3 Costly Legal Mistakes Your Business Should (and Can) Avoid
by Arina Shulga, founder of Shulga Law Firm, P.C.
Starting and running your own business is a risky undertaking. We all know the statistics that tell us that the overwhelming majority of new businesses fail. However, you can minimize your risks by avoiding certain common legal pitfalls. Here are my top 3:
1. Selecting the wrong legal entity type. Most entrepreneurs in New York choose among these 3 types of legal entities when incorporating: a C corporation, an S corporation, or a limited liability company (LLC).
A C corporation is your regular corporation. It has a board of directors, who are elected by the shareholders. The directors appoint officers and oversee the strategic direction of the corporation. The officers manage day-to-day affairs of the corporation. A C corporation is subject to double taxation: income of the corporation is taxed twice, first at the level of the corporation and second, at the shareholders’ individual tax rate when dividends are distributed.
An S corporation is a C corporation that has elected the special federal and state “pass-through” tax treatment. Only U.S. citizens or permanent residents can be shareholders of an S corporation. Further, an S corporation can have only up to 100 shareholders, all of whom must be individuals (or family trusts). Shareholders of an S corporation can have only 1 class of shares: common stock. All shares have to have the same economic rights to profits, distributions, and the same preferences in liquidation of assets.
An LLC can have unlimited number of members. Members can be foreigners, and can be other companies. An LLC has the most flexible form: it can be managed by members or by managers. Members can even agree to share profits and losses disproportionately to their equity in the company. For example, if there are 2 members with 50% equity ownership each, they can agree to distribute 75% of their profits to 1 of the members and only 25% to the other. In New York State, all LLCs must comply with a publication requirement and publish a notice of formation in 2 newspapers in the county where the LLC was formed for a period of 6 weeks. This can get expensive, especially in New York County.
If you do not plan to hire employees, raise capital for your business, and your business is profitable (i.e., you are relying on your revenue to cover costs of running your business), then forming an LLC may be a great choice for you. If you plan to hire employees, but still you do not rely on outside financing to run your business, consider an S corporation. However, if your business requires substantial outside capital from angel investors or venture capital firms, consider forming a C corporation. Many professional investors will not invest in an LLC because of its pass-through tax structure. They prefer investing into a S or C corporation that is incorporated in Delaware.
Converting from one entity type to another may result in unexpected tax consequences and high legal fees. To avoid this, I definitely recommend consulting with a business attorney and an accountant to choose the right legal entity for your business from the start.
2. Not entering into written shareholder agreements with your partners. When several partners decide to start a business together, they should enter into a partnership agreement that would define the internal rules of their company. Absence of such agreement is by far the most common mistake I see – and also the most costly one to correct.
Typically, a partnership agreement (also called a “shareholders agreement” or an “operating agreement”) deals with the following issues:
· Who manages the company?
· What are the duties and expectations of each of the partners?
· What happens if one of the partners commits a crime or his employment is terminated for cause?
· Do some corporate decisions require unanimous or super-majority vote of the partners?
· What happens in the case of a death or disability of a partner? Can the company buy back his or her shares?
· How can partners exit from the company? Can they sell their equity to a third party?
· Can partners be required to sell if a partner holding majority of equity wants to sell his or her equity to a third party?
Partners should know the answers to these questions before any of these situations arise. Then, all they need to do is refer to the agreement and follow its provisions.
3. Doing handshake deals with your vendors and customers. If you do not have a written agreement, then you may be surprised to find out that you and your vendor or customer had a different idea about what was supposed to happen. Often, deals end up in court because parties thought they had an understanding. You do not need a long and complicated contract full of legal terms that are difficult to understand. A simple contract that lays out all of the material terms is sufficient.
Next time you negotiate with a vendor or customer, think about these questions:
· What is the scope of work or services?
· When will it be performed?
· Who will perform the work/services?
· What is the payment structure?
· Is it a flat payment or will the total amount depend on hours worked or some other factor?
· Does the payment depend on the costs of materials?
· Who owns the work that was created?
· What if certain services or work is not performed or is not performed to your satisfaction? Can you get out of payments?
Beware if someone tells you “you don’t need a lawyer,” pressures you to get the deal done quickly, or says that they already had a lawyer review the agreement. You may be in for a surprise if things go wrong. Make sure to have a contract in writing, and have contracts that are drafted by others reviewed by an attorney representing your interests. Legal fees for contract reviews and drafting are typically much less than the fees for law suits.
Arina Shulga is the founder of Shulga Law Firm, P.C., a law firm that focuses on representing small and growing businesses. Arina conducts a monthly free legal clinic at NYC Business Solutions, Brooklyn Center. She writes a blog, www.businesslawpost.com, and is active on Twitter (@Businesslawpost). If you have a question or comment for Arina, drop her a note below. And, please share this blog entry with your colleagues on Facebook and Twitter.
Note that this blog is for informational purposes only and should not be relied upon as a legal advice.
The views, opinions, or expressions provided by Arina Shulga do not necessarily represent the views, opinions, or expressions of the City of New York, the New York City Department of Small Business Services, and/or NYC Business Solutions.