New Ventures and the Law

New ventures are a vital source of employment and growth for the economy. Entrepreneurs who engage in new ventures, whether as part of a large corporation or as an individual working out of a studio apartment, should be aware of the requirements imposed by the law. State business formation law and federal intellectual property law offer entrepreneurs powerful tools to protect their assets and ideas. Other laws impose duties on business, for example, federal and state tax, tort law, employment law, and securities law, among other legal issues. Entrepreneurs should be diligent in understanding which laws apply to their chosen activity to ensure the maximum chances for success. Accordingly, the entrepreneur should educate themselves to the greatest extent possible and engage the most experienced attorney that their budget will allow.

Keywords Business Formation; Business Tax; Employee; Entrepreneur; Independent Contractor; Intellectual Property Rights; New Ventures

Entrepreneurship > New Ventures & the Law

Overview

A new venture or an entrepreneurial undertaking involves the coordination of a number of people and resources. New businesses form the foundation upon which market economies are built, because they capitalize on a recognized need in the marketplace. Entrepreneurs are often creative and energetic and can be one person working alone or teams of people working within multinational corporations forming a partnership to take advantage of a new market in light of their respective expertise. While new ventures can and often do form from within an organization, the common notion seems to be that of a visionary starting with little more than limitless determination to see a vision become reality. However, businesses start without a new or revolutionary idea, and open to fill an existing need that is perhaps being underexploited. For example, when a lawyer leaves a law firm to open a new firm or a private solo practice, it may be entrepreneurial or could be considered self-employment. The distinction between entrepreneurship and self-employment rests on the premise that entrepreneurship is the act of creating something new as opposed to offering something substantially similar.

In light of this distinction, it is appropriate to endorse a clear definition of the meaning of new venture for discussion here. A new venture is any enterprise that generates profit based on a business model that did not previously exist. Whether a new venture is entrepreneurial in the sense of novelty may be of great importance to marketing and potential profit concerns. However, the law is largely unconcerned with whether a business has a good or bad idea, a new approach or tried-and-true system, because the law tends to apply uniformly to a given class of businesses.

The law as applied to new ventures can be regarded as separate from business concerns, but it is always included, to some degree or another, in all business activity. Business activities address such matters as the identification of products suited to certain markets, pricing, sales, distribution channels, advertising methods, and human resources. Legal questions may address whether to operate as a corporation or limited liability company. In a general sense, a business question is the subjective assessment of whether a business should take some action and a legal question is an objective determination of how or whether a business may lawfully take that action.

Recognizing the dual requirements of business and legal considerations and that due diligence is required in each area leads to an important preliminary step in the formation of a new venture, seeking legal advice and expertise. Good legal advice and planning often goes unnoticed because nothing happens; operations carry on smoothly and efficiently and entrepreneurs are free to focus on their business activities. On the other hand, a failure to adequately address legal concerns can cause a business to fail. A business may be packed with customers and generating profit but may nevertheless be forced to close due to lack of compliance with the law or from liability that could have been avoided. The complexity and nature of the business and the resources of its organizers will determine the type of legal counsel is required. A joint venture between two large oil companies would clearly require a highly specialized team of legal professionals, while a person opening a pet grooming service would need far less expertise but would nevertheless require some legal consultation from time to time.

Selecting an attorney is likely to be one of the more important decisions in the business start-up process. While legal issues are best handled by lawyers and business decisions are best handled by business people, each professional can benefit significantly from knowledge of the other. The attorney that has experience and particular expertise in the target industry and start-ups is preferable to one that does not. Initially, an entrepreneur may be inclined to use their existing legal counsel or an attorney recommended by a friend or family. However, because effective legal counsel is so important, considerations of skill and expertise should take priority over considerations based on expediency and convenience. Additionally, it is always wise to retain the services of the best professional that a budget will allow. An effective team is critical to the success of a new venture and legal counsel is an important part of that team during all phases of the business life cycle.

Applications

Business Forms

The form of business refers to the legal category to which a business belongs. Generally, the options are sole proprietorship, corporation, limited liability company (LLC), joint venture, or some form of partnership. Each has certain advantages and disadvantages. Generally, the two major criteria that are used to decide between forms are the potential for limited liability and exposure to taxes. Typically, the goal is to minimize the potential for legal liability for the owners and to minimize taxes. Because potential personal liability for business liability is a major concern, sole proprietorships are generally not recommended because they afford no limited liability. Legally, a sole proprietorship is an extension of an individual, that is to say, there is no legal difference between the owner and the business that they own. Therefore, should the business incur some debt or obligation, the individual owner would be personally liable for that debt. For example, a person sets up a shop that operates as a sole proprietorship. A customer trips and suffers severe injury and sues. A court rules that the shop was negligent and returns a judgment in favor of the customer. The judgment will be satisfied by the business's assets, including any insurance. If those assets are insufficient, the sole proprietor's personal assets (house, car, personal savings etc.) may also be taken to satisfy the judgment. The owner of a sole proprietorship is said to have unlimited liability for business liabilities including debts that arise from contracts, business operations, taxes, and torts.

