The Top 25 Legal Issues that Entrepreneurs

Must Consider Before Starting a New Business

 

 

 

By: Brent Meyer

FIN 402

Dr. Gasper

April 27, 2002

Table of Contents

Executive Summary                                                                                                          1

Introduction                                                                                                                  2

Company Structure                                                                                                          2

            1. Profit Sharing/ Funding                                                                                    2

            2. Liability                                                                                                            2

            3. Taxation                                                                                                           2

            4. Sole Proprietorship                                                                                       3

            5. Partnership                                                                                                       3            6. Limited Liability Company                                                                                 3

            7. Corporation                                                                                                      3

Funding                                                                                                                        4

            8. Taking Out a Loan                                                                                        4

            9. Equity                                                                                                   4

Product Protection                                                                                                         4

            10. Patent                                                                                                   5

            11. Trademark                                                                                                       5

            12. Copyright                                                                                                         5

Product Liability                                                                                                            5

            13. Suppliers and Subcontractors                                                             5

            14. Product Development Analysis                                                                        6

            15. Negligence                                                                                           6

            16. Government Regulations                                                                               6            17. Taxes                                                                                                   6

Employment                                                                                                                 7

            18. Discrimination                                                                                       7

            19. Wrongful Termination                                                                             7

            20. Payroll Taxes                                                                                        7

            21. Worker’s Compensation                                                                          7

            22. Health Insurance                                                                                              8

            23. Exit Strategy                                                                                                8

Documentation                                                                                                 8

            24. Documentation                                                                                     8

            25. Keep the Attorney Involved With the Business                                          8

Conclusion                                                                                                                   9

Endnotes                                                                                                                      10

References                                                                                                                   11

Glossary                                                                                                                       12-13

 

 

 

 

 

 

 

Executive Summary

            The topic of the paper is the top twenty-five legal issues an entrepreneur should consider before starting a business.  The outline of the paper and the topics were chosen with the assistance of small business attorney, John Herdzina.  The paper stresses the decision criteria for the proper business structure for a new venture as well as possible legal dangers an entrepreneur may be vulnerable.  The purpose of the paper is to enlighten future business owners on legal issues that they might not have considered.

 

            The information for this paper came from primary and secondary sources.  The primary sources were an interview with attorney John Herdzina and Internal Revenue Service documents.  John Herdzina is a small business attorney and the Bellevue City Attorney.  His experience and expertise gave insight into reoccurring legal problems entrepreneurs run into.  The Internal Revenue Service documents contributed to the percentages of tax taken out of wages for Social Security and Medicare. The secondary sources came from periodicals that are relevant to the paper topic.

 

            The findings from this paper are that an entrepreneur must consider many areas of business administration such as employment, taxation, government regulation, funding, product protection, and product liability.  A failure to deal with any of these issues will lead to the termination of a new venture if not handled correctly.  Protection from legal pitfalls in these areas could give an entrepreneur a competitive advantage.  There are no recommendations from this paper except consult an attorney before entering into a new venture. 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Introduction

President Calvin Coolidge once said “the business of America is business.”  Coolidge’s statement eloquently summarizes this country’s fascination with and dependence on business in six perfect words.  Even though the times have changed from when President Coolidge was in office, the entrepreneurial passion of the American people has not.  New businesses are started every day in this country with the hope that the entrepreneur will be successful and be able to enjoy the independence of being a business owner.  To be successful, the entrepreneur must avoid financial and legal pitfalls.  This paper will discuss the top 25 legal issues that an entrepreneur must consider before starting a new business.  Issues 1-7 deal with company structure; issues 8 and 9 discuss funding; issues 10-15 pertain to product protection and liability; issues 16 and 17 discuss government interaction, issues 18-22 deal with employment; issue 23 discusses exit strategy; issues 24 and 25 deal with the importance of documentation and attorneys.

 

Company Structure

            The first legal issue that any entrepreneur should be concerned about is how the new venture will be structured and legally established.  Choosing the right business structure involves balancing liability protection, profit sharing/funding, and taxation.  Therefore, the “right” company structure depends on the characteristics of the business, as well as the owner’s wants and needs.  This section includes major factors that affect choosing the best company structure and which company structures accommodate those factors.

