In Part 1 we discussed the importance of working with professionals and how to select and protect a name for your business or product. In Part 2, we’ll discuss how to select the right business entity, how the entity can protect you, and how you can fund your business.
3. Decide on the Legal Structure.
Forming a limited liability company or corporation to run your business not only helps to establish credibility for your new venture, but, more importantly, can protect your personal assets from potential future liabilities of your business. There may be tax advantages to forming an entity, and filing in certain states (such as Delaware and Nevada) may provide additional benefits, even if the business is not physically located in one of those states. You should consult with your attorney and accountant to determine the best entity for your business.
Additionally, if your company is minority- or women-owned, you may derive significant advantages from Disadvantaged Business Enterprise (DBE) certification or similar programs. However, many of these programs look to how the business was initially formed and funded, so setting up your entity in line with these programs’ restrictions is extremely important.
If you are starting a business with more than one person, a Company Agreement (also known as an Operating Agreement) or Corporate Bylaws are important documents that will govern how the business is run and outline management plans, voting rights, and profit and loss allocations. Essentially, these documents are prenups for business, and it is best (and sometimes required) to negotiate these agreements at the beginning of the business relationship.
If, in the future, you contemplate any major structural or financial changes with respect to the entity, e.g., you accept any additional members into the entity, a building is purchased by the entity, any major investments are made by the entity, etc., you should contact your attorney before these matters are completed so that any appropriate changes to the entity documents (i.e., the Articles or the Operating Agreement) can be made.
If you are set up as a corporation, limited liability company, or partnership, are a sole proprietorship with employees, or would just prefer not to use your Social Security Number in connection with company business, you will need to apply for a Federal Employer Identification Number (FEIN) from the Internal Revenue Service (IRS). The IRS uses this number to identify your business for all taxation matters, and it is required for businesses with employees. Some states require businesses to also have a state tax identification number.
If you act responsibly and take a few precautions, a limited liability company or corporation is a major benefit over a sole proprietorship or general partnership. If you do not form an entity, you could become a de facto sole proprietorship or partnership, either of which could expose you to personal liability for business-related debts and claims.
4. Separate Business From Personal.
In order to benefit from the protections a legal entity provides, it is imperative to keep the entity completely separate from your personal assets and to keep separate, detailed records of all business-related funds and transactions. For example, you should open a bank account and obtain a credit card in the name of the entity (which will usually require a copy of the Articles of Organization/Incorporation and the Federal Employer Identification Number for the business – but you should check with your bank to determine its requirements). You will likely deposit an initial amount into this account from your personal funds (which is often treated as an initial capital contribution to your company), and any additional monies you put into the business can be treated as loans to the company or additional capital – all of which should be documented. In the future, all company revenues should be deposited into, and all company expenses should be paid out of, the company bank account. It is very important that you do not commingle your personal funds with the funds of the business (i.e., you should not pay personal bills out of, or deposit personal income into, the business account), as this could result in “piercing the corporate veil” and effectively make you personally liable for the business as though the entity never existed. You may take periodic distributions out of the entity, but such distributions should be reflected as such on the books and records of the entity.
Note: Even if you have formed an entity, you may still be held personally liable for certain claims, such as claims arising out of an act or omission you, such as your own negligence, fraud or illegal act; claims arising out of a contract, particularly one that was personally guaranteed by you; claims based on the concept of “piercing the veil” of the entity (which usually arise over commingling or diversion of assets); and liability for consenting to or receiving a distribution in violation of the business’s operating agreement or the applicable business entity statute.
5. Speaking of Money…
The initial funding of a business can come from many potential sources, such as personal savings, loans or investments from friends and family, business loans from banks or through Small Business Administration (SBA) loan programs, lines of credit, government backed loans, venture capital, research grants, or third-party investors. Be sure to provide adequate capital for the entity’s intended purposes — and document the capital infusion, whatever the source.
Avoid personal guarantees whenever possible. Act ethically. Don’t attempt to mislead the entity’s creditors about the financial condition of the business. Do not divert assets. If the business looks like it is going down, don’t attempt to lessen your own loss by taking big draws or moving assets out of the entity. That will only help open the floodgates to your personal assets.
Note: If you are raising money for a company, whether through the sale of stock, LLC interests, or LP interests, or bonds, notes, or other debt instruments, you’re selling a “security” under federal and state securities laws — the failure with which to comply may carry criminal penalties. If you fail to comply with the applicable regulations, you could be liable to pay back the investors out of your pocket — with interest. It is highly advisable to consult with an attorney before attempting to raise money for your business.
In Part 3, we’ll discuss obtaining other licenses you may need to run your business, working with employees and contractors, and the importance of written agreements.