Raising Capital & Managing Liabilities

Typically, companies raise capital by selling equity, which is an ownership stake in the company, or by incurring debt. A sole proprietor may wish to entice an investor by offering ownership in the business. If the investor agrees and contributes money in exchange for ownership, the two have formed a partnership. Partnerships (a general partnership in this example) can typically arise without any filing; they are said to arise as a matter of law so long as two or more people carry on business for profit. General partnerships and sole proprietorships both have unlimited liability for the owners. In the case of a general partnership, each partner is usually liable for all partnership debts, even if the other partner entered in the contract or made the deal. Imagine investing in a sole proprietorship, legally converting it to a partnership, and then after the company defaulted on payment, having creditors knock on your door demanding your house and savings to satisfy business debts. That is the nature of unlimited liability, which creates grave risks for anyone who owns a business without any protection from liability. Investors would typically require that a sole proprietor or general partnership structure be converted into some entity that had limited liability.

Fortunately, unlimited liability can be converted to limited liability with the use of state laws that allow the formation of such entities. The major alternatives are limited liability companies (LLCs), corporations, and limited liability partnerships (LLPs) or limited partnerships (LPs). These business forms provide limited liability to the owners and generally consider the business to be a separate legal entity from its owners. That means that, barring certain owner misconduct, the owner of a business is not liable beyond the money and assets of the business; in other words, an owner's liability is limited to the money that they invested in the business. As a result, the personal assets of the owners are protected from claims arising from the business. This protection is included in the LLC, corporation, and the LLP. The LP typically requires at least one general partner with unlimited liability with other limited partners having limited liability, provided that they are generally inactive in the business. All these entities require filings with the appropriate state office.

Business Forms & Taxes

The other major consideration in deciding on a business form is taxes. Federal taxes are applied according to entity type, either sole proprietorship, corporation, or partnership. Corporations, or technically C corporations, are subject to double taxation. The profits are first taxed once at the corporate level and then again at the individual level when those profits are distributed to the owners, or shareholders, as dividends. For most new ventures that chose a corporate form, there is an alternative to the C corporation called an S corporation. An S corporation has certain limitations, such as on the number and type of owners allowed; provided that those requirements are met, the corporation may enjoy so-called pass-through taxation and otherwise have the same legal benefits of the C corporation. Pass-through taxation means that taxes are paid only once on the profits of the business when distributed to the owners as personal income. The LLC may be taxed either as a corporation or have pass-through taxation, depending the particular circumstances and desires of owners, or members as they are called. The composition of owners, the desired capital structure, and the state law under which a business is organizing will determine how a new venture may enjoy limited liability and the most preferential tax treatment allowable by law.

Other Concerns Regarding Business Form

Liability and taxes are the dominant legal concerns in the choice of a business form. However, organizing as a particular type of entity does have an impact on continuing business operations and should also be considered. Administrative concerns, decision making, and the amount and form of financing can all be affected by chosen business structure. Corporations and other business entities have specific rules of governance, formalities, and practices that must be followed to retain the advantages provided by those entities. For example, state law generally requires corporations to have annual meetings and make certain business decisions according to defined rules. A major business decision such as the sale of a major asset, may require a board of director's approval or an approval of a specific number of shares. Rules also address the number of directors or shareholders (quorum) required for a corporation to take a particular act; the required composition of the board of directors; and the powers and responsibilities of the officers, shareholders, and directors. Often the state laws that govern business activities are default rules. The rules apply if a business fails to adopt or address the specific matter at issue. Therefore, the law typically allows businesses to agree to different rules within a specified range or opt out of certain rules. For example, state partnership law may presume that general partners share profits and losses equally. In the event of a dispute, the equal share rule would prevail unless the partners mutually agreed to some other arrangement. The internal business agreements that set up these rules have different names. In an LLC the governing agreement is called an operating agreement, in a corporation those agreements are found in both the charter and the bylaws, and a partnership has partnership agreements. A relatively simple and inexpensive filing will create a particular entity and afford the advantages of limited liability and certain tax treatment. However, much of the internal operations are determined by agreement between the parties, and entrepreneurs would be wise to carefully consider, negotiate, and address as many as possible to maximize the chances of smooth operations within the business. Market forces and competition are formidable obstacles for a new venture and the laws of business entities of governance can be allies; if ignored, they can also cause significant damage to a new venture by way of unanticipated liability or internal disagreement.