 

  1. Profit Sharing/Funding- Starting a new business is not cheap and it will require either personal funds or other people’s money.  Seldom does an entrepreneur have enough capital to cover all the start up costs.  The entrepreneur will then have to rely on other people’s money, either through debt or equity.  The decision of how to fund a new venture is a huge determinant of company structure.  For instance, if an entrepreneur is able to attain a loan from a bank then the entrepreneur does not have to sacrifice any ownership for funding.  On the other hand, if the entrepreneur chooses not to (or is not able to) go into debt then the entrepreneur may have to concede some ownership for capital.  Thus, the entrepreneur must share profits with partners, venture capitalists, or shareholders. 

 

  1. Liability- Different businesses have different risks associated with the product or service sold.  Therefore, different businesses need different liability protection.  For example, an automobile brake service company has more liability than a hair stylist company.  If a worker at the brake service company mishandles a job, lives may be at stake.   On the other hand, if a stylist botches a job, only hair and a repeat customer are at stake.

 

  1. Taxation- Another factor that regulates company structure is the amount of taxation on the income.  If the owners want the benefits of being protected from the liability of a company or the ability to gain huge amounts of equity, then they must absorb the cost of higher taxation.  Some structures allow profits to be taxed as individual income while others are subject to business income tax.

 

 

Different Company Structures

            Before choosing the company structure, an entrepreneur should consult an attorney about the pros and cons of each structure.  Understanding the characteristics of each company structure will ensure that a new venture will get off on the right foot.

 

  1. Sole Proprietorship- This company structure is the easiest to form and maintain.  A sole proprietorship has one owner, who receives all profits and accepts all financial and legal responsibility.   The profit is considered the owner’s income and is subject to personal income tax.  Sole proprietorships are best for when the entrepreneur funds the company with personal capital and the liability of the business is small.  Sole proprietorships are also easy to dissolve because it only takes one person (the owner) to decide when to end the business.   Sole proprietorships are bad for any business that may undertake a large financial or liability burden.

 

  1. Partnership- Partnerships allow several owners to combine capital to cover start-up expenses.  There are two types of partnerships: general and limited.  General partners share profits, management power, and liabilities.  A limited partnership is similar to a general partnership with the exception that a limited partner has little management power.  In return, the limited partner does not carry the same liability risk as does a general partner.  Income from partnerships is treated as personal income and in subject to income tax.  Partnerships are best for when a business requires more start up capital than a sole proprietorship and when liability is small.  Partnerships require more legal attention because there are more than one individual running the business.  Legal services needed for partnerships are contracts of partnership agreements, state registrations, and buyout processes for partners.

 

  1. Limited Liability Company or Partnership (LLC)- Limited liability companies are the newest trend in business structure creation.  The limited liability company allows lenient tax regulations, liability protection, and no maximum on the number of shareholders.  Limited liability companies are emerging as the best structure for small business, especially for professional services.  Legal services required for a limited liability company is filing a certification of formation with the Secretary of State and shareholder agreements if needed.

 

  1. Corporation- Corporation is the best company structure for businesses that are experiencing significant growth or expansion.  Corporations protect shareholders from any liability because legally the corporation is viewed as a separate entity.  Corporations offer the potential for enormous equity funding because the number of shareholders is unlimited.  For the liability protection and the possibility of equity cash inflow, corporations are taxed as an entity and the dividends paid to owners are also taxed as personal income.  Legal services needed for corporations are the creation of the articles of corporation, shareholder agreements, and stock certificates.  Corporations also allow large earnings to be retained and reinvested in the growth of the business.

 

Funding

      Aggregating capital, as we have already seen, has a huge affect on the new venture’s identity as well as its success.  Assessing the right amount of capital is crucial to a new business’s life.  John Herdzina, a small business attorney in Omaha, NE, states,

 

“In my experience with new business ventures, the biggest reason small businesses fail is because of under capitalization.  Meaning, new business owners do not secure enough capital to cover late paying account receivables.  Therefore, the business does not have enough on hand cash to cover daily expenses.”1 

 

The legal issues that are associated with new venture funding deal with legal documents such as notes, securities, membership agreements, and shareholder agreements.

