Making It Legal:

My colleague Rush Nigut recently posted a piece in his blog about a little-known provision of Iowa law that could invalidate shareholder agreements after 10 years.

Think about it: You’re humming merrily along with your business partner, thinking you’re covered (because of COURSE, you hired an attorney and worked out an agreement), and your partner gets hit by a bus and dies. Your partner’s spouse (whom you’ve never really gotten along well with) looks at the agreement, and sees that it’s invalid because you signed it 12 years ago. Brings a lawsuit to get hold of the “dearly departed’s” share of the business. All of the careful buyout formulas and procedures you’ve thought through go down the toilet.

Your state might not have this law on the books . . . but maybe it does. Have you checked?  Have you dusted off that agreement to make sure that it still meets your needs after time has passed? Are the same owners involved in the business? Does the valuation formula make sense in light of changes to your business? These are issues you should revisit periodically with counsel.

And there are a number of other legal issues that may be due for a checkup.  To have a good sense of what they are, get your copy of my Legal Health Checklist, available at GreatBusinessLawResources.com–and make sure that your business records and practices are fortified against potential claims and lawsuits.

Q: Does an S Corporation protect your personal assets?  It has become obvious I need help with this.  Any ideas you have would be very much appreciated.

A: Generally, yes, a corporation will protect the business owner’s personal assets.  The “S” in “S Corp” is merely a way of designating the way in which the corporation will be taxed.

However, there are circumstances where people can come after the business owner personally, despite operating as an S Corp.  They include:

• Payment of payroll taxes
• Payment of sales taxes
• Failing to maintain certain corporate formalities–for example, not having a separate bank account for the business, not preparing annual minutes for the corporation, not issuing stock certificates, inadequate capitalization or siphoning the assets from the corporation in a way that leaves it unable to pay its debts.

There are other entities (like an LLC) that can protect your assets, too–again, provided you follow the formalities. But asset protection is not the only reason to choose an entity.  Speak with your attorney and your accountant to figure out which form would best meet your needs.

Q.: I have always been advised, by CPAs, that until a small company has a specific NET income of approximately $100,000, incorporating is out of the question.  The fees associated with Inc. may not be worth the trouble of incorporating. Wrong? If wrong, why? Thank you.

A.: A $100,000 threshold?  Hmmm.  Plenty of companies are incorporated every day for businesses that are just starting and have no income whatsoever.  Depending on your state, incorporation costs only about $300 to $800–and is a one-time expense–so I don’t see why a business earning a net income of, say, $50,000 wouldn’t be able to absorb that. In fact, the owners of small business corporations have been known to put a lot of expenses through the company, precisely so that they don’t show a lot of net income for taxation purposes.  The corporation could have a gross income of $250,000, but with salaries, rent, expenses, taxes, etc., it only shows a net income of (for example) $80,000 for income tax purposes.  Is that company too small to incorporate?  I don’t think so.

There are important legal reasons to incorporate.  A disgruntled vendor who sues you doesn’t care whether you’re earning $25,000 or $250,000  If you aren’t operating your business through a corporation (or limited liability company), your personal assets are at risk.  Or if a customer comes into your business, trips, falls and smashes her head open, you could be personally responsible for any damages.  Your earnings capacity isn’t the issue:  your asset protection is.

Finally, if you’re looking to work as an independent contractor, more and more companies want to be sure they’re dealing with corporations or LLCs so that there aren’t any misunderstandings about payroll taxes and entitlement to employee benefits.  You could find that there are fewer opportunities open to you–especially for longer-term projects–because bigger businesses don’t want to get caught in the IRS/Department of Labor’s net.

Why open yourself up to personal liability when you don’t need to?  Today’s query comes from someone wanting to know that fundamental first question: “What form of business should I be?”

Q.:  I’m wondering what kind of company you would recommend for me to register under for a clothing company. I was thinking going Limited Liability because I would not be personally responsible if companies came after me for some reasons and couldn’t take my personal assets. Which one would you recommend because I don’t really know how much money I’m going to make in the first year.

A.:  For all but a v-e-r-y few situations, I recommend that entrepreneurs form either a corporation or a limited liability company.  There are simply too many variables and pitfalls in starting and running a business . . . so why leave your personal assets exposed? 

Which form of limited liability entity you choose, though, depends on a number of factors:

• Where the business will be located
•  How many people will own the business
• The nationality of the business owners
• Whether you will involve passive investors in the company, or want to take the business public
• The federal, state, and local taxes that may be levied against the entity
• The costs of formation
• Your exit strategy and what you want to get out of the business

Before you take the step of forming the business, make sure you’ve taken the time to calculate the kind of financial investment you’ll have to make in startup and ongoing costs.  While 1st year’s revenue will be guesswork, you can have a more solid sense of what’s involved with the right financial planning.  It will also help you decide whether the venture will be worth the risk and financial investment.

Investors can be a real boon to your business, but no question–they’ll want a piece of the action.  What’s involved in issuing shares to them?

Q: We currently have a market cap of $200,000 (2,000 shares X $100 per share). We were wondering how to authorize new shares to new investors.

A: It’s not unusual for companies to issue new shares at some stage in their existence. This can happen when:

• You want to provide bonuses to employees or directors
• You’re issuing additional equity as part of a takeover of another company
• As in your case, you want to provide equity to new investors.

