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Structuring Your Business for Investment and Growth

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  1. Structuring Your Business for Investment and Growth Presented by Teri G. Rasmussen Capital Crash Course 2008 December 2007

  2. Teri G. RasmussenPartner and Vice Chair, Business Law Practice GroupLane, Alton & Horst, 233-4753 Lane, Alton & Horst, LLC Two Miranova Place, Suite 500 Columbus, Ohio 43215 Lane, Alton & Horst, LLC

  3. Teri G. Rasmussen B.A., with honors, 1981, University of Iowa J.D., cum laude, 1984, University of Michigan Bar Admissions:Supreme Court of Ohio, 1984 U.S. District Court, Southern District of Ohio, 1984 U.S. District Court, Northern District of Ohio, 1993 U. S. Sixth Circuit Court of Appeals, 1997Professional Associations:Columbus Bar association (Former Chair, Financial Institutions Committee), Ohio State Bar Association (Former Chair, Banking, Commercial and Bankruptcy Committee) American Bar Association American Bankruptcy Institute National Association of Women Business Owners (NAWBO) Lane, Alton & Horst, LLC

  4. Teri G. Rasmussen Business Acquisitions and Sales General Corporate and Business Law Joint Ventures and Strategic Alliances Corporate Governance and Shareholder Disputes Contracts and Loan/Lease Documentation Business Formation and Financing Business Planning Creditors’ Rights and Debt Collection Business Bankruptcy and Insolvency UCC and Secured Transactions Commercial Finance Litigation Real Estate Lane, Alton & Horst, LLC

  5. Visit my legal blog: OHIO PRACTICAL BUSINESS LAW COUNSEL Lane, Alton & Horst, LLC

  6. I. Structuring Your Business THE BASIC SETUP Lane, Alton & Horst, LLC

  7. EVERY Business Has a Legal Form • If you don’t make a Decision, the Law will make one for you. • A one-person business will automatically be a sole proprietorship. • A businesswith two or more Owners will automatically be treated as a general partnership Lane, Alton & Horst, LLC

  8. The TYPE of LEGAL ENTITY Matters • Level of Formality Required for Recordkeeping • Level of Formality Required in Decisionmaking • Effect of Death or Disability of Anyone Actively “Involved” in the “Management” of the Business • Taxes – Who Pays and How Much • Ability of Business Creditors, Disgruntled Employees, and Others to Reach Personal Assets of Owner(s) • Who Has “Say” in, or Control of Business and its Operations Lane, Alton & Horst, LLC

  9. Factors to Consider in Choosing a Legal Structure • How much record-keeping are you able and willing to do on a continuing periodic basis? • What is YOUR tolerance for risk? • What sort of risks are you most comfortable having? • What sort of risks do you MOST need/want to avoid? • How will the business be financed? • Outside Investors and Creditors • Personal and Family Funds Lane, Alton & Horst, LLC

  10. Factors to Consider in Choosing a Legal Structure • What sort of business risks are there in your industry or type of business? • How much government regulation is your business generally subject to? • Where will your business sell or provide good and/or services? • Locally or within one state? • Regionally? • Nationally? • Worldwide? Lane, Alton & Horst, LLC

  11. Factors to Consider When You Are Not the Only Owner • How well do you know your fellow owner(s) and can you really trust them? • Compatibility of Owners in Temperament, Work Habits, Spending, Risk Tolerance, Etc. • Strengths and Weaknesses of Fellow Owner(s) • Could a Weakness Cause a Problem for the Business? • How Can That be Guarded Against? Lane, Alton & Horst, LLC

  12. Factors to Consider When You Are Not the Only Owner • How Many Owners Will There Be? • Owners individuals or business entities? • What Role, Responsibilities and/or Duties Will Each Owner Have? How will these be Shared or Allocated? • Will any owner(s) or group of owners have veto power with respect to certain specific issues? Lane, Alton & Horst, LLC

  13. Factors to Consider When You Are Not the Only Owner • Are you the “money” person or the “sweat equity” person? • What happens if an owner wants out of the business? • Getting Investment Out of the Business • Transfer, and Restrictions on Transfer, of Ownership • What happens to ownership interest upon death or disability of owner? • Will some owners get their “investment” back sooner than other owners? Lane, Alton & Horst, LLC