 

  1. Taking a Out Loan- The major concern is correctly assessing how much money the new venture really needs.  To adequately predict the amount of capital needed requires in depth research of costs.  Once the proper figure is assessed, the real fun begins.  The entrepreneur most come up with a business plan that, which requires exhaustive research of the market, competitors, cost analysis, customer segment, employee characteristics, and pro forma financial statements.  After forming the business plan, the entrepreneur is now faced with selling the business idea to bankers who require extensive knowledge of the market and financial information, as well as assurance of the ability of the entrepreneur to provide timely repayment of the principal with interest.  Once a bank is willing to give a loan, the legal issues of clauses and wording of financial contracts come into play.  A lawyer’s expertise just might save you from costly misinterpretation of these loan agreements (see Brennan and Hunt, “Loan Covenant: The Underrated Foes of Borrowers,” April 2002).

 

  1. Equity- If debt is unattractive to the entrepreneur, for whatever the reason, then capital can be raised through equity.  No matter how the new business owner seeks capital for equity (partners or selling stock), there will be legal issues associated.  The ownership sale will be agreed upon through a contract that will specify how much capital is required for acquisition of ownership, the return for the ownership, how and when the return in paid, and how the agreement can be terminated.  Once again, legal expertise can save the owners of the business unforeseen costs by clarifying language, properly placing legal clauses in the contract, and understanding statues that pertain to such contracts.

 

Product Protection

            Imagine a normal person, while daydreaming at work, has just come up with a product that will revolutionize an industry.  The person gets so excited about their product that he or she decides to start their own business selling it.  A large corporation offers to buy the concept of the new product from the person, but the person refuses.  The person feels the product will give their new business a competitive advantage in the industry.  The new entrepreneur anticipates that competitors will attempt to duplicate the product, and therefore, will need to ensure that the product is protected from competitors who are reluctant to give up their market share.  How can the person protect their new idea? Talk to an attorney!

 

  1. Patent- A patent is a grant made by the government that confers upon the creator of an invention the sole right to make, use, and sell that invention for a set period of time.  In the United States, the grant can last up to twenty years.2  The inventor must submit every detail in writing of how the invention is made and how it is used in a practical situation.  The patent acquisition process is very time consuming and expensive because of all the research that must be done to make sure no one has invented the product before.  On average, the patent process takes two years.  However, a competitive advantage in an industry for twenty years is worth the two years of research and expenses.

 

  1. Trademark- A trademark is a name, word, slogan, or symbol that is used by a business to identify and distinguish its goods from those sold by others.  A trademark can be a very powerful marketing tool.  An owner or the owner’s attorney must submit a written application to the Patent and Trademark Office with a drawing of the trademark, an actual specimen of the design, and a filing fee.  The PTO will evaluate the application and if they approve the application they will publish the trademark in the Official Gazette where the public has 30 days to file an opposition.  On average, the process takes about 12 to 18 months.3  A trademark can give a new business an identity and a marketing competitive advantage.

 

  1. Copyright- A copyright is designed to protect original work of authorship that is fixed in tangible form.  The creator of the work does not have to file anything with the government to obtain a copyright.  The owner, however, must follow certain steps that attorneys are knowledgeable of to ensure copyright protection.  The copyright will last 50 years after the author’s death.4  Copyrights, by far, are the easiest and cheapest product protection to acquire.

 

 

Product Liability

      Product Liability is a huge legal concern for business because of the possibility for costly lawsuits and expensive settlements.  In 1996, the average award for product liability lawsuits was $773,000 and the average settlement was $176,000.5  Product liability can be reduced drastically if the entrepreneur involves his or her attorney in supplier and subcontractor relations and product development.

 

  1. Suppliers and Subcontractors- To reduce the probability of product liability lawsuits, a business owner should select suppliers and subcontractors on more than price.  Researching the history of the suppliers and their business operations will reduce the chances of you putting faulty materials into your product.  Also, an attorney can be beneficial in supplier relations if “hold harmless” clauses are included purchasing agreements.  The “hold harmless” clause will waive any liability of a dysfunctional product if the defect can be tied to the material of the product that is provided by the supplier.

