Key Legal Considerations When Starting a Business
Starting a business is a daunting task in many respects. From a legal perspective, a few careful steps in the beginning go a long way in protecting the business and ensuring its viability later on.
Choosing a Name and BrandingA new business should ensure that its name and branding are unique through searches of state business registration databases and trademark databases, as well as ordinary internet searches. Using a similar name or branding to another business in the same industry can put the business in the position of potentially committing trademark infringement.
For businesses seeking production or sales opportunities in other countries, it may be important to register trademarks in those countries. Some countries (particularly China) are known as havens for “trademark squatters,” who proactively register the names and branding of foreign businesses as their own, which creates huge problems if the foreign business ever attempts to sell or produce products there.
Choosing an Entity TypeThe easiest option, from a legal perspective, is to carry out the business personally. If the business has only one owner, this is called a sole proprietorship. If the business has more than one owner, this is called a general partnership. For a more formal structure, a business may be organized as a corporation or limited liability company (LLC). The key considerations here are:
(1) Liability. Sole proprietorships and general partnerships have “unlimited liability,” meaning that the owner(s) will be fully personally liable for any claims against the business. In the case of a general partnership, this liability is “joint and several,” meaning that any partner can be sued for the full amount of the business’s obligations. A corporation or LLC provides a “liability shield” that becomes increasingly critical as the business scales up beyond personal services provided by the founder(s).
(2) Needs for third-party investment. For ambitious start-ups that want to seek outside investors or eventually go public, it is almost a necessity to be set up as a corporation. Venture capital investors in particular look for certain structural features in the companies that they invest in.
(3) Taxes. Sole proprietorships and general partnerships do not pay taxes of their own; their profits and losses “pass through” directly to their owners’ tax returns. Corporations generally pay corporate tax on their earnings as “C corporations,” but in some cases can elect to be treated as “S corporations” and get pass-through status with a few beneficial elements. LLCs have the flexibility to be taxed as pass-through entities, S corporations, or C corporations.
Choosing a State of FormationIf a legal entity is needed for the business, it is necessary to choose a state to register the entity. In most cases, this can be any state or equivalent jurisdiction in the US.
An entity has to be registered in any state where it regularly does business (for example, where it has an office or other facility, or has full-time employees). Therefore, it is easiest to register the entity in a state where the business will be physically based.
Sometimes, there are reasons to choose a different state. For corporations that wish to take on third-party investment or eventually conduct an IPO, the most popular option is Delaware. Other states (such as Florida and Nevada) are sometimes recommended for specific purposes.
Documenting the EntityA sole proprietorship does not generally require any special legal documentation, but the owner may wish to register a fictitious name (commonly known as a “DBA”) or acquire an Employer Identification Number in order to avoid using their own name or Social Security Number for the business.
An LLC or corporation with a single owner can often get by with very simple organizational documents, but it is important to respect the entity’s separate legal status in order to preserve its liability shield. This means carefully keeping separate accounting books and records for the entity, documenting any transactions between the entity and its owner, and ensuring that the owner signs business-related documents in the name of the entity.
It is very important for partnerships, LLCs, and corporations with multiple owners to have a detailed written agreement among the owners in order to prevent future disputes over the business.