Chapter 7: Preparing a Proper Ethical and Legal Foundation

CHAPTER 7

PREPARING A PROPER ETHICAL AND LEGAL FOUNDATION

1. Describe how to create a strong ethical culture in an entrepreneurial venture.

2. Explain the importance of “leading by example” in terms of establishing a strong
ethical culture in a firm.
3. Explain the importance of having a code of conduct and an ethics training
program.
4. Explain the criteria important to selecting an attorney for a new firm.
5. Discuss the importance of a founder’s agreement.
6. Provide several suggestions for how entrepreneurial firms can avoid litigation.
7. Discuss the importance of nondisclosure and noncompete agreements
8. Provide an overview of the business licenses and business permits that a start-up
must obtain before it starts conducting business.
9. Discuss the differences among sole proprietorships, partnerships, corporations, and
limited liability companies.
10. Explain why most fast-growth entrepreneurial ventures organize as corporations or
limited liability companies rather than sole proprietorships or partnerships.

CHAPTER OVERVIEW

This chapter focuses on the ethical and legal challenges involved with starting a firm.
Most entrepreneurs overestimate their knowledge of the legal issues involved with
starting and running a business. As a result, it is necessary for an entrepreneur to
thoroughly review the legal issues involved to make sure that a costly mistake isn’t made.

The chapter beings by discussing the most important ethical and legal issues facing a new
firm, including establishing a strong ethical culture for the firm, choosing an attorney,
drafting a founder’s (or shareholder’s) agreement, and avoiding legal disputes. The
chapter next discusses the licenses and permits that businesses need before they can start
conducting business. The chapter ends with a discussion of the different form of business
organization available to new firm, including sole proprietorships, partnerships,
corporations, and limited liability companies.

CHAPTER OUTLINE

I. Initial Ethical and Legal Issues Facing a New Firm

A. Establishing a Strong Ethical Culture for a Firm
1. Lead By Example
2. Establish a Code of Conduct
3. Implement an Ethics Training Program
B. Choosing an Attorney for a Firm
D. Drafting a Founders’ Agreement
E. Avoiding Legal Disputes

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Chapter 7: Preparing a Proper Ethical and Legal Foundation

1. Meet All Contractual Obligations

2. Avoid Undercapitalization
3. Get Everything in Writing
4. Set Standards

II. Obtaining Business Licenses and Permits

A. Business Licenses
B. Business Permits

III. Choosing a Form of Business Ownership

A. Sole Proprietorships
B. Partnerships
1. General Partnerships
2. Limited Partnerships
C. Corporations
1. C Corporation
2. Subchapter S Corporation
D. Limited Liability Companies

CHAPTER NOTES

I. Initial Ethical and Legal Issues Facing a New Firm

1. As the opening case suggests, new ventures must deal with important ethical
and legal issues at the time of their launching. Ethical and legal errors made
early on can be extremely costly for a new venture down the road.

2. And there is a tendency for entrepreneurs to overestimate their knowledge of

the law.

A. Establishing a Strong Ethical Culture

1. Lead By Example. The most important thing that any entrepreneur, or

team of entrepreneurs, can do to build a strong ethical culture in their
organization is to lead by example.

2. Establish a Code of Conduct

a. A code of conduct (or code of ethics) is a formal statement of an

organization’s values on certain ethical or social issues.

b. The advantage of having a code of conduct is that it provides

specific guidance to managers and employees regarding what is
expected of them in terms of ethical behavior.

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 Chapter 7: Preparing a Proper Ethical and Legal Foundation

3. Implement an Ethics Training Program

a. Ethics training programs teach business ethics to help employees

deal with ethical dilemmas and improve their overall ethical conduct.

b. An ethical dilemma is a situation that involves doing something that

is beneficial to oneself or the organization, but may be unethical.
Ethics training programs are designed to help employees resolve
ethical dilemmas in an appropriate manner.

c. Ethics training programs can be provided by outside vendors or can

be developed in-house.

B. Choosing An Attorney for the New Firm

1. It is important for an entrepreneur to select an attorney as early as

possible when developing a business venture. Table 7.3 in the
textbook provides guidelines to consider when selecting an attorney.

2. It is critically important that the attorney be familiar with start-up

issues and that he or she has successfully shepherded entrepreneurs
through the start-up process before.

3. Many attorneys recognize that start-ups are short on cash and will
work out an installment plan or other payment arrangement to get
the firm the legal help it needs without starving it of cash.

4. The following are several ways for entrepreneurs to save on legal fees.

- Group together legal matters

- Offer to assist the attorney
- Ask your attorney to join your advisory board
- Use nonlawyer professionals

C. Drafting a Founders’ Agreement

1. A founder’s agreement (or shareholders’ agreement) is a written document

that deals with issues such as the relative split of the equity among the
founders of the firm, how individual founders will be compensated for the
cash or the “sweat equity” they put into the firm, and how long the
founders will have to remain with the firm for their shares to fully vest.

