Many start-up businesses are formed by first-time entrepreneurs who are often unfamiliar with the requirements and pitfalls involved in forming a new business.  As a result, they often fall victim to the following mistakes:

1. Failing to choose the right form of business entity.

When an individual goes into business without registering as a corporation or a limited liability company (an “LLC”), the business is called a “sole proprietorship.”  A group of two or more people who go into business together without registering as a corporation or an LLC is called a “partnership.”   In the case of both a sole proprietorship and a partnership, the owners of those businesses are personally liable for all of the debts and liabilities of the business.  That includes ordinary debts, such as amounts due to suppliers, landlords, employees, and the taxman, as well as liabilities arising out of injuries caused by the business or its employees.

In contrast, if the business is registered with the appropriate state office (in Indiana, the Secretary of State) as a corporation or a limited liability company, the choice of that form of business entity will generally shield the owners of the business from becoming personally responsible for the debts and liabilities of the business – unless the owners specifically agree to personally guaranty a particular debt (as is often required with a bank loan).   Because of the ability to limit the owners’ personal liability, and given the minimal cost of registering with the state as a corporation or a limited liability company, it is almost always advisable for a business to operate as a corporation or an LLC rather than as a sole proprietor or partnership.  Less frequently, “limited partnerships” and “limited liability partnerships” are registered with the state, which can also protect some or all of the owners from personal liability for the debts and other liabilities of the business.

Finally, depending upon the nature of the business, there may be certain tax considerations that should be taken into account in choosing a form of business entity.

2. Failing to have a clear understanding and agreement as to the owners’ respective rights and obligations.

Whenever a business is formed with more than one owner, it is essential to have governing documents that clearly establish the relative rights and obligations of the owners – including their relative shares of ownership in the business.  In the case of a partnership, those rights and obligations should be spelled out in a written partnership agreement; in the case of a corporation, they should be spelled out in the Articles of Incorporation, By-Laws, and organizational minutes of the corporation or in a separate “shareholders agreement”; and, in the case of an LLC, they should be spelled out in the Articles of Organization and in a written “operating agreement.”  In addition, the owners need to understand that the person or persons who have a majority of the ownership interests in the business will have total control of nearly all aspects of the business, unless the governing documents explicitly provide otherwise.

In most cases, the individuals who form a start-up business expect to be working in the business.  For that reason, it is also important to recognize the difference between an individual’s rights and obligations as an owner of the business (which are the subject of the governing documents), and an individual’s rights and obligations as an employee of the business (which should be the subject of a written employment agreement for each owner).  Thus, as is illustrated by the following example, the fact that an owner ceases to be an employee of the business does not mean that he or she has ceased to be an owner.

Imagine that Joe and Mary each pay one-half of the expenses to start up a new corporation where they are equal owners, and they each provide business consulting services to the corporation’s clients.   They are each then paid a salary for their services per their employment agreements with the corporation, and at year-end the corporation distributes one-half of whatever profit is left over to each of them as a dividend.  After a few years, Joe decides to embark on a new career and quits working for the corporation, at which point he is no longer entitled to be paid his salary as an employee.   However,  even though all of the revenue being earned by the corporation following Joe’s departure is now being derived solely from Mary’s efforts, Joe will continue to be an owner and will continue to be legally entitled to receive his proportionate share of the net profits being distributed at year-end.  In addition, as an equal owner, Joe will continue to have the right to participate in any owners’ meetings and will continue to have an equal vote on any matters requiring a vote of the owners.

The events described above are likely to be very distressing to Mary.  However, her concerns would be mitigated if the business had a “buy-sell agreement” in place [Choosing The Right Type Of Buy-Sell Agreement For Your Business, Does My Business Need (Or Need To Update) A Buy-Sell Agreement?].  The purpose of a buy-sell agreement is to give the business and its owners the right to repurchase the interest of an owner in the event of that owner’s death, termination of employment, or any proposed transfer of that owner’s interest.   Thus, in the example above, a typical buy-sell agreement would give Mary the right to buy back Joe’s ownership interest upon the termination of his employment at a set purchase price so that Joe would then cease to be an owner in the business.  A typical buy-sell agreement would also prevent an owner from selling that owner’s interest to anyone else unless that interest was first offered to the other owner(s) on the same terms.