 

  1. Product Development Analysis- Another technique used to reduce product-liability risk is to evaluate a product while it is still in development.  An attorney can review the product design, purpose, possible misuse, and need for instructions or labels to help assess if the product is worth producing as well as the extra cost for the instructions and warning.  Safety review teams and hazard analysis can assist in detecting possible defects currently being manufactured that were missed earlier in the product development analysis.  Basically, acknowledging the fact that product liability is a risk to a company and using analysis to prevent it can reduce the chances of an expensive lawsuit from a customer.

 

  1.   Negligence- Another product liability concern that can result in a huge legal cost is negligence.  Negligence is the failure to exercise the degree of care considered reasonable under the circumstances, resulting in an unintended injury to another.  A company can be found liable for negligence in many different ways; an employee could fail to do the job correctly, management could forget to communicate certain guidelines for production, or a company could have “inadequate or non-existent warnings” on products.6 Negligence is a major legal concern for a company but an attorney cannot do much to prevent it.  The owner or the management is responsible for ensuring everyone in the company uses a “degree of care.”  If an employee fails to use that “degree of care,” then the management is responsible for punishing the action or lack of action.

 

16.  Government Regulations- All businesses are vulnerable to government regulations and guidelines.  Unfortunately, pleading ignorance of the government regulation will not excuse the business or the owner from the fines or punishments if the government finds violations.  Attorneys are responsible for being knowledgeable of the regulations and keeping up with changes in those regulations.  Government regulations cover a wide area of government levels from state, federal, and city governments that pertain to production, labor and safety guidelines, and environment protection.  Owners will be billed for the time it takes attorneys to research the government regulations, but the cost for the attorney will be significantly cheaper than the fines and possible lawsuits from the government.

 

  1. Taxes- Taxes are another government related concern for new business ventures.  Different state tax rates for income and sales may affect where an entrepreneur wants to locate a new business.  An entrepreneur must also keep excise tax in mind if they are entering in the alcohol, tobacco, airline travel, and luxury items industries.  Those excise taxes might discourage consumers from buying the product.  Also, some new business ventures may get tax deductions or discounts if they meet certain requirements established by tax law.  An attorney would have to research the new tax laws to find those tax advantages.

 

Employment

            Employment law is a huge concern for business owners and top management.  The area of employment is like a minefield where one mistake could seriously hurt or even destroy a business.  An attorney must communicate the legal requirements that employers must follow to prevent future lawsuits.

 

  1. Discrimination- An employer has to be sensitive to Federal statue that states it is illegal for an employer to not offer a job or pass on promotion because of gender, race, religion, age, or national origin.  Also, an employer cannot include questions that pertain to those characteristics of an individual on an application.  An attorney is responsible for informing the process of hiring and promotion to prevent discrimination lawsuits, but the owner is accountable for following those processes.

 

  1.  Wrongful Termination- The Dunlap Commission, an institution created by the Labor Secretary Robert Reich, stated that 10,000 wrongful termination cases are filed every year.  The Dunlap Commission also states wrongful termination cases have grown 2,000% over the last twenty years.7  Wrongful termination can be defined very broadly, from discrimination to harassment to personal grudges.  Gillian Flynn, the editor of Personnel Journal, states that wrongful termination can be prevented by “being consistent, document everything, treat people equally, and being fair.”8  Documentation of an employee’s mistake or reason for termination is usually the deciding factor in wrongful termination cases.  Without documentation the employer is left without evidence.

 

  1. Payroll Taxes- An entrepreneur must have knowledge of payroll taxes to understand who is liable to make the payments for the taxes as well as include those tax payments in tax expenses.  The three payroll taxes are Medicare, Social Security, and Unemployment Compensation.  Both the employer and the employee pay 6.2% of wages for Social Security and 1.45% of wages for Medicare.9  The maximum income to be taxed by Social Security is $84,900.  Medicare, on the other hand, does not have a maximum.10  The Unemployment Compensation payroll tax is 6.2% for the first $7,000 of income per employee.11  The Unemployment Compensation tax is paid by the employer and can be calculated at the beginning of the year for tax expense if the number of employees and salaries are known.

