VenturePORT Series - Legal Matters
Depending upon the type of business you want to start, the U.S. has a relatively friendly legal environment. Unless your business involves food items, chemicals, pharmaceuticals, health care, wines and liquors, transportation, children, or any kind of regulated product or service, you will not face much in the way of government burdens. That said, depending on the state, owners of any business face several important legal issues related to the following topics:
Incorporation — creating a legal and tax entity for your company.
Employees and independent contractors (freelancers) — state and federal regulations related to the people you employ or use on a work-for-hire basis.
Intellectual property rights — the names, logos, and inventions, if any, you wish to try to protect.
The last thing a fledgling, cash-strapped business needs is loads of legal fees. If you can find a good, young lawyer who works independently or in a new partnership, you can get affordable advice and assistance to lay the groundwork for a successful sale later on. Eventually, you will want to sell all or part of your company. The more you lay a solid legal foundation in terms of "dotting your i's and crossing your t's," the easier it will be when a potential buyer or investor comes in to do "due diligence." An analysis of all parts of your company will ensure all of your ducks are in a row before the close of a purchase.
On the other hand, unless your business particularly involves issues related to Intellectual Property Rights, which means protection of its name, look, or inventions, you don't have to get too distracted by legal issues. You'll find yourself plunking down valuable resources on activities unlikely to yield any tangible revenue or profits right when you need them most.
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Incorporation
To open a bank account for a business entity or to accept and cash a check made out to a name other than your own, your business has to have a name and some kind of legal standing. This is critical to how it will be treated for tax and liability issues. Different kinds of business entities get taxed different kinds of ways, and subject you to different levels of liability. Personal liability is the ability of people or creditors to come after your personal assets if you fail to pay them or if they sue you.
Below we provide a summary of the basic types of business entities and what they are designed for. The type of entity you select generally depends on your objectives for the company and the nature of your relationship with partners, if any. You sometimes can change a business entity after you have gotten started, but it is often complex and difficult, so try to make the right decision now.
Sole Proprietorship. You don't necessarily need to rush into any decisions. Those who plan to "sell themselves" into business often start out as a sole proprietorship and by getting a DBA ("Doing Business As."). This is simply a form you fill out with your state. Your bank can give you one. This enables you to open up a bank account under the name of that company. In this case, you generally file your federal income taxes using a Schedule C, which accounts for the revenue and expenses related to your business. With this type of entity, you are fully and personally liable for anything that happens while you're in business. Once you feel confident that you're on your way, you will probably want to step up and make a decision about becoming a real company.
LLC (Limited Liability Company). For many companies, this is the dream entity, and all states now have laws permitting companies to operate as LLCs. It gives owners protection from having people go after their personal assets in case of money problems, it enables you to have multiple shareholders with relative ease, and it eliminates some of the tax burdens of C corporations — the structure utilized by most publicly held corporations. LLCs are relatively inexpensive to set up — it can be done for several hundred dollars in filing and legal fees. You must also file a public notice of incorporation in your local weekly or daily newspaper. LLCs create a business and legal entity technically separate from your personal assets. The LLC carries the liabilities, not you, except to the extent that you personally guarantee any loans or other obligations taken on by your company.
Subchapter S. Also known as an S corporation, this type of corporation generally is for closely held organizations owned by one or just a few people. Essentially it permits the owner or shareholders to operate as a corporation while being taxed as an individual, whereas with a C corporation business earnings are taxed in addition to individual earnings creating a sort of "double taxation" for small businesses. It is often beneficial to people who have other income sources or assets and who expect the business to lose money in the short term at least. With this type of corporation losses can also be deducted from personal income. Since Subchapter S corporations treat business income in the same pool as other income, multiple partners have to report losses or gains on their personal tax returns in direct proportion to their ownership. Someone with 15 percent of the company will get what's called a K-1 form, submitted to the IRS for tax purposes, reflecting 15 percent of the loss of the company or 15 percent of the gain. Since the advent of LLCs, Subchapter S filings have become less common. Generally speaking, a Subchapter S is not the best entity if your goal is to scale into a large company with many shareholders.
Partnerships. Closely held entities consisting of partners often enter into legal partnerships specifically designed for professional practices and other business entities with working partners. In most cases, a partnership is considered a distinct legal entity separate from its partners. There are different types of partnerships, but generally a partnership can be sued, and it can own property in its own name. This entity has many tax advantages in the right circumstances, but you need legal advice to determine if it's right for you. It too includes protections of the partners' personal assets in the event of financial problems or litigation directed at the partnership.
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Employees and Independent Contractors (Freelancers)
Probably one of the more common danger areas for entrepreneurs involve state regulations related to independent contractors and employees. The state governments expect your organization to pay unemployment and disability insurance for your employees, and they don't like it when companies deliberately avoid those taxes by attempting to make employees look like independent contractors. Employees are salaried people for whom you will withhold state and federal taxes, and pay a contribution for state unemployment insurance, disability, and for half of that person's social security tax, which is roughly 13% of the first $90,000 or so of pay. From the point of the view of the IRS and state regulators, independent contractors are not employees; they are free agents who work for many organizations, using their own tools or equipment, providing their own training, much like a plumber who comes to your house. They usually come with the equipment, rather than use yours, and they control the means and manner of achieving the work outcome.
