Many have said that small business is the engine that drives the United States economic engine. I would tend to agree. As the barriers to entry in almost every industry continue to drop, business owners of all ages and varieties are cropping up all over the country. There are a few common mistakes that new business owners have made for decades. This blog is intended to help new business owners avoid some of the standard mistakes.
Most entrepreneurs in recent years have been gravitating to the LLC. While this isn't necessarily a "bad" decision, it isn't the best selection in all cases. Secondarily, in the past, the commonly held belief was that forming your business in Delaware was the best choice. In some cases, it still is. However, the judiciaries in a variety of other states have done an excellent job bringing their business "literacy" up to speed. Accordingly, the litigation benefits once held exclusively in Delaware are no longer quite as strong.
If you have a partner, investor, or co-founder that is taking an equity stake in your company from the outset, it is vitally important that a custom tailored agreement be in place to ward off and or simplify future disputes between the parties. Unfortunately, companies often wait until after they've had an issue to address this type of agreement. While Bylaws will determine the way a business is operated generally, the Shareholder/Operating agreement is narrowly tailored to control the roles and responsibilities of the partners and how very specific situations will be handled such as buyouts, death of member, death of the founder, sale of the company to a non-member, etc.
Authorized v. Issued
When creating an entity, you have the opportunity to Authorize a certain # of Shares or Units. Those shares or units are then "Issued" to the various equity owners. There are two potential pitfalls.
Pitfall # 1: Non-Issued Shares
A business owner files their Articles of Incorporation, authorizes 100 shares, and then never "issues" any shares. This typically involves physically issuing paper shares of stock or membership certificates.
Pitfall #2: Authorized = Issued
Some business owners follow this logic. "I will authorize 100 shares and then issue all 100 shares to myself since I own 100% of the business."
Logically, this makes sense. 100% of 100 is 100. Duh! The problem with this logic that that if the original owner wants to add a partner, reward a family member, or otherwise issue equity, they have to sell their own shares. This creates a taxable event to the original owner where a gain has been realized. Instead of using the 100/100 method, I always advise the 1000/100 method.
The 1000/100 method involves authorizing 1000 shares and issuing 100 of them. The beauty of this method is that the person owning the 100 issued shares is still the 100% owner of the company. The primary difference is that the business owner can issue new shares as opposed to selling his own shares. This functions as a way to dilute his ownership without creating a capital gain on the sale of the stock asset.
Consulting an attorney on the front end can save you a lot of money and headache later. Avoiding these pitfalls early is the key to setting your business up for success. If you have any questions, please feel free to contact us directly.