 

  1. Worker’s Compensation- Worker’s Compensation is a form of insurance that protects employees when they are injured at the workplace.  There are two types of benefits in worker’s compensation; wage replacement and payment for medical costs.  For owners to receive worker’s compensation reimbursement they must pay premiums based on the “aggregate loss of work experience for the type of jobs people work.”12  Each job is classified by risk of work place injury.  There are some expenses that are uninsured by worker’s compensation for which the employer is forced to pay such as replacement costs for temporary labor and training cost for replacement workers.  Attorneys and owners need to know the arrangements of the insurance policy for worker’s compensation to identify what expenses are covered and which are not.

 

  1. Health Insurance- Health insurance for employees is becoming a huge issue for employers because of increasing premium rates.  In the past, employers could afford to pay for health insurance of employees.  Now, with increasing rates, the employers, especially small business, are having trouble covering the health insurance expenses.  Attorney John Herdzina believes that, in the future employees will have to carry part of the burden of paying health insurance premiums.  Once again, the attorney is responsible for understanding the characteristics of the health insurance policies so that the business is not exposed to risk.

 

Exit Strategy

  1. Exit Strategy- Every business that is started has a possibility of failing no matter how good the business plan is or how smart the entrepreneur is.  A new business owner must acknowledge the fact that the business might fail.  If a business cannot make payments on its debts it must file bankruptcy and the courts will decide how the business will be broken up.  If an owner or owners decides to end their ownership, then a plan for dissolution or buyout must be agreed upon and documented by an attorney.  The attorney is responsible for making sure that there is some type of legal plan for the dissolution of the business, especially when there are multiple owners.  Usually, partnership and shareholder agreements have buyout and dissolution segments that set up procedures and price calculation guidelines for the dissolution of a business.

 

Documentation

  1. Documentation- Every business attorney will agree that documentation of business practices is essential in protection against lawsuits.  Documentation gives concrete evidence as to why a business acted in a certain way and can silence false allegations.  Without documentation a business is extremely vulnerable to lawsuits in all areas discussed in this paper.  Although the documentation process may be tedious and time consuming, the benefits are enormous when disgruntled consumers, employees, or even partial owners decide to pursue legal action against your company.

 

  1. Keep the Attorney Involved with the Business- Legal counsel is a necessity for a new business venture.  Attorneys play a major role in your business from the creation of your company to the dissolution.  Every change in policy, every new product, and every expansion should include your legal representation to protect you from legal risk that management might overlook.  Even though attorney fees are high they don’t even compare to the cost of legal snafus.

 

Conclusion

            As more and more businesses are started in America, more and more businesses will fail.  Some will fail because of financial problems and some will fail because the business was just a bad idea.  Some will fail because the markets are saturated and some will fail because of legal problems.  Hopefully, after reading this paper you will have a basic understanding of how important an attorney is to the success of a new venture.  With that knowledge, the probability of failure is less likely and the entrepreneurial passion will remain strong in this country, ensuring that the business of America is still business.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


Endnotes

1Herdzina, John, Interview, at his office- Abrahams, Kaslow, and Cassman, March 15, 2002.

 

2 Judd, Richard, “Trademarks, Copyrights, and Patents,” Franchising Second Edition Desktop Publishing, Cincinnati, OH, p. 14-2. 2001.

 

3 Judd, Richard, “Trademarks, Copyrights, and Patents,” Franchising Second Edition Desktop Publishing, Cincinnati, OH, p. 14-2. 2001.

 

 

4 Judd, Richard, “Trademarks, Copyrights, and Patents,” Franchising Second Edition Desktop Publishing, Cincinnati, OH, p. 14-2. 2001.

 

5 Godden, Randall, “Product Liability Prevention- The Next Dimension of Quality,” Total Quality Management, August 2001, p. 623.

 

6 Godden, Randall, “Product Liability Prevention- The Next Dimension of Quality,” Total Quality Management, August 2001, p. 623.

 

7 Flynn, Gillian, “Take the Fear Out of Termination,” Personnel Journal, January 1995, p. 123.

 

8 Flynn, Gillian, “Take the Fear Out of Termination,” Personnel Journal, January 1995, p. 123.

 

 

9 Internal Revenue Service, “Circular E: Employer’s Tax Guide,” Department of the Treasury, Publication 15, January 2002.