3. Failing to understand and comply with federal and state securities laws.

It comes as a surprise to most start-up businesses that any ownership interest in a partnership, corporation, or LLC, no matter how large or small the business, is considered a “security” and is subject to federal and state securities laws.  Moreover, if a business has owners in more than one state, the business will be subject to the securities laws of each state in which an owner resides, in addition to the federal securities laws.

The purchase and sale of securities in violation of the applicable securities laws can have criminal penalties.  Additionally, the business and any individual who participated in the sale of a security in violation of these laws can be held liable to the buyer for damages in a lawsuit.

The state and federal securities laws have two basic requirements: (1) securities may not be sold unless they are registered with the applicable state and federal agencies (the “registration” requirement), OR unless there is an available exemption from the registration requirements; and (2) all material facts regarding the business must be fully disclosed in connection with the sale of any security (the “anti-fraud” requirement).

Full compliance with the registration requirements of the federal and state registration requirements is generally an enormously expensive (six-figure) proposition beyond the budgetary constraints of a start-up business.  Fortunately, the private sale of securities by start-up companies to a small number of purchasers who are all residents of the state in which the business was formed will often qualify for an exemption from these registration requirements.  Additionally, depending upon the amount of money being raised by the sale of the securities and the number of purchasers, there may be more limited (and far less expensive) filing requirements with state and federal agencies. Again, competent legal counsel can assist in determining the extent to which these various exemptions are available.

With regard to the anti-fraud requirement, a “material” fact is any fact that might influence the buyer’s decision to acquire the security.  In practice, this means that anything the business would prefer NOT to tell the buyer for fear of dissuading the buyer from purchasing the security is necessarily a material fact that must be disclosed.   It is important to note that there are NO exemptions from the anti-fraud requirements of federal and state securities laws. Full disclosure of all material facts will always be required, regardless of whether the securities are exempt from registration requirements.

4. Failing to properly address employment-related issues.

The list of employment-related issues that can arise in connection with the operation of a new business is virtually limitless.  These include the obligation to obtain worker’s compensation insurance coverage, the obligation to register with the applicable unemployment insurance agency (in Indiana, the Department of Workforce Development), payroll tax withholding, compliance with OSHA, compliance with minimum wage and overtime laws, and compliance with the federal employment eligibility verification (“I-9”) statute.  In addition, two other critical employment matters should be addressed.

First, every business should prepare and distribute an “employee handbook” to its employees, and all employees should sign and return a receipt acknowledging that they have read and understood the handbook.  A well-written employee handbook can be an invaluable tool for an employer in preventing or defending against employment discrimination and other wrongful discharge claims, and in resisting claims for unemployment compensation by employees terminated for good cause.

Second, every business should strongly consider the use of written employment agreements that: (i) prohibit employees (including owner-employees) from using or disclosing confidential information, other than in the course of their duties for the company; and (ii) restrict employees who have customer contact from diverting business from the company during and after the termination of their employment with the company.   Note, however, that applicable state laws limit the allowable scope and duration of post-employment restrictions on competition such that, in order to be legally enforceable, they must be carefully drafted to comply with those limitations.

5. Failure to obtain competent professional advice.

The legal requirements and operational considerations facing a new business go well beyond those mentioned above.  Additional legal requirements may include, for example, tax-related obligations (such as obtaining a tax ID number, sales/use tax registration and collection, and the possible making of an S-Corporation election), as well as industry-specific requirements (such as licenses and permits).

There is a well-known adage that “an ounce of prevention is worth a pound of cure.”  In the legal arena, a more apt adage would be that an ounce of prevention is worth a ton of cure, given the significant legal and other expenses (including possible fines and penalties) that would likely be incurred in attempting to “cure” a problem that could easily have been prevented.  The process of avoiding such problems should begin with the retention of an experienced law firm and accounting firm to assist with the formation of the business.

© Riley Bennett Egloff LLP

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Posted on May 17, 2022, by John L. Egloff