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Chapter 7

Preparing a Proper
Ethical and Legal
Foundation
Bruce R. Barringer
R. Duane Ireland
Copyright ©2012 Pearson Education, Inc. publishing as Prentice Hall 7-1

Chapter Objectives
1 of 3

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 founders’ agreement.


Chapter Objectives
2 of 3

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.

Chapter Objectives
3 of 3

10. Explain why most fast-growth entrepreneurial
ventures organize as corporations or limited
liability companies rather than sole proprietorships
or partnerships.


Initial Ethical and Legal Issues Facing a
New Firm

Establishing a strong Drafting a founder’s
Choosing an attorney
ethical culture agreement

Avoiding legal Obtaining business Choosing a form of
disputes licenses and permits business organization


Establishing a Strong Ethical Culture
1 of 2

• 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.
• Establish a Code of Conduct
– A code of conduct (or code of ethics) is a formal statement
of an organization’s values on certain ethical and social
issues.


Establishing a Strong Ethical Culture
2 of 2

• Implement an Ethics Training Program
– Ethics training programs teach business ethics to help
employees deal with ethical dilemmas and improve their
overall ethical conduct.
– An ethical dilemma is a situation that involves doing
something that is beneficial to oneself or the organization,
but may be unethical.


Potential Payoffs for Establishing a Strong
Ethical Culture


Choosing an Attorney for a Firm

• Select an Attorney Early
– It is important for an entrepreneur to select an attorney as
early as possible when developing a business venture.
– It is critically important that the attorney be familiar with
start-up issues.
• Intellectual Property
– For issues dealing with intellectual property (patents,
trademarks, copyrights, and trade secrets) it is essential to
use an attorney who specializes in this field.


How to Select an Attorney
• Contact the local bar association and ask for a list of attorneys who
specialize in start-ups in your area.
• Interview several attorneys.
• Select an attorney who is familiar with the start-up process.
• Select an attorney who can assist you in raising money for your new
venture.
• Make sure your attorney has a track record of completing his or her work
on time.
• Talk about fees.
• Select an attorney that you think understands your business.
• Learn as much about the process of starting a business yourself as
possible.


Drafting a Founders’ Agreement

• Founders’ Agreement
– A founders’ 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.
– The items to include in the founders’ agreement are shown
on the following slide.


Items to Include in a Founders’ Agreement

• Nature of the prospective business.
• Identity and proposed titles of the founders.
• Legal form of business ownership.
• Apportionment of stock (or division of ownership).
• Consideration paid for stock or ownership share of each of the founders.
• Identification of any intellectual property signed over to the business.
• Description of the initial operating capital.
• Buyback clause.


Avoiding Legal Disputes
1 of 2

• 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 an
entrepreneur should work hard to avoid.
– There are several steps that an entrepreneur can take to
avoid legal disputes:
• Meet all contractual obligations.
• Avoid undercapitalization.
• Get everything in writing.
• Set standards.


Avoiding Legal Disputes
2 of 2

• Although it’s tempting to try
to show people you trust
them by not insisting on
written agreements, it’s not a
good practice.
• One of the simplest ways to
avoid misunderstandings
and ultimately legal disputes
is to get everything in
writing.


Obtaining Business Licenses and Permits
1 of 2

• Business Licenses
– In most communities, a business needs a license to operate.
– If the business will be run out of the founder’s home, a
separate home occupation business license is often
required.
– 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.
– A narrow group of companies are required to have a federal
business license, including investment advising, drug
manufacturing, and interstate trucking.


Obtaining Business Licenses and Permits
2 of 2

• Business Permits
– 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.
• If you plan to sell food, you’ll need a city or county health permit.
• If your business is open to the public, you may need a fire permit.
• Some communities require businesses to obtain a license to put up
a sign.
• All businesses that plan to use a fictitious name need a fictitious
business name permit.


Choosing a Form of Business Ownership
When a business is launched, a form of legal entity must be
chosen. The most common legal entities are…

Sole Proprietorship Partnership

Limited Liability
Corporation
Company


Issues to Consider in Choosing a Legal
Form of Business Ownership


Sole Proprietorship

• Sole Proprietorship
– The simplest form of business entity is the sole
proprietorship.
– A sole proprietorship is a form of business organization
involving one person, and the person and the business are
essentially the same.
– A sole proprietorship is not a separate legal entity. The
sole proprietor is responsible for all the liabilities of the
business, and this is a significant drawback.


