it new. The firm must decide what types of risks it will accept and cover itself versus those that it will purchase insurance to cover. It is fairly standard to obtain coverage for fire, wind-storms, hail, and smoke. However, the firm may also wish to obtain a special form of insurance that covers issues such as floods and earthquakes. The greater the insurance coverage obtained by the new business, the greater the cost. Thus, each firm needs to take some care to balance risk and cost.

The other forms of insurance an entrepreneurial business might obtain include liability insurance, bonding insurance, and workers’ compensation.

  A new business can also obtain liability insurance, which helps to protect the business against lawsuit judgments. Such insurance does not cover intentional acts of malice; however, it does cover the business for accidents. Product liability insurance is expensive, but it can also be obtained to provide a legal defense fund in the case of a negligence lawsuit.

  Bonding is a type of insurance in which the business is covered in case the workers cause any damage in the performance of their work. To illustrate, a plumber may hire an assistant who makes some of the calls on customers. The assistant may make a mistake that leads to a pipe breaking, which floods the house or apartment. The damage done can be very costly and perhaps even cause bankruptcy. However, through bonding, the insurance company agrees to pay for such damages. In an office setting the owner can also purchase bonding to cover losses from employee embezzlement.

  Workers’ compensation insurance covers liability for workers who are injured on the job. In many states, workers’ compensation insurance is required and can represent a major expense for a business.

Insurance is such a critical issue that it merits spending time with an insurance agent, or multiple agents, to discuss the needs of the new business. Discussion with multiple agents will allow the new businessperson to obtain different viewpoints on the issue. The new business owner should seek out agents who have expertise in the industry in which the business operates.

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When Chris was still developing his brewery and bar business, he really believed that getting all the equipment and supplies in place would be the biggest time holdup to starting the new business. Several weeks into the process, his uncle asked him how long it would take to get his business, liquor, and food preparation licenses. In all the effort to craft up the business, Chris simply had not taken the time to start the licensing processes. ** He was stunned to find out the substantial number of licenses he was going to have to acquire, and some were going to take real time. These included: 1. A local business license just like that for any new business. 2. A license for producing alcoholic beverages, which included a federal permit from the Bureau of Alcohol, Tobacco, Firearms,

and Explosives. 3. A license from the local police department to serve liquor. 4. A food preparation license. 5. An environmental disposal permit for the waste products. 6. A specialized “fry fat” recycling unit structure and permit. 7. A license for a sign. (A recently passed city ordinance required each store owner to apply for a license to put a sign on the

building and/or the street. The restrictions on new signs were substantial.) On the whole, these licenses were not particularly expensive to obtain; however, the time and effort it took to address these

licenses was not a small matter. The regulation associated with each license had typically arisen in response to an abuse by a preceding business. In addition, there was so much sensitivity around the serving of alcohol and issues such as drinking and driving that there was simply no flexibility on the part of the regulators. Chris had to allocate time to attend classes for some of the licenses and, in hindsight, he wondered if some of the licensing was still relevant.

QUESTIONS 1. What are your thoughts about the nature of licensing for Chris’s business? 2. What licenses do you believe will be required for your business idea? Check with the local Small Business Assistance Center

to see if you are right. 3. If you are dealing with a product or issue that is highly sensitive, such as alcohol sales, how will that affect your licensing

effort? **Recall as we noted at the beginning of this chapter that even though we present these tasks sequentially, the steps of the process often happen simultaneously. Thus, legal issues like those Chris is facing may occur at the same time as some of the financial issues.

How to Develop an Effective Board of Advisors and Board of Directors LO9-7 Discuss how to develop an effective board of advisors or board of directors.

Two related entities that can help the new business owner foresee potential legal liabilities are boards of advisors and boards of directors. These boards are composed of people who have both insight and experience with which to advise the founders. An effective group of advisors will not only help the new business owner foresee if legal problems might arise, but also help the new business wind its way through a full range of other issues and opportunities where experience is the best teacher. The new business should have at least one of these entities that will advise the founder. A business that chooses to form a corporation must have a board of directors. These are individuals who have a fiduciary responsibility to the shareholders of the organization. In new corporations, the shareholders and board of directors are often the same individuals. In contrast, a board of advisors may be

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formed at the discretion of the founders (regardless of the legal form chosen); it is composed of individuals outside the new business who will advise the firm.13

board of advisors

A group formed at the discretion of the founders (regardless of the legal form chosen) and composed of individuals outside the business who advise the founders.

Although the size of the board of advisors is a matter of choice, as a practical matter, it is better to have a few, well-placed individuals who are motivated to help the firm through the start-up process rather than enlist

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a large number who serve as a means of false showmanship. There is a set of basic needs for most new businesses; thus, we suggest choosing individuals who have experience navigating the following:

1. Licensing requirements for your type of industry in your locality (if such licensing is relatively complex or difficult). 2. Regulations for your specific industry. 3. New start-up experience and success. 4. Financial and accounting background with new start-ups. 5. Human resources experience, especially establishing basic personnel criteria. This board can formally meet on whatever schedule seems appropriate. Many boards of advisor meetings are held virtually using

applications such as Skype. The reality is for a new firm to obtain highly knowledgeable people willing to help, the new firm cannot ask the potential advisors to commit too much time. Often these highly knowledgeable individuals may be happy to have the entrepreneur contact them as issues arise without the formality of calling for a meeting to resolve the problems. Asking busy people to travel and spend a half day or more in a formal meeting may be too much of a commitment of their time.

In keeping with the efficient operation of a new business, we suggest that the board size be maintained at fewer than six individuals. Some advisors may be investors or else are involved in a professional capacity working with the firm. However, many expert advisors get involved with start-ups because of their love of seeing a business flourish. As the firm develops, formality and compensation can be considered.

SUMMARY This chapter covered a wide variety of legal issues related directly to the starting of a new business. The legal form that the founders choose has implications from an operational, tax, and legal perspective. The new venture owners must be aware of and deal with regulations imposed by local, state, and federal authorities; obtain all relevant licenses; and be sufficiently savvy regarding the evaluation of contracts, leases, and insurance. All of these areas can be quite complex, and throughout the chapter we suggest that awareness of the issues is the first step, but getting some professional advice is the most prudent long- term move.

KEY TERMS ADA board of advisors contract copyright draw general partner LLC LLP partnership patent sole proprietorship Subchapter C Corporation Subchapter S Corporation trademark

REVIEW QUESTIONS 1. Why is a legal system so critical to a new business? 2. Do you think such legal protections are more or less important to a new business than to an established business? 3. What are the impacts on a business that chooses to form as a sole proprietorship? 4. What are the impacts on a business that chooses to form as a partnership? 5. What are the impacts on a business that chooses to form as a Subchapter S Corporation? 6. What are the impacts on a business that chooses to form as a Subchapter C Corporation?

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7. What are the impacts on a business that chooses to form as an LLC? 8. What are the major differences between a board of directors and a board of advisors?

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