Tuesday, June 26, 2012

Small Businesses Can Avoid Expensive Problems Up Front with Thoughtful Formation Documents

All too often, entrepreneurs do not put enough thought into formation issues when forming their small business.  When unforeseen circumstances later arise, what seemed a quick and easy way to form a business can be revealed as an unexpected source of aggravation, expense, and worry.  

The first formation issue that must be considered is, of course, what form of business entity to create.  There are two kinds of mistake here, each of which can be costly.  On the one hand, entrepreneurs may simply begin and continue operating without any formalities, in which case the law treats the business as a sole proprietorship or partnership.  This can be appropriate depending on the nature of the business, but if personal liability is a concern, it could be very expensive, as these default organizational forms provide no protection against personal liability for the business's debts or torts.  On the other hand, many entrepreneurs assume that some particular form, such as a corporation or an LLC, is appropriate, without considering the need for the form, its sustainability, its long-term appropriateness, or the expense of setting it up.  For some businesses, sole proprietorship or partnership is perfectly appropriate and there is little to nothing to be gained by forming a corporation or LLC and thus incurring filing fees and annual franchise taxes.  A corporation, though cheaper to form than an LLC, may be less appropriate if there are going to be issues with maintaining the formality of a corporation, or if the organizational and management flexibility of an LLC is desirable.  A brief discussion with an attorney and a tax professional could result in significant savings if it avoids an inappropriate form decision.

The second common formation issue is the failure to provide for the dissolution of the business.  There is an old saying:  hope for the best, prepare for the worst.  Business partners that get along today may not tomorrow.  Every partnership should have a written partnership agreement to, at the very least, address what happens if the partners have a falling out.  The LLC form provides great flexibility to structure the management of the business and to provide for the admission of new active or passive members and the exit of existing members.  If you are forming an LLC and not preparing an LLC Agreement that addresses these issues, you are not making the most of the form.  If you've settled on a corporation as the form of your entity, executing a shareholder agreement and/or a buy-sell agreement now could save you a lot of trouble and money in the event new shareholders buy in, or an existing shareholder dies, exits the business, or is terminated.

My firm advises on and handles small business formation and dissolution issues and disputes.  Contact us if you require such services.

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