Chapter 7. Preparing the Proper Ethical and Legal Foundation

Establishing a Strong Ethical Culture for a Firm

One of the most important things the founders of an entrepreneurial venture can do is establish a strong ethical culture for their firms. The data regarding business ethics are both encouraging and discouraging. The Ethics Resource Center concluded that the most important thing an organization can do to combat ethical misconduct is to establish a strong ethical culture. Strong ethical cultures don't emerge by themselves. It takes entrepreneurs who make ethics a priority and organizational policies and procedures that encourage ethical behavior (and punish unethical behavior) to make it happen. The following are specific steps that an entrepreneurial organization can take to build a strong ethical culture.

Lead by Example

Leading by example is the most important thing that any entrepreneur, manager, or supervisor can do to build a strong ethical culture in their organization. In strong ethical cultures, entrepreneurs, managers, and supervisors:

• Communicate ethics as a priority
• Set a good example of ethical conduct
• Keep commitments
• Provide information about what is going on
• Support following organizational standards

Employees also have responsibilities. The most important things that employees can do to support a strong ethical culture in an organization are to:

• Consider ethics in making decisions
• Talk about ethics in the work (they) do
• Set a good example of ethical conduct
• Support following organizational standards

In companies where these attributes are present, a stronger ethical culture exits. This reality demonstrates the important role that everyone involved with a start-up plays in developing a strong ethical culture for their firm.

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. The advantage of having a code of conduct is that it provides specific guidance to entrepreneurs, managers, and employees regarding expectations of them in terms of ethical behavior. In practice, some code of conduct are very specific, like Google's. Other codes of conduct set out more general principles about an organization's beliefs on issues such as product quality, respect for customers and employees, and social responsibility. In all cases though, codes of conduct are intended to influence people to behave in ways that are consistent with a firm's ethical orientation. 

Implement an Ethics Training Program

Firms also use ethics training programs to promote ethical behavior. 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. Most employees confront ethical dilemmas at some point during their careers. Ethics training programs can be provided by outside vendors or can be developed in-house. In summary, ethical cultures are built through both strong ethical leadership and administrative tools that reinforce and govern ethical behavior in organizations. Building an ethical culture motivates employees to behave ethically and responsibly from the inside and out, rather than relying strictly on laws that motivate behavior from the outside in. 

Dealing Effectively with Legal Issues

Those leading entrepreneurial ventures can also expect to encounter a number of important legal issues when launching and then, at least initially, operating their firm.

Choosing an Attorney for a Firm

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 and that he or she has successfully shepherded entrepreneurs through the start-up process before. It is not wise to select an attorney just because she is a friend or because you were pleased with the way she prepared your will. For issues dealing with intellectual property protection, it is essential to use an attorney who specializes in this field; such as a patent attorney when filling a patent application.

Drafting a Founder's Agreement

If two or more people start a business, it is important that they have a founders' (or shareholders') agreement. A founders' 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.

Most founder's agreements include a buyback clause, which legally obligates departing founders to sell to the remaining founders their interest in the firm if the remaining founders are interested. In most cases, the agreement also specifies the formula for computing the dollar value to be paid. 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 have a positive future for the venture.

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 that an entrepreneur should work hard to avoid.
There are several steps entrepreneurs can take to avoid legal disputes and complications:

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. If an obligation cannot be met on time, the problem should be communicated to the affected parties as soon as possible.

Avoid Undercapitalization
If a new business is starved for money, it is much more likely to experience financial problems that will lead to litigation. A new business should raise the money it needs to effectively conduct business or should stem its growth to conserve cash. Most entrepreneurs have a goal off retaining as much of the equity in their firms as possible, but equity must often be shared with investors to obtain sufficient investment capital to support the firm's growth.

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. Disputes are much easier to resolve if the rights and obligations of the parties involved are in writing. There are also two important written agreements that the majority of firms ask their employees to sign. A nondisclosure agreement binds an employee or another party (such as a supplier) to not disclose a company's trade secrets. A noncompete agreement prevents an individual from competing against a former employer for a specific period of time.

Set Standards
Organizations should also set standards that govern employees' behavior beyond what can be expressed via a code of conduct. When legal disputes do occur, they can often be settled through negotiation or meditation, rather than more expensive and potentially damaging litigation. Meditation is a process in which an impartial third party (usually a professional mediator) helps those involved in a dispute reach an agreement.

Obtaining Business Licenses and Permits

Depending on the nature of the business, licenses and permits may be required at the federal, state, and/or local levels. There are three ways for those leading a business to determine their licenses and permits that are necessary. The first is to ask someone who is running a similar business, and they will usually be able to point you in the right direction. The second is to contact the secretary of state's office in the state where the business will be launched. In most cases, they will be able to help you identify the federal, state, and local licenses that you'll need. The third is to use one of the search tools available online.

