Business Formation – A Practical Guide to Legal Issues

If you are considering starting your own business it is imperative that you assemble a group of trusted advisors.  At a minimum this group should include an experienced business lawyer and an accountant who can assist you as you begin your business.  While there is no substitute for an individual meeting with an attorney to discuss your specific situation, the purpose of this article is to share with you some of the most important items you should consider when starting a business and what steps you should take now to avoid significant problems in the future.

The information below is based upon businesses located in the Commonwealth of Massachusetts.  If you are located outside of Massachusetts, the information below may be helpful but you should always consult with an attorney in the state where you plan to locate your business.  In addition, before you make any decisions regarding your business you should ALWAYS consult with an attorney for particular advice about your specific situation.  All situations are unique and the particular facts of your case could make a significant difference in how you should proceed.

Do you need to form a corporation or a limited liability company?

 The very first question you need to address is should you form a separate legal entity, i.e. a corporation or a limited liability company (“LLC”).  When deciding if you need to form a corporation or a LLC the real question you need to ask is: could the operation of your business put your personal assets at risk?   How possible is it that in the course of your business operations you could face a lawsuit where damages could be substantial?

In general, there is almost always the possibility of potential liability from business situations which could put your personal assets (e.g. house, car, personal bank accounts) at risk.  The benefit of forming and operating a corporation or LLC correctly is that if there is a lawsuit against the company then the liability exposure is limited to the assets owned by the company and, importantly, not your personal assets.

There are some businesses where you may be able to protect yourself by just purchasing business liability insurance.  The cost for the filing fees and/or taxes to keep a corporation or LLC qualified to conduct business in Massachusetts is approximately $550.00 per year.  This $550 cost does not include the potential extra cost involved in additional bookkeeping and tax preparation fees you may incur if you form a corporation or LLC.  If you are conducting a business where you do not believe there are significant liability issues, you may be better off taking the $550.00 annual costs and use that money to buy insurance to protect your personal assets.

If you are going into business with another person, even if it is a low risk business, then my advice is that you should always form either a corporation or a LLC.  The fact that there is more than one owner makes the formation of a separate legal entity almost essential to address the issues that will be discussed below.

Are you operating the business as the only owner? 

 The formation of either a corporation or an LLC is much simpler if you are going to be the only owner of the legal entity.   If you are the sole owner it is important that you have the corporate governing documents in place (e.g. operating agreement for an LLC and the bylaws for a corporation) but you do not need to spend a significant amount of time confirming the terms of these documents.  If you are the 100% owner then you can always amend the terms of the governing documents when you deem necessary.

Are you going to operate a business with one or more other owners? 

             The biggest area of controversy related to the operation of a business occurs when there is more than one owner.  If you are starting a business and there is more than one owner, the most important thing you can do is meet with an experienced business lawyer who can advise you on what items you need to discuss and agree upon in writing BEFORE you start your business.  Having what can be very difficult conversations before you open your business can prevent a significant amount of problems that can be very difficult to resolve.  The following are some of the more important questions/issues you should discuss and come to agreement on before your business begins.

  1. How will the ownership percentage be divided? If there are 2 owners, do both own 50%?
  2. How will major decisions be handled? Must 100% of the owners agree on major decisions?  What is considered a major decision (e.g. expenditures over $1,000 or $10,000)?
  3. Are all owners going to work in the business? How much will the owners be paid?  What will the owner who does not work in the business be entitled to receive?  How will the pay raises (or decreases) be determined for the owners of the company?
  4. How much will each owner contribute in actual cash to fund the initial operations? If someone is contributing “sweat equity” to a project, how will you determine what that is worth and what ownership percentage in the company the person is entitled to receive?
  5. What happens if the company needs an additional cash infusion? Will all owners be required to make equal contributions?  What happens if one of the owners cannot contribute?  How does this impact the ownership percentage of each person?
  6. What happens if one of the owners decides they want to leave the business?
  7. Is a departing owner permitted to sell his or her ownership interest to a third party? What restrictions will there be on transferring the ownership interest?
  8. What happens if one of the owners dies? Will the remaining owner now be in business with the deceased owner’s heirs?
  9. When someone leaves the business for any reason (e.g. voluntary departure or becomes disabled or dies) how will you value the departing owners interest in the business?
  10. When the remaining owner(s) or the business buys the shares of the departing owner, is the purchase price paid all at once or can it be spread over time?
  11. Will the company maintain life insurance on the owners to fund the buyout?

The above list is not intended to be exhaustive but does contain some of the most important issues that need to be addressed before a business is formed by more than one owner.  By having honest discussions about these very important issues before you start your business you can make some very important decisions to prevent future problems.  If you know what happens when you leave a business after 6 months, 6 years or what will happen if you can no longer work, you could prevent a significant legal dispute from ever developing.  The agreement on how you will resolve the issues raised by the above questions should be included as part of the corporate documents (e.g. operating agreement, bylaws or shareholder agreement, etc.) that are signed by all the owners.  If any of the issues arise after the company is formed, the fact that the owners have already discussed and agreed to how this situation will be treated will be a significant benefit to all involved.

As the saying goes, you don’t know what you don’t know.  The best time to discuss the important issues which could arise when you have more than one owner of a business is BEFORE you start your business.  If you can’t agree on the terms before you start, you should seriously consider if this is the right business partner for you.  Making that decision before the business is started can save you from a very expensive and frustrating experience which occurs when co-owners cannot agree.

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