  14. THE CHOICES Lane, Alton & Horst, LLC

  15. Choices in Basic Legal Structure • Sole Proprietorship • Partnership • Limited • General • Corporation • C-Corp • S-Corp • Limited Liability Company (LLC) Lane, Alton & Horst, LLC

  16. Basic Types of Ownership Interests Partnership Partnership Interest Corporation Shares of Capital Stock LLC Membership Interest Lane, Alton & Horst, LLC

  17. Sole Proprietorship Basic Characteristics • No separate existence from owner. • Business assets in owner’s personal name • Owner signs contract in personal capacity • If owner dies or becomes disabled, so does the business • Profits and losses from, as well as expenses of, business included on individual income tax return • Difficult to transfer Lane, Alton & Horst, LLC

  18. Advantages Maximum authority and control Simplest and least expensive to start – just find a location and open the doors Appropriate for very small service business not likely to borrow much money and not likely to be sued Business losses can offset income from other sources Disadvantages Death or Illness endangers business Growth limited by personal energies Obtaining financing and investment may be difficult Personal and business affairs easily mixed Weighing the Sole Proprietorship Alternative Lane, Alton & Horst, LLC

  19. General Partnership Definition • Ohio law defines a general partnership as “an association of two or more persons to carry on as co-owners, a business for profit” Ohio Rev. Code 1775.05(A) Lane, Alton & Horst, LLC

  20. Purpose of Forming Partnership Nothing more than a common law contract between owners • To operate broad-based business • To share in the responsibilities of management • To divide the profits realized from the enterprise Lane, Alton & Horst, LLC

  21. Partnership Characteristics • Almost any management and profit-sharing arrangement can be agreed upon among the partners. • Must have at least two partners at all times. • Joint Venture or Strategic Alliance differ from true partnership because they are generally limited to an isolated and particular transaction. Lane, Alton & Horst, LLC

  22. Creation of General Partnership • Can be “accidentally” created – formation occurs whenever parties expressly or implicitly start sharing profits and losses and the management of the business • Can be created orally – no written agreement required, though recommended Lane, Alton & Horst, LLC

  23. Limited Partnership Only valid if written and formed in compliance with statutory requirements • One General Partner – same responsibilities as in general partnership. • Other Limited Partners – Have limited rights in exchange for limited liability for partnership debts. Lane, Alton & Horst, LLC

  24. General Partnership All Partners Participate in Management Dissolves upon death or withdrawal of any partner Limited Partnership Limited Partners Must Not Be Involved in Day-to-Day Operations Dissolves only upon death or withdrawal of General Partner More Complex than General Partnership General and Limited Partnerships Comparison Lane, Alton & Horst, LLC

  25. Advantages Two (or more) heads are better than one Income passes through to Partners Management Structure Flexibility No qualification requirements for doing business in other states Disadvantages Difficult to get rid of bad partners More Expensive to form than sole proprietorship, especially in case of limited partnerships Difficult to transfer ownership interest Hazy line of authority in general partnership Cannot have both management responsibilities and limited liability Weighing the Partnership Alternative Lane, Alton & Horst, LLC

  26. Usefulness of Partnership Alternative • General Partnership is obsolete except in very special circumstances • Owner is particularly concerned about deductibility and capital gains treatment of continuing payments to retiring partners(IRC 736(a)) • Important that business not be treated as entity for tax purposes(e.g. oil and gas investments) • Limited Partnership duplicated and supplemented by LLC alternative Lane, Alton & Horst, LLC

  27. Distinguishing Characteristics of Corporations • Ownership interests are known as “shares” or “stock” and are freely transferable to anyone else unless shareholders otherwise agree • Shareholders are not liable for company obligations except under highly unusual circumstances, but the company itself will be held liable • Existence continues even after departure of original owners or key individuals Lane, Alton & Horst, LLC