The following is an overview of the licenses and permits that are required in the United States at the federal, state, and local levels for business organizations.

Federal Licenses and Permits

Most business do not require a federal license to operate, although some do. Seemingly simple businesses sometimes require more licenses and permits than one might think. 

State Licenses and Permits

In most states, there are three different categories of licenses and permits that you may need to operate a business. Most states have start-up guides that walk you through the steps of setting up a business in the state.

Business Registration Requirements

Some states require all new businesses to register with the state. The best way to determine if your state has a similar document is to ask a business owner or contact your secretary of state's office.

Sales Tax Permits

Most states and communities require businesses that sell goods, and in some cases services, to collect sales tax and submit the tax to the proper state authorities. If you're obligated to collect sales tax, you must get a permit from your state.

Professional and Occupational Licenses and Permits

In all states, there are laws that require people in certain professions to pass a state examination and maintain a professional license to conduct business. There are also certain businesses that require a state occupational license or permit to operate.

Local Licenses and Permits

On the local level, there are two categories of licenses and permits that may be needed.

The first is a permit to operate a certain type of business. Examples include child care, barber shops and salons, automotive repair, and hotels and motels.

The second category is permits for engaging in certain types of activities. Examples include the following:

• Building permit
• Health permit
• Signage permit
• Street vendor permit
• Sidewalk cafe permit
• Alarm permit
• Fire permit

Choosing a Form of Business Organization

When a business is launched, a form of legal entity must be chosen. Sole proprietorships, partnerships, corporations, and limited liability companies are the most common legal entities from which entrepreneurs make a choice. Choosing a legal entity is not a one-time event. It is important to be careful in selecting a legal entity for a new firm because each form of business organization involves trade-offs among these factors and because an entrepreneur wants to be sure to achieve the founder's specific objectives. There are factors critical in selecting a form of business organization:

• The cost of setting up and maintaining the legal form
• The extent to which personal assets can be shielded from the liabilities of the business
• Tax considerations
• The number and types of investors involved

Sole Proprietorship

The simplest form of business entity is the sole proprietorship. A sole proprietorship is a form of a business organization involving one person, and the person business are essentially the same.

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.
• The business is easy to dissolve.

Disadvantage 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.
• 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

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 partnerships.

A general partnership is a form of business organization where two or more people pool their skills, abilities, and resources to run a business.

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 partner's other sources of income.
• It is not subject to double taxation.

Disadvantages of a General 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.
• 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.

A limited partnership is a modified form of a general partnership. A limited partnership includes two classes of owners: general partners and limited partners. A limited partnership is usually formed to raise money or to spread out the risk of a venture without forming a corporation.

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

A C corporation is a separate legal entity that, in the eyes of the law, is separate from its owners. In most cases, the corporation shields its owners, who are called shareholders, from personal liability for the debits and obligations of the corporation. Most C corporations have two classes of stock: common and preferred. Preferred stock is typically issued to conservative investors who have preferential rights over common stockholders in regard to dividends and to the assets of the corporation in the event of the liquidation. Common stock is issued ore broadly than preferred stock. The common stockholders have voting rights and elect the board of directors of the firm. The common stockholders are typically the last to get paid in the event of the liquidation of the corporation: that is, after the creditors and the preferred stockholders.

The advantages and disadvantages of a C corporation are as follows:

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 trough stock option 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 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

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. The subchapter S corporation does not pay taxes; instead, the profits or losses of the business are passed through to the individual tax returns of the owners.

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

• The business cannot be a subsidiary of another corporation.
• The shareholders must be U.S. citizens.
• 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.
• All shareholders must agree to have the corporation as a subchapter S corporation.

The primary disadvantages of a subchapter S corporation are restrictions in qualifying, expenses involved with setting up and maintaining the subchapter S status. If a subchapter S corporation wants to include more than 100 shareholders, it must convert to a C corporation or a limited liability company.

Limited Liability Company

The Limited liability company (LLC) is a form of business organization that is rapidly gaining popularity in the United States. The main advantage of the LLC is that all partners enjoy limited liability. The LLC combines the limited liability advantage of the corporation with the tax advantages of the partnership. An LLC must be a private business⎯it cannot be publicly traded.

The advantages and disadvantages of an LLC are as follows:

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.

Disadvantage 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 businesses.
• Some states levy a franchise tax on LLCs⎯which is essentially a fee the LLC pays the state for the benefit of limited liability.