Staffing

Small new ventures are often staffed exclusively by the owners. Larger or growing businesses require employees, and employees potentially implicate a host of laws. When looking for outside assistance a business may, in appropriate circumstances, opt to engage independent contractors as opposed to employees. From a legal perspective, an independent contractor differs greatly from an employee in a number of ways that are potentially beneficial to a business. The independent contractor arrangement may be appropriate if a business requires only a product of the labor and does not exercise significant control over the method by which the independent contractor achieves that result. The use of independent contractors typically requires less compliance with employment law, and therefore is less expensive. For example, businesses typically do not have to provide workers' compensation coverage for independent contractors, certain employment discrimination laws do not apply to independent contractors, and tax responsibilities for the business are far less for independent contractors than for employees.

When a new venture considers whether employees or independent contractors are appropriate, it is helpful to consider the legal test applied by many courts to determine the difference. Despite what a contract may state, whether a person is an independent contractor or an employee will be decided by the courts. A common test used by courts is called the "right-to-control" test. If a business retains control over the manner and means of the job performance, a court may find an employer-employee relationship. On the other hand, if a business only specifies the finished product but not the manner in which it is achieved, a court would likely find independent contractor status. Because independent contractors and employees expose a business to different sets of laws, the consequences of being one or the other can be great and can arise in a number of legal situations. Accordingly, businesses that intend to hire an independent contractor as opposed to an employee should make that election explicit in a well-drafted written agreement after consultation with legal professionals and in accord with relevant state laws. If a business decides that the traditional employer-employee relationship is appropriate, the new business should be aware of the attendant state and federal responsibilities, including taxation, Social Security benefits, workers' compensation, the proper procedures for hiring and termination, and the relevant antidiscrimination laws.

New Ventures & New Ideas

New ventures often involve new ideas. Those new ideas or representations can distinguish a business from competitors and provide the competitive edge that can lead to success. The federal government provides protection for such intellectual property by way of patent, trademark, and copyright law. The inventor of a novel and useful device can seek trademark protection under United States patent law. Patent registration, once completed, affords the owner exclusive rights to sell and license the device and allows the owner to seek legal remedy if another infringes, or illegally uses, the patented invention. Copyright law protects literary and creative works committed to a tangible form and also affords exclusive rights to the creator to control and profit from the work. Trademarks, and the related service marks, are unique groups of words or arrangements. Those marks are associated with a particular business and identify and distinguish the business from competitors. Any new venture that may have intellectual property entitled to legal protection would be wise to explore the advantages of pursuing such protection.

Conclusion

New ventures are a vital source of employment and growth for the United States economy. Entrepreneurs who engage in new ventures, whether as part of a large corporation or as an individual working out of a studio apartment, should be aware of the advantages and requirements imposed by the law. State business formation law and federal intellectual property law offer entrepreneurs powerful tools to protect their assets and ideas. Other laws impose duties on business, such as federal and state tax laws, tort law, employment law, securities law, and other legal considerations. Entrepreneurs should be diligent in discovering and understanding which laws apply to their chosen activity to ensure the maximum chances for success. Accordingly, the entrepreneur should educate themselves to the extent possible and, as part of the team- building process, engage the most experienced attorney that their budget will allow. Establishing and advising businesses is a complicated matter and this article merely touches on a few areas that may come up in the process and is not intended as a legal guide applicable to any given set of facts. As with all legal matters, every person should consult their own counsel who can address the specific facts of their case.

Terms & Concepts

Entrepreneurship: The practice of setting up and financing new commercial enterprises to make a profit

Charter & Bylaws: The organizational documents of a corporation that govern the corporate affairs in conjunction with relevant state laws.

Copyright: The exclusive right of the author or creator of a literary or artistic property (such as a book, movie, or musical composition) to print, copy, sell, license, distribute, transform to another medium, translate, record, perform, or otherwise use (or not use) and to give it to another by will.

Intellectual Property: Class of intangible property rights protecting the product of human intellect. Includes, among others, patent, trademark, and copyright.