 

10 Internal Revenue Service, “Circular E: Employer’s Tax Guide,” Department of the Treasury, Publication 15, January 2002.

 

11 Internal Revenue Service, “Circular E: Employer’s Tax Guide,” Department of the Treasury, Publication 15, January 2002.

 

12 Gice, Jon, “The Cost of COMP,” Occupational Health and Safety, February 2001, p. 59.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

References:

 

Copperthwaite, William, “Limited Liability Companies: The Choice for the Future,” Commercial Law Journal, Summer 1998, p. 222.

 

Gice, Jon, “The Cost of COMP,” Occupational Health and Safety, February 2001, p. 59.

 

Godden, Randall, “Product Liability Prevention- The Next Dimension of Quality,” Total Quality Management, August 2001, p. 623.

 

Grover, Mary Beth, “Startup Interruptus,” Forbes, June 17, 1996, p. 184.

 

Herdzina, John, Interview, at his office- Abrahams, Kaslow, and Cassman, March 15, 2002.

 

Internal Revenue Service, “Circular E: Employer’s Tax Guide,” Department of the Treasury, Publication 15, January 2002.

 

Flynn, Gillian, “Take the Fear Out of Termination,” Personnel Journal, January 1995, p. 123.

 

Judd, Richard, “Trademarks, Copyrights, and Patents,” Franchising Second Edition Desktop Publishing, Cincinnati, OH, p. 14-2. 2001.

 

Parrish, Deidra-Ann, “Choosing the Best Corporate Structure,” Black Enterprise. September 1998, p. 34.

 

Rubenstein, David, “Safety First,” Industry Week, October 19, 1998, p. 90.

 

Unknown, “It’s Hard to Sell Out,” ABA Journal, July 1999, p. 60.

 

 

 

Glossary

 

Account Receivables- an asset on the balance sheet that represents revenue or cash not received.

 

Buyout- the purchase of the entire holdings or interests of an owner or investor.

 

Certification of Formation- legal document required for a business entity to become a limited liability company.

 

Copyright- the legal right granted to an author, composer, playwright, publisher, or distributor to exclusive publication, production, sale, or distribution of a literary, musical, dramatic, or artistic work.

 

Corporation- a body that is granted a character recognizing it is a separate legal entity having its own rights, privileges, and liabilities distant from those of its members.

 

Discrimination- the illegal act of making decision based on an individual’s gender, race, age, national origin, and religion.

 

Excise Tax- an internal tax levied on the sale, production, or consumption of a certain product within a particular country.

 

Harassment- the illegal act of annoying or tormenting fellow employees.

 

Hold Harmless Clause- a clause included into supplier and subcontractor contracts that protect companies from defects in parts in case of defects.

 

Liability- a financial obligation entered on a balance sheet or the responsibility of a company or person for a product or service they produce or sell.

 

Limited Liability Company- a business structure that allows liability protection and lenient tax regulations.

 

Negligence- omission or neglect of reasonable care, precaution, or action.

 

Partnership- a legal contract entered into by two or more persons in which agree to furnish a part of the capital and labor for a business enterprise, and by which each shares a fixed proportion of profit and losses.

 

Patent- a grant made by a government that confers upon the creator of an invention the sole right to make, use, and sell the invention for a set period of time.

 

Product Liability- obligation on a company or owner to sell or produce a good that functions properly and does not cause harm to the consumer.

Pro Forma Financial Statement- financial statements that use estimated figures instead of actual figures.

 

Shareholder Agreement- an agreement that outlines the requirements for the seller and buyer of ownership or interest in a business entity.

 

Sole proprietorship- a business structure in which an individual and his/her company are considered a single entity for tax and liability purposes.

 

Statues- a law enacted by the legislative assembly of a nation or state.

 

Subcontractor- one who enters into an agreement who takes on some of the liability of the agreement.

 

Trademark- a distinctive name, symbol, motto, or design that allows a company to identify its product or service as well as preventing competition from duplication.

 

Under Capitalization- the dilemma derived from an entrepreneur not gaining enough funds to cover all the short-term expenses during the beginning of the business.

 

Venture Capitalists- individuals who invest money into start up businesses for partial ownership.

 

Worker’s Compensation- payments required by law to be made to an employee who is injured or disabled in connection to work.