2. Most founders’ agreements include a buyback clause, which legally

obligates the departing founder to sell to the remaining founders his or
her interest in the firm if the remaining founders are interested.

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Chapter 7: Preparing a Proper Ethical and Legal Foundation

3. The presence of a buyback clause is important for at least two reasons.

First, if a founder leaves the firm, the remaining founders may need the
shares to offer to a replacement person. Second, if founders leave because
they are disgruntled, the buyback clause provides the remaining founders a
mechanism to keep the shares of the firm in the hands of people who are
fully committed to a positive future for the venture.

E. Avoiding Legal Disputes

* Most legal disputes are the result of misunderstandings, sloppiness, or a

simple lack of knowledge of the law. Getting bogged down in legal
disputes is something than an entrepreneur should work hard to avoid.
There are several steps entrepreneurs can take to avoid legal disputes
and complications.

1. Meet all contractual obligations. It is important to meet all contractual

obligations on time. This includes paying vendors, contractors, and
employees as agreed and delivering goods or services as promised.

2. Avoid undercapitalization. If a new business is starved for money, it is

much more likely experience financial problems that will lead to
litigation.

3. Get everything in writing. Many business disputes arise because of the

lack of a written agreement or because poorly prepared written
agreements do not anticipate potential areas of dispute.

3. Set standards. Organizations should also set standards that govern

employees’ behavior beyond what can be expressed via a code of
conduct.

a. When legal disputes do occur, they can often be settled through

negotiation or mediation, rather than more expensive and
potentially damaging litigation.

b. Mediation is a process in which an impartial third party (usually a

professional mediator) helps those involved in a dispute reach an
agreement.

II. Obtaining Business Licenses and Permits

* Before a business is launched, a number of licenses and permits are typically

needed. What is actually needed varies by city, country, and state, as well as
by type of business, so it’s important for the entrepreneur to study local
regulations carefully.

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A. Business Licenses

1. In most communities, a business needs a license to operate. A business

license can be obtained at the city clerk’s office in the community where
the business will be located.

2. If a business is a sole proprietorship, it can usually stop after it receives

its license from the community where it will be located. If a business has
employees, or is a corporation, limited liability company, or limited
partnership, it will usually need a state business license in addition to its
local one.

3. A narrow group of businesses are required to have federal business

licenses, including investment advising, broadcasting, interstate trucking,
and businesses that manufacture tobacco, alcohol, or firearms, or sell
firearms. These licenses are obtained through the Federal Trade
Commission.

B. Business Permits

1. Along with obtaining the appropriate licenses, some businesses may need
to obtain one or more permits. The need to obtain a permit depends on the
nature and location of the business.

a. For example, if you plan to sell food either as a restaurateur or as a

wholesaler to other retail businesses, you’ll need a city or county
health permit.

b. Similarly, if your businesses will be open to the public or will use

flammable material, you may need a firm department permit.

2. All businesses that plan to use a fictitious name, which is any name other
than the business owner’s name, need a fictitious business name permit
(also called dba or doing business as).

II. Choosing a Form of Business Ownership

1. When a business is launched, a form of legal entity must be chosen. The most
common legal entities are sole proprietorship, partnership, corporations and
limited liability companies.

2. There is no single form of business ownership that works best in all situations.
It is up to the owners of a firm and their attorney to select the legal entity that
best meets their needs.

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3. The decision typically hinges on several factors, including the following:

- The cost of setting up and maintaining the legal form

- The extent to which an entrepreneur can shield his or her personal assets
from the liabilities of the business
- Tax considerations
- The ease of raising capital

A. Sole Proprietorship

1. A sole proprietorship is a form of business organization involving one

person, and the person and the business are essentially the same.

2. Setting up a sole proprietorship is cheap and relatively easy compared to

the other forms of business ownership. The only legal requirement, in
most states, is to obtain a license to do business.

3. A sole proprietorship is not a separate legal entity. For tax purposes, the
profits or loss of the business flows through to the owner’s person tax
return.