Independent Contractor: A person or business that performs services for another person or entity under a contract between them, with the terms spelled out such as duties, pay, the amount and type of work, and other matters. An independent contractor is distinguished from an employee, who works regularly for an employer. The exact nature of the independent contractor's relationship with the hiring party has become vital since independent contractors pay their own taxes without payroll deduction, have no retirement or health benefits, and often is not entitled to worker's compensation coverage. Public agencies, particularly the Internal Revenue Service, look hard at independent contractor agreements when it appears the contractor is much like an employee. An independent contractor must be able to determine when and where work is performed, be able to work for others, provide own equipment and other factors which are indicative of true independence.

Partnership: A business enterprise entered into for profit that is owned by more than one person, each of whom is a "partner." A partnership may be created by a formal written agreement, but may be based on an oral agreement. Each partner invests a certain amount (money, assets, and/or effort) that establishes an agreed-upon percentage of ownership, is responsible for all the debts and contracts of the partnership even though another partner created the debt or entered into the contract, has a share in management decisions, and shares in profits and losses according to the percentage of the total investment. Often a partnership agreement may provide for certain division of management, shares of investment, profit and/or rights to buy out a partner upon leaving the partnership or death. Each partner owes the other partners a duty of full disclosure of information that affects the business and cannot commandeer for him/herself business opportunities that rightfully belong to the partnership. A partnership that does business under a trade name must file with the county or state a certificate of "doing business under a fictitious name," which gives notice to the public of the names of partners and the business address. A "limited partnership" limits the responsibility for debts beyond the investment to the managing "general partners." The investing "limited partners" cannot participate in management and are limited to specific percentages of profit. A partnership differs from a "joint venture," which involves more than one investor for only a specific short-term project and prompt division of profits. Partnerships are traditionally the most fragile of business arrangements and are often dissolved and subject to disputes. Several million of these partnerships exist in the United States and, ironically, they are the favorite business entity for law firms (www.dictionary.law.com).

Pass-through Taxation: A type of taxation associated with partnerships, sole proprietorships, some LLCs, and S corporations where taxes are paid only once on the profits of the business when distributed to the owners as personal income. To compare, C corporations are subject to double taxation—once at the corporate level and then again when distributions are made to individual shareholders.

Members: Owners of an LLC whose ownership interest is usually referred to as units; similar to shareholders in corporations.

Operating Agreement: An internal document of an LLC that governs the operations.

Sole Proprietorship: A business where one person owns all the assets, owes all the liabilities, and operates the business in their personal capacity.

Bibliography

Cusumano, M. A. (2013). Evaluating a startup venture. Communications of the ACM, 56, 26–29. Retrieved November 27, 2013 from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=90502519

Garner, B. (Ed.). (1999). Black's Law Dictionary (7th ed.). St. Paul, MN: West Publishing.

Garner, W.B., Shaver, K.G., Carter, N.M, & Reynolds, P.D. (Eds.). (2004). Handbook of entrepreneurial dynamics: The process of business creation. Thousand Oaks, CA: Sage Publication .

Koch, C., & Schunk, D. (2013). Limiting liability? Risk and ambiguity attitudes under real losses. Scmalenbach Business Review, 65, 54–75. Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=85818616

Murphy, C. (Ed.) (2003). Inside the minds: The ABCs of entrepreneurship: The fundamentals all professionals should know and remember. Boston, MA: Aspatore Books.

Merrill, R.E & Sedgwick, H.D. (1993). The new venture handbook. NY, NY: American Management Association.

Toporowski, J. (2010). Corporate limited liability and the financial liabilities of firms. Cambridge Journal of Economics, 34, 885–893. Retrieved November 27, 2013 from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=53062299

Suggested Reading

Audia, P., & Rider, C. (2005). A garage and an idea: What more does an entrepreneur need? California Management Review, 48, 6-28. Retrieved June 11, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=19077685&site=ehost-live

Edwards G. (2007, March 21) Begin with the end in mind. Business Week Online, pp.17. Retrieved June 4, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=24456260&site=ehost-live

Entrepreneurs and the law. (2006). BizEd, 5, 12. Retrieved June 4, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=23197913&site=ehost-live

Malach, S., Robinson, P., & Radcliffe, T. (2006). Differentiating legal issues by business type. Journal of Small Business Management, 44, 563-576.

Smeal, L. N., & Ransopher, T. D. (2013). LLC material participation policy shift: new regulations focus on management rights. Journal of Legal Issues and Cases in Business, 2, 1–21. Retrieved November 27, 2013 from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=91096084