Top Legal Considerations for Startups: a Business Formation Guide

When starting a business, it’s crucial for entrepreneurs to make informed decisions from the onset to ensure long-term success. Navigating the legal process of creating a startup can be complex, and missing important steps can be detrimental to the company’s viability. In this guide, we'll explore key legal considerations that every startup must consider, covering business formation, operating agreements, exit plans, and the importance of seeking professional guidance.

Choosing the Right Business Formation

One of the first decisions you will need to make as an entrepreneur is deciding which business structure best aligns with your goals. Selecting the appropriate formation will lay the foundation for your company’s future success. Each business structure comes with its own set of advantages and disadvantages, and understanding these nuances is vital for making informed decisions.

Corporations:

Corporations are a standout choice for those seeking expansion and investor interest. This structure is more likely to attract investors, who are able to become shareholders. However, this results in double taxation, where shareholders are taxed on profits and distributions without the ability to offset losses on their individual tax returns. Despite this, corporations remain strategic for businesses with targeted growth objectives.

Partnerships:

Partnerships provide a valuable asset protection advantage, shielding assets from individual partner’s creditors, as the partnership owns the assets not the individual. This structure also serves as an alternative to trusts for distributing family wealth. However, it's crucial to acknowledge the trade-off: partners carry a fiduciary duty. This is a legal obligation of the highest responsibility to act in the best interest of the other partner. While this duty is essential, it can also give rise to legal challenges and potential litigation, underscoring the need for careful consideration when opting for this business structure.

Sub S Corporations:

This business structure appeals to businesses seeking a balance between limited liability and tax advantages. Sub S Corporations shield shareholders from personal liability for company debts while featuring pass-through taxation. However, constraints such as a limit of 100 shareholders and administrative complexities similar to those of regular corporations exist. Despite these limitations, the enticing combination of liability protection and favorable tax treatment positions Sub S Corporations as an attractive option for specific business scenarios.

Limited Liability Companies (LLCs):

Functioning as a hybrid between a partnership and a corporation, LLCs enjoy the advantages of limited liability protection. Members benefit from limited personal liability, shielding them from responsibility for company debts. The appeal of LLCs lies in their flexible management structure and fewer formalities. However, challenges may arise, including potential difficulties in accessing capital compared to corporations. Despite these considerations, LLCs present a well-balanced choice for those seeking a combination of liability protection and operational ease.

Importance of an Operating Agreement

Regardless of the business formation chosen, it is crucial to draft a comprehensive operating agreement. This document outlines the internal workings of the business, including member responsibilities, profit distribution, dispute resolution mechanisms and exit rights. An operating agreement is a vital tool for preventing and resolving conflicts among business partners. ​

​Crafting an Exit Plan

Equally crucial is having a well-defined exit plan. Whether due to retirement, disagreement among partners, or a desire to sell the business, a clear exit strategy ensures a smooth transition and protects the interests of all parties involved. It's important to note that the process for exiting each business structure differs significantly. Each structure comes with its own unique considerations that must be thoughtfully incorporated into the exit plan. For more in-depth information on exit planning, you can read our blog post titled "Exit Planning for Closely Held Companies." Both operating agreements and exit plans must be drafted at the inception of the business. ​

Staying Compliant with Paperwork and Deadlines

Ensuring your startup stays compliant with legal paperwork is crucial, and each type of business formation comes with distinct requirements. For example, Sub S Corporations and LLCs that wish to have pass through taxes have to file a Form 2553, Election by a Small Business Corporation with the IRS. Failing to meet crucial deadlines, such as this filing requirement, can result in significant consequences for your company. Working with an attorney experienced in business law can play a pivotal role in keeping your startup on track and in legal compliance. ​

Seek Professional Guidance

Navigating the legal intricacies of starting a business benefits from professional expertise. Hiring an attorney is not just a wise decision; it's a strategic investment in your company’s success. These legal professionals can provide tailored advice, helping startups make informed decisions and avoid pitfalls.

From helping you pick the best business structure aligned with your goals to drafting a comprehensive operating agreement and well-defined exit plan, an attorney will bring clarity to this complex legal process. They will ensure your startup stays compliant with necessary paperwork and deadlines, setting a strong foundation for future success. With the guidance of a dedicated attorney, entrepreneurs can pave the way for a thriving and legally sound business journey.