Before beginning a new business, you should have an understanding of the business, a written business plan, a good understanding of the economics of the business, experience in a related business and enough funds to cover your costs until the business becomes profitable. Before starting a business, it is a good idea to speak to an accountant and a lawyer so that you understand the tax and legal issues involved and, if desirable, structure the business to minimize taxes, avoid legal problems and reduce the chances of personal liability. The legal structure of your business is extremely important. State law enables you to create a legal entity (a separate identity from your own person) under which you can transact business, without the risk of exposing your personal assets to any liability that might arise out of your business affairs.
The most common types of business organizations include:
- Sole Proprietorship - you are the only owner of the business.
- Partnership, which can take the form of a regular partnership, a general partnership, limited partnership or limited liability partnership.
- Corporation - the default form of a corporation is a C Corporation (also known as Subchapter C Corporation). Smaller corporations typically file for the S Corporation (Subchapter S) tax election so they are not double taxed.
- Limited Liability Company (LLC) - a hybrid formation that provides personal liability protection similar to a corporation, with the flexibility and tax advantages of a single proprietorship or partnership.
WHAT ARE CORPORATIONS?
Corporations are legal entities which are separate and distinct from their owners. They provide liability protection for their owners and are also usually somewhat less burdensome to operate than limited liability companies. Corporations are subject to varying tax treatment depending on whether they have elected "S" corporation status. S corporations are taxed similarly to partnerships (see - limited liability companies below). Corporations that have not elected "S" status have the disadvantage of double taxation, but have certain other advantages such as unlimited shareholders and liberal fringe benefit opportunities.
The limited liability company ("LLC") is a relatively new form of entity that combines the tax advantage of a partnership (single level of tax) with the limited owner liability advantage of a corporation, even if the owner(s) participate in the management of the company. LLC's have the following advantages: limited liability protection, no restriction on the number or nature of members, "pass through" of entity profits and losses to investors (that is, profits and losses are passed on to members without being taxed), flexibility in structure and tax-free removal of assets from the business. LLC's do, however, have some drawbacks: the operating agreement must be carefully drafted and it can be more difficult to make an equity offering than with a corporation.
WHAT IS A GENERAL PARTNERSHIP?
A partnership is any arrangement in which two or more parties (such as a corporation or an individual) conduct business as "partners," whether officially or not. In terms of asset protection, general partnerships can be even worse than sole proprietorships. Anything that one partner does affects all of the partners, because each partner of the general partnership is personally responsible for all obligations of the partnership. Thus, each partner's exposure to potential liability is increased by the number of general partners in the business.
DO I NEED A FICTITIOUS BUSINESS NAME STATEMENT?
If you do business under a name that is not the actual name of the business entity or your own name, you need to comply with fictitious business name rules. It is important for purposes of limited liability to use the exact name of a corporation, including the "Inc." (or "LLC" for a limited liability company), on all correspondence, contracts, stationery, business cards and other documents and with respect to all corporate dealings, unless the corporation has filed a fictitious name certificate with the appropriate authorities.
DO I NEED INSURANCE?
Whether you need insurance depends on your business activities and the amount of liability exposure that you have from the activity. In addition, insurance may be required for employees (such as worker's compensation insurance or unemployment insurance). Some common forms of business insurance include: (1) commercial multi-peril policies (covering a variety of exposures), (2) liability insurance covering premises, activities, and products, (3) business interruption insurance, (4) surety and performance bonds, and (5) malpractice and errors and omissions coverage. In deciding whether to purchase insurance, you should analyze your risk exposure. If you are unable to determine your risk of loss from engaging in business, contact a commercial lines insurance broker.
DO I NEED ANY LICENSES OR PERMITS?
Whether you need a license or permit to conduct your business depends upon the type of business you engage in, the location of your business, and federal, state, city, and local rules and ordinances. Some businesses and professions require a license from the state (for example, barbers, beauticians, doctors, lawyers, day care providers, contractors and building trades persons). Cities and towns also require permits for many business activities (such as construction permits).
CAN I RUN A BUSINESS OUT OF MY HOUSE?
Zoning laws on home-based businesses vary considerably among cities and towns. Compliance may depend on the nature of the business, whether you have any employees or business visitors, your hours of operation, parking and delivery issues, etc. Before getting into trouble, it pays to check out the zoning rules concerning what you can and cannot do in your town before you decide to set up shop. Some communities have begun to impose license fees on home-based businesses to generate money for local coffers. Some zoning ordinances in some strictly residential areas will absolutely prohibit all in-home businesses (if you are lucky, your local town officials may overlook these ordinances, especially if your at-home business operation is hidden from public view and is not disruptive for your neighbors). Other communities permit a home business, but may (1) specify the kinds of work that can be run out of your home (i.e., law, dentistry, music, beauty salon, physical therapy, tutoring), (2) limit the amount of floor space that can be utilized, (3) restrict hours, (4) limit the use of on-street parking, (5) prohibit or limit the number of employees you may hire, (6) ban or require a entrance to your business that is separate from your residence, or (7) ban advertising signs.
In equity financing, you sell an ownership interest in your business in exchange for capital. The first obstacle to equity financing is finding investors who are willing to buy into your business. However, the amount of equity financing that you undertake may depend more upon your willingness to share management control than upon the investor appeal of the business. By selling equity interests in your business, you sacrifice some of your autonomy and management rights.
WHAT IS EQUITY COMPENSATION?
Many new companies have difficulty recruiting and retaining talented employees. These companies need to attract high quality employees, but often lack the resources to offer competitive salaries. One way to help level the compensation playing field between start-ups and established companies is with equity compensation. Equity compensation is non-cash compensation that represents an ownership interest in the company. The two most common forms of equity compensation are stock options and restricted stock.
A stock option is a right to purchase stock at a predetermined exercise price. The right to exercise the option generally accrues, or "vests," over time. This vesting creates an incentive for the employee to remain with the company. Option holders are not stockholders and so are not entitled to vote or otherwise exercise any other rights of stockholders. Vesting often accelerates upon the sale of the company, unless the buyer assumes the options. Conversely, if an employee leaves the company, the vesting of stock options ceases, and the employee usually has a limited period of time to exercise the options that were vested at the employment termination date.
Read Peter's article on Equity Compensation