For startups, it is tempting to reduce fixed costs as much as possible by using independent contractors who have multiple clients, so they don't mind working for you only when you have work. This applies to many service businesses, such as software development, consulting, marketing, publishing and writing, engineering, and many more fields. In this case, they submit to you invoices for their work, and you pay them for their work. They are responsible for all taxes.
Now if those independent contractors really work full-time for you, use your location, your equipment, and are trained by you, an enlightened state auditor will come after your company, not only to collect the unemployment and disability taxes going forward, but also retroactively to when your working relationship began with that person or people. If they find a pattern, financial consequences can be greater. Sounds improbable? We know of two startups that got snared by this, and one had to pay tens of thousands of dollars in back taxes.
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Intellectual Property Rights
Government provides some protection for certain names, logos, and ideas through copyright, trademark, and patent law. Depending on your type of business, these issues can have significant impact — or very little. Even if your company's name or product has no need for a distinctive name, you still have to make sure whatever name you use doesn't infringe on somebody else's rights. Here's a basic primer on Intellectual Property Rights and what they might mean to your company.
Trademarks. These are the rights bestowed by the U.S. Patent and Trademark Office on a word, name, symbol, or device used in trade with goods to indicate the source of the goods and to distinguish them from the goods of others. Trademarks stop other people from using your name or logo, or a similar name or logo, in the field for which you have been granted exclusive rights. Not every name can be trademarked. The more common and general the term, the less likely you will be able to trademark it. In the magazine field, there is a classic example: Condé Nast Traveler and National Geographic Traveler can have the same name because the word "traveler" is too generic to be trademarked on its own. You often need a combination of words to make a distinct trademark. That's why many small businesses never bother with a trademark, simply using their names or the type of service they provide to market themselves. Trademarks make sense when you intend to market a product or service nationally or you want to build a brand name for your area of distinction. It shouldn't cost more than $2,500 to do the whole thing, and you can get it for less if you shop the Internet to find a hungry young lawyer working on his or her own or in a new partnership. Note: You can establish a trademark by using it on a contested basis over time. You will need a trademark attorney to secure your trademark.
Those of you coming up with a distinct name for your company will have to run a check to make sure there's no infringement on someone else's trademark.
Copyright. When you write an article or produce any form of "original work of authorship," whether published or unpublished, you have copyright over it. Copyright gives you the exclusive right to reproduce the work, to prepare derivative works, to distribute copies, and to perform or display the work publicly. Some of these rights come automatically from the mere fact that you created the original work and it's in some form of usage or distribution. Those rights can be further enforced by filing for a formal copyright on materials created by your company, assuming they are original. But legally, no one has the right to take original material published by your company and use it for commercial purposes without your permission, whether or not you have filed for any formal copyrights. For most entrepreneurs, this is not a major issue. To formalize your copyrights, you can generally use the same attorney who handles your trademark.
Also, make sure you do not use anyone else's published material without proper permission and attribution.
Patents. The question of whether or not to file for a patent for a unique product or process was always murky. It became worse during the dot-com era, when companies filed patents to fill every nook and cranny of software and Internet technology. It can easily cost between $10,000 and $20,000 to get a patent. The process takes years, and the patent in many cases is only as good as your ability to legally enforce it. Every so often you will read headlines about one big company having to pay another company huge sums for patent infringement. Therefore, a patent never hurts if you have the money to spend. And getting a patent is certainly an honor. Your invention will have met some standard of originality and distinctiveness. Thousands of patents have never earned anyone a cent. So, unless you think you've really invented the most incredible, paradigm-shifting concept imaginable, take a cold hard look at whether a patent will really provide the protection you need. In addition, you should use an attorney who specializes in patents. These generally are not the same attorneys who handle trademarks.
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Finding Legal Help
Many of us need attorneys, whether we like it or not. No matter what your view of lawyers, you will one day or another need a good lawyer — if for no other reason than to help you sell your company. Early-stage companies with tight resources should spend as little on legal fees as possible. However, it is penny-wise and pound-foolish to make important decisions without good legal advice.
Several factors go into finding a lawyer, not the least of which is money. Assuming money is an issue, and you don't come from a wealthy family or a community with a bevy of top-flight legal connections, you might have to use the Internet to find an attorney. You will undoubtedly pay less if you can find an independent attorney rather than a major law firm. Then, it is even more important to find an attorney who specializes in the issue at hand and has a reasonable amount of experience in the field. For routine trademark and incorporation issues, you do not need a $600-an-hour attorney to give you good advice. As soon as the issue gets complex, and the stakes high, you might have to seek more experienced counsel for guidance.
To find an attorney, use the Internet, and then ask the right questions related to how much experience they have in this area. What special licenses they have, if any, related to that expertise? What associations they belong to? And, how much they will charge? Beware of any attorney who wants a large upfront fee. They may want an advance payment from a start-up company, but the right attorney will be understanding and try to minimize your costs. Remember, it's not always the hourly rate that counts, it's how long they take to do the work. Try to get the attorney to commit him or herself to a basic fee for the project you've requested, so you can estimate your expenses.
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