Advantages and Disadvantages of a
Sole Proprietorship
1 of 2

Advantages of a Sole Proprietorship
 Creating one is easy and inexpensive.
 The owner maintains complete control of the business and retains all of 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.


Sole Proprietorship
2 of 2

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 successful.
Of course, the owner can hire employees who have additional skills and abilities.
 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.


Partnerships
1 of 3

• Partnerships
– If two or more people start a business, they must organize
as a partnership, corporation, or limited liability company.
– Partnerships are organized as either general or limited
liability partnerships.


Partnerships
2 of 3

A form of business organization
where two or more people pool
General Partnership their skills, abilities, and
resources to run a business. The
primary disadvantage is that all
partners are liable for all the
partnership’s debts and
obligations.


Partnerships
3 of 3

• A modified form of general
partnership.
• The major difference between
the two is that a limited
Limited Partnership partnership includes two classes
of owners: general partners and
limited partners.
• The general partners are liable
for the debts and obligations of
the partnership, but the limited
partners are only liable up to
the amount of their investment.


General Partnership
1 of 2

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).


General Partnership
2 of 2

Disadvantages of a Partnership
 Liability on the part of each general partner is unlimited.
 The business relies on the skills and abilities of a fixed number of partners. Of
course, the owners can hire employees who have additional skills and abilities.
 Raising capital can be difficult.
 Because decision making among the partners is shared, disagreements can occur.
 The business ends with the death or withdrawal of one partner unless otherwise
stated in the partnership agreement.
 The liquidity of each partner’s investment is low.


Corporations

• Corporations
– A corporation is a separate legal entity organized under the
authority of a state.
– Corporations are organized as either C corporations or
subchapter S corporations.
– C corporations are what most people think of when they
hear the word “corporation.” However, business startups
are often organized as subchapter S corporations.


C Corporation
1 of 2

• Is a separate legal entity that, in the
eyes of the law, is separate from its
owners.
• In most cases a corporation shields
its owners, who are called shareholders,
C Corporation from personal liability for the debts of
the corporation.
• A corporation is governed by a board
of directors, which is elected by the
shareholders.
• A corporation is formed by filing
articles of incorporation.


C Corporation
2 of 2

• A corporation is taxed as a separate
legal entity.
• A disadvantage of a C corporation is
that it is subject to double taxation.
This means that a corporation is taxed
C Corporation on its net income, and when the same
income is distributed to shareholders
in the form of dividends, the income is
taxed again on the shareholders’
personal tax returns.


C Corporation
1 of 2

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.


C Corporation
2 of 2

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 shareholder’s 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.


Subchapter S Corporation
1 of 2

• Combines the advantages of a
partnership and a C corporation.
• Is similar to a partnership in that the
income of the business is not subject
to double taxation.
Subchapter S • Is similar to a corporation in that the
Corporation owners are not subject to personal
liability for the debts or behavior of
the business.
• A Subchapter S Corporation does not
pay taxes. Profits and losses are passed
through to the tax returns of the owners.


Subchapter S Corporation
2 of 2

There are strict standards that a business must meet to qualify for status as a
subchapter S corporation. The standards are shown below:

 The business cannot be a subsidiary of another corporation.
 The shareholders must be U.S. citizens. Partnerships and C corporations may
not own shares in a subchapter S corporation. Certain types of trusts and
estates
are eligible to own shares in a subchapter S corporation.
 It can only have 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 corporation.


Limited Liability Company

• Is a form of business ownership that
is rapidly gaining popularity in the
U.S.
• Along with the Subchapter S, it is a
popular choice for start-up firms.
Limited Liability • The limited liability company combines
Company the limited liability advantage of the
corporation with the tax advantages of
a partnership.
• A limited liability company does not
pay taxes. Profits and losses are passed
through to the tax returns of the owners.


1 of 2

Advantages of a Limited Liability Company
 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.


2 of 2

Disadvantages of a Limited Liability Company
 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 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.


All rights reserved. No part of this publication may be reproduced,
stored in a retrieval system, or transmitted, in any form or by any
means, electronic, mechanical, photocopying, recording, or otherwise,
without the prior written permission of the publisher. Printed in the
United States of America.

Copyright ©2012 Pearson Education, Inc.
publishing as Prentice Hall


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