  28. Corporate Governance • Shareholders have no authority to control day-to-day management or business operations • Shareholders elect Directors • Board of Directors set general policy • Board of Directors appoint Officers such as President, Vice President, Treasurer, and Secretary • Officers manage day-to-day operations of company • Officers are answerable to Board for their actions Lane, Alton & Horst, LLC

  29. Formation of Corporation • Corporation has NO owners until stock shares have actually been issued to owners by the Incorporator. • Corporation IS NOT validly formed until • Shareholders elect Directors AND • Directors appoint Officers. Lane, Alton & Horst, LLC

  30. Corporation Formation Procedure • Articles of Incorporation are signed by “Incorporator”, who may or may not become a Shareholder, and filed with the Secretary of State. • Incorporator receives subscriptions and payment for shares and issues them to owners. • Incorporator calls first meeting of Shareholders to elect Directors, adopt Code of Regulations, and transact any other business. 4.After Shareholders elect Directors, Directors pass resolution appointing Officers. Lane, Alton & Horst, LLC

  31. Incorporating Helps separate your personal identity from that of your business. Once incorporated, the shareholders of a corporation have only the money they put into the company to lose, and usually no more as a result of being a shareholder. Remaining Unincorporated Sole proprietors and general partners are subject to unlimited personal liability for business debt or law suits against their company. Creditors of the sole proprietorship or partnership, including ordinary suppliers, vendors, and other trade creditors can bring suit against the owners of the business and can move to seize the owners’ homes, cars, savings or other personal assets. Weighing the Incorporation Alternative:Effect Upon Personal Liability Lane, Alton & Horst, LLC

  32. Weighing the Incorporation Alternative:Credibility of Business • Adds Credibility. • A corporate structure communicates permanence, credibility and stature. • Even if you are the only stockholder or employee, your incorporated business may be perceived as a much larger and more credible company. Lane, Alton & Horst, LLC

  33. Incorporated Capital can be more easily raised with a corporation through the sale of stock. Investors are more likely to purchase shares in a corporation where there usually is a separation between personal and business assets. Some banks prefer to lend money to corporations. Unincorporated With sole proprietorships and partnerships, investors are much harder to attract because of the inability to have control without personal liability. Weighing the Incorporation Alternative:Attracting Capital and Financing Lane, Alton & Horst, LLC

  34. Incorporated Ownership of a corporation may be transferred, without substantially disrupting operations or the need for complex legal documentation, through the sale of stock. Unincorporated Cannot sell sole proprietorship as a going concern, i.e. can only sell individual assets Partnership may dissolve; generally not easily transferable Weighing the Incorporation Alternative:Transferring Ownership Lane, Alton & Horst, LLC

  35. Types of Corporations • C-Corp -for larger more mature businesses, especially those publicly held, and for those anticipating making initial public offerings (IPO) of capital stock in the VERY near future • Cannot later be converted to S-Corp or LLC without tax consequences • S-Corp -for smaller privately held businesses with less than 100 owners, all of whom are individuals; must specifically affirmatively select this status • Can later be easily converted to C-corp Lane, Alton & Horst, LLC

  36. S-Corporation Restrictions on Shareholders • Maximum of 100 shareholders • Must be individuals (or their estate planning trust) – no corporations, LLCs, or partnerships • Shareholders must be U.S. citizen or permanent resident – no foreign nationals • Only one class of shares/stock permitted – no preferred permitted • Taxes on corporation income are “passed through” to shareholder’s income Lane, Alton & Horst, LLC

  37. Close Corporations • A close corporation is a special sort of corporation (either S or C) designed for businesses with only a few owners. • Allows owners by agreement to bypass many of the usual formalities required of corporations, thereby simplifying management of company affairs • Requires a WRITTEN agreement complying with specific statutory requirements(Ohio Rev. Code 1701.591) • Often has restrictions on ability of shareholders to transfer ownership Lane, Alton & Horst, LLC

  38. Close Corporation Agreement • Allows shareholders to vary and discard many of the legal formalities otherwise imposed on corporations. • Allows shareholders to be more specific about how they will treat one another. This can be helpful if a question later arises as to whether a shareholder’s “fiduciary duty” to the company and other shareholders has been met. Lane, Alton & Horst, LLC