However, before you run to the secretary of state and fill out the forms to issue more shares (and to change your certificate of incorporation to reflect the increased number of authorized shares), you need to look carefully at a couple of matters. First, is there a shareholders’ agreement among the current owners?  You need to be sure that you properly document the shareholders’ approval of this transaction and follow the procedures in the agreement for admitting new shareholders.  If this transaction will dilute the profit percentages (and it likely will), the current shareholders may need to be specifically apprised of this effect that the transaction will have. Make sure your legal counsel helps you through this process. 

In addition, you’ll want to speak with your accountant to determine both the value of the shares and whether they will fall within the same class of shares as those already issued. If not, that, too, will need to be documented and squared away with the secretary of state of the state you’re incorporated in.

When you’re in business by yourself, the math is easy.  But when you have multiple owners, how should you share the spoils?  That’s the nature of this week’s basic training post.

Q: How should I divide profits in an LLC?

A: Especially in an LLC, you have many options for how to divide your profits. There’s no hard-and-fast rule. The formula you choose can depend on a number of factors, including:

• The number of people actively involved in the day-to-day operations of the business
• Whether there are any passive investors who have contributed capital
• The extent to which the active owners are actively involved (e.g., are some full-time with the company, whereas others are only part-time?)
• The non-cash contributions the owners have contributed to the company (e.g., inventions, client lists or other intellectual property) and the value placed on that contribution
• The time commitment each owner is prepared to make to the business (are some in it for the long haul, whereas others want a quick ROI and to move on?)

It’s not something you want to take lightly, because it will guide the amount you’re required to pay someone to buy him or her out, should the time come. Best to speak to an attorney and an accountant in your area who can specifically guide you to the result that’s right for your company.

You may have plenty of opportunities to get it (legally) right . . . but not as many to hear me speak on the subject! 

For those of you near Brooklyn, N.Y., on July 15, stop by the Brooklyn Creative League, where I’ll be talking about everything you need to know about business law in 90 minutes.  (Well, not quite . . . but close!)  In this entertaining and lively session, I’ll provide entrepreneurs with an overview of the most common legal issues they will face as they start and build their businesses.  I’ll touch on:

• How to choose the right form of business
• Working with business partners
• What to look out for in your commercial leases
• How clear contracts make for happy clients/customers
• Intellectual property: what to protect and how to protect it
• Choosing the right attorney/advisory team

RSVP: Contact the Brooklyn Creative League at info@BrooklynCreativeLeague.com or (718) 576-2104.

Date:  Wednesday, July 15, 2009
Time:  9:30 to 11 a.m.
Location: Brooklyn Creative League, 540 President Street (between 3rd and 4th avenues)
(Take N/R Subway to Union Street)
Price:  Free for members; $10 non-members

Yes, legalese is its own language. Like the Latin spoken at the Vatican, it’s truly understood only by a few.

So for the rest of us, here’s a handy definition of a term relevant to all business owners (whether a corporation or an LLC):

“piercing the corporate veil“

It’s considered a privilege to be able to do business in a way that creditors can’t get to your personal assets. But some business owners abuse the privilege. In those situations, a court will let a creditor ignore the fact that you’ve formed a corporation (or an LLC)–the “corporate veil”–and hold you personally responsible for the debts you’ve accumulated.

Are you treating the business like your own personal slush fund, paying out personal expenses through the business? That’s a problem. Have you failed to comply with corporate paperwork and the niceties of annual minutes? That’s another strike against you. For more on this, go to my site, WiseCounselPress.com, and check out the article “The Simple But Powerful Reasons for Corporate Minutes.”

Lest my previous post be construed as just a plug to pay lawyer fees for no reason, here’s the primary reason that kind of corporate housekeeping is so important:

You risk exposing your personal assets to creditors if you don’t do them.

What? Wasn’t protecting your personal assets the whole point of forming an LLC or corporation? Yes, but formation is only one part of it. There’s maintenance as well. Legally, most states have laws providing that the owners and managers of a business (e.g., the shareholders and directors if a corporation and the members if an LLC) have an annual meeting. At the annual meeting, you are supposed to choose who will run the company for the following year. Even if you’re a solopreneur and hold all the posts, you’re supposed to have a meeting to confirm the decision. If you don’t, you are technically in violation of the law and have just given your creditors a basis for ignoring the limited liability shield you spent good money to establish.

For other reasons why it’s good business practice to prepare minutes at least annually, check out my article, “The Simple But Powerful Reasons for Corporate Minutes,” on my Wise Counsel Press site.

One last tidbit to explain why minutes are good: Potential purchasers of your business look for them as part of their due duiligence. If you’ve gone without them for a number of years, the sloppy record keeping may dissuade the purchasers altogether or reduce the price you could get for your company.

Happy New Year.

With the new year comes the sweeping out of the old, which is where your corporate housekeeping comes into play. Many entrepreneurs think their legal work is done once they’ve incorporated or formed a limited liability company. Not so. Most states’ statutes require you to compile a written record of your major activities at least once a year (called “annual minutes”). Nina Yablok’s Bizblawg gives a nice summary of what to do.

I’m not sure how to document “unanimous written consent.” Consult your business attorney, who can tell you what should be included and how it should be worded. Better yet, don’t do it yourself–delegate it.