4. The primary advantages and disadvantages of a sole proprietorship are as

follows:

Advantages of a Sole Proprietorship

- Creating one is easy and inexpensive

- The owner maintains complete control of the business and retains all
the profits
- Business losses can be deducted against the sole proprietor’s other
sources of income
- It is not subject to double taxation (explained later)
- The business is easy to dissolve

Disadvantages of a Sole Proprietorship

- Liability on the owner’s part is unlimited

- The business relies on the skills and abilities of a single owner to be
be successful
- Raising capital can be difficult
- The business ends at the owner’s death or loss of interest in the business
- The liquidity of the owner’s investment is low

B. Partnerships

1. Partnerships are organized as either general or limited partnership.

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a. A general partnership is a form of business organization where

two or more people pool their skills, abilities, and resources to
run a business. The primary advantages and disadvantages of a
general partnership are as follows:

Advantages of a General Partnership

- Creating one is relatively easy and inexpensive compared to a

corporation or limited liability company
- The skills and abilities of more than one individual are available
to the firm
- Having more than one owner may make it easier to raise funds
- Business losses can be deducted against the partners’ other
sources of income
- It is not subject to double taxation (explained later)

Disadvantages of a General Partnership

- Liability on the part of each general partner is unlimited

- The business relies on the skills and ability of a fixed number of
partners
- Raising capital can be difficult
- Because decision making among the partners is shared,
disagreements can occur
- The business ends at the death or withdrawal of one partner
unless otherwise stated in the partnership agreement
- The liquidity of each partner’s investment is low

2. A limited partnership is a modified form of a general partnership. The

major difference between the two is that a limited partnership includes
two classes of owners: general partners and limited partners.

a. Similar to a general partnership, the general partners are liable for

the debts and obligations of the partnership, but the limited partners
are liable only up to the amount of their investment.

b. Limited partnerships are common in real estate development, oil and

gas exploration, and motion picture ventures.

C. Corporations

1. A corporation is a separate legal entity organized under the authority of a

state.

2. Corporations are organized as either C corporations or subchapter S

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corporations.

a. A C corporation is a separate legal entity that, in the eyes of the law, is

separate from its owners.

b. A corporation is formed by filing articles of incorporation with the

secretary of state’s office in the state of incorporation.

c. If the owners of a corporation don’t file their annual paperwork, neglect

to pay their annual fees, or commit fraud, a court could ignore the fact
that a corporation has been established, and the owners could be held
personally liable for actions of the corporation. This chain of events is
referred to as “piercing the corporate veil.”

d. A disadvantage of corporations is that they are subject to double

taxation, which means that a corporation is taxed on its net income and,
when the income is distributed to shareholders in the form of dividends,
is taxed again on shareholders’ personal income tax returns.

e. The following are the advantages and disadvantages of a C corporation.

Advantages of a C Corporation

- Owners are liable only for the debts and obligations of the corporation up
to the amount of their investment
- The mechanics of raising capital is easier
- No restrictions exist on the number of shareholders, which differs from
subchapter S corporations
- Stock is liquid if traded on a major stock exchange
- The ability to share stock with employees through stock options or other
incentive plans can be a powerful form of employee motivation

Disadvantages of a C Corporation

- Setting up and maintaining one is more difficult than for a sole

proprietorship or a partnership
- Business losses cannot be deducted against the shareholders’ other
sources of income
- Income is subject to double taxation, meaning that it is taxed at the
corporate and the shareholder levels
- Small shareholders typically have little voice in the management of the
firm

f. A subchapter S corporation combines the advantages of a partnership

and a C corporation. It is similar to a partnership in that the profits and
losses of the business are not subject to double taxation.

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Standards to qualify for a Subchapter S Corporation

- The business cannot be a subsidiary of another corporation

- The shareholders must be U.S. citizens. Partnerships and C
corporations may not own share in a subchapter S corporation.
Certain types of trusts and estates are eligible to own shares in
a subchapter C corporation
- It can have only one class of stock issued and outstanding (either
preferred stock or common stock
- It can have no more than 100 members. Husbands and wives count as
one member, even if they own separate shares of stock
- All shareholders must agree to have the corporation formed as a
subchapter S

D. Limited Liability Company

1. The limited liability company is a form of business organization that is

rapidly gaining popularity in the U.S.

2. As with partnerships and corporations, the profits of an LLC flow through

to the tax returns of the owners and are not subject to double taxation.

3. The main advantage of the LLC is that all partners enjoy limited liability.
This differs from regular and limited partnerships, where at least one
partner is liable for the debts of the partnership.

4. The advantages and disadvantages of an LLC are as follows:

Advantages of an LLC

- Members are liable for the debts and obligations of the business only up
to the amount of their investment
- The number of shareholders is unlimited
- An LLC can elect to be taxed as a sole proprietor, partnership,
S corporation, or corporation, providing much flexibility
- Because profits are taxed only at the shareholder level, there is no
double taxation

Disadvantages of the LLC

- Setting up and maintaining one is more difficult and expensive

- Tax accounting can be complicated
- Some of the regulations governing LLCs vary by state
- Because LLCs are a relatively new type of business entity, there is not
as much legal precedent available for owners to anticipate how legal

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disputes might affect their business

- Some states levy a franchise tax on LLCs—which is essentially a fee the
LLC pays the state for the benefit of limited liability

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