  39. Contents ofClose Corporation Agreement • Respective voting rights of owners • Circumstances giving rise to the right of one or more shareholders to dissolve company • Conditions of employment of owners • Management authority • Payment and timing of dividends • Permissibility of transactions with shareholders (e.g. leases) • Can includeBuy-sell provisions, including redemption provisions Lane, Alton & Horst, LLC

  40. Close Corporation Agreement Formalities • All shareholders must sign the Close Corporation Agreement. • Adoption of Close Corporation Agreement must also be recorded in the Company’s official minutes. • Agreement must specifically reference the statute authorizing close corporation agreements. Ohio Rev. Code §1701.591 • Very important that the Company’s stock certificates carry a legend indicating the existence of the Close Corporation Agreement. Lane, Alton & Horst, LLC

  41. Impetus for Emergence of Limited Liability Company (LLC) • AROSE FROM DESIRE OF BUSINESS OWNERS AND INVESTORS • To combine the limited liability protection provided by corporation law with • Advantageous income treatment available to Partnerships • BUT WITHOUT • Management issues of Limited Partnerships • S-Corp Restrictions on Type and Number of Shareholders Permitted Lane, Alton & Horst, LLC

  42. Brief History of Limited Liability Company (LLC) Relatively recent legal form of business allowing owners to take advantage of the benefits of both the corporation and partnership forms of business • First statute enacted in Wyoming in 1977 • Gained popularity after IRS ruled LLC could be treated as a partnership for federal income tax purposes (IRS Rev. Rul. 88-76) • Ohio has allowed since 1994 • Single member LLC permitted since 1997 • Written Agreement Not Required; Default Provisions of Ohio Rev. Code 1705.13 would govern • Now available in all 50 States Lane, Alton & Horst, LLC

  43. Limited Liability Company Characteristics • Unlimited number of Members with any mix of individuals and business entities • Management Participation without loss of Limited Liability Protection • Flexible allocations and distributions of profits and losses • Flexible Control and Governance • Minimal Statutory Formalities Required • Taxation Options – Can choose to be taxed either as corporation or as a partnership Lane, Alton & Horst, LLC

  44. Types of Limited Liability Company • Manager Managed • Similar to Corporationwith only a single Member or small group of selected Members in control of management of business and affairs of company • Member Managed • More like a Partnership with all Members actively participating in management of company and it business affairs Lane, Alton & Horst, LLC

  45. Manager Managed LLC • Manager(s) selected and replaced in whatever manner agreed upon by Members • In general, Manager(s) make all decisions concerning the company’s business, operational, and financial affairs without input or prior approval of Members • Some major substantive decisions still reserved to Members • Manager does not have to be a Member • Any number of Managers permitted Lane, Alton & Horst, LLC

  46. Member Managed LLC • Ohio statutory provisions govern unless displaced by provisions of a written Operating Agreement • Can vote by headcount, pro rata Membership Interest, or any other system agreed upon by the Members • A Member’s management voting rights do not have have any relationship to that Member’s ownership interest Lane, Alton & Horst, LLC

  47. MAKING THE DECISION Lane, Alton & Horst, LLC

  48. Self–Sufficient “Lifestyle” Company • Businesses with • a local focus • Non-technology product or service • Not requiring or seeking large amounts of outside capital • SHOULD PROBABLY CHOOSE BETWEEN • LLC • S-Corporation Lane, Alton & Horst, LLC

  49. Special Advantages of LLC • If you're planning to start a business that will hold real property that will appreciate • “C” corporations and their shareholders are subject to tax on the appreciation when assets are sold or liquidated • An LLC and its members are not subject to this double taxation Lane, Alton & Horst, LLC

  50. Special Advantages of LLC • If you're thinking about forming an "S" corporation: • An "S" corporation is taxed in the same way as an LLC, but it has some restrictions on • the number and types of shareholders, • how profits and losses can be allocated among the owners, and • The kinds of stock they can issue to investors. • The LLC has none of these restrictions Lane, Alton & Horst, LLC