A Quick Primer on Corporations (C-Corps & S-Corps)

A corporation is the business entity that most people think of when they think of a business. Seeing the Inc. or Corp. at the end of a business name conjures up images of well-known, successful businesses. Beyond that, though, corporations are seen as people in the eyes of the law. Just like an individual, a corporation can bring lawsuits, own property, and enter into contracts, among other things. Corporations have a perpetual lifespan, meaning that short of dissolution, corporations will persist indefinitely, allowing their shareholders to buy, sell, and trade shares for years to come. Speaking of shareholders, corporations, while sometimes thought to be owned by the board of directors, are actually owned by their shareholders and managed by the board of directors. Officers, such as the president, CEO, and CFO, run the corporation through its day to day activities, in turn delegating work to managers and other employees. In smaller corporations, a single person may hold several roles, as shareholder, board member, and officer.

S-Corporations, formally known as Subchapter-S Corporations after the tax code section which authorizes them, are very similar to C-Corps above. As far as similarities go, both are corporations and are inherently structured the same in the eyes of the law. However, S-Corps are designed with certain tax savings in mind—at the expense of the large amount of growth a C-Corp can experience. While all of the differences between the two are outside of the scope of this quick guide, the most important thing to keep in mind when comparing an S-Corp to a C-Corp is that with an S-Corp, you sacrifice the ability to grow to a very large size and issue a wide variety of stock for tax savings benefits.

Photo courtesy: ernestopletsch

A Quick Primer on Limited Liability Companies and Partnerships (LLCs & LLPs)

A Limited Liability Company, or LLC, is a far newer type of business entity than a corporation, though they have quickly become the most popular type of business entity around. This rapid growth in popularity is because LLCs combine liability protection afforded by a corporation with a partnership’s lack of strict administrative rules and formalities. And let’s not forget that an LLC can also provide for tax savings as well. While it would be overkill to say you can form an LLC and immediately forget about its required formalities, it is the simplicity of the LLC that has made it hugely popular among small business owners who would much rather be running their business than scheduling shareholder and board meetings.

A Limited Liability Partnership, or LLP, is very similar to the LLC discussed above. In most situations, if you’re considering an LLC versus an LLP, choosing the LLC is the way to go simply because it affords you more options for growth and provides a better business structure overall. However, some states, like California, require certain professionals to form LLPs instead of LLCs for liability purposes. Some professionals, such as attorneys, architects, and accountants, are prevented by state law from organizing as an LLC, and therefore must form an LLP instead.

Photo Courtesy: Manish Prabhune

Understanding the Difference Between Common Stock and Preferred Stock Equity Financing for Startups

Financing your startup is easily one of the most important steps in the process of developing your company—but is it also one of the most despised. When it comes to financing, you’re looking at several rounds, ranging from the very beginning when you’re just getting money from friends and family members who want to help you out from the kindness of their hearts all the way to the IPO and taking your company public. Through it all, though, there are three main ways to structure your company’s financing. Common Stock, Preferred Stork, and Convertible Notes. While this article is limited to a discussion of common stock and preferred stock, each type of equity financing has its own benefits and drawbacks, and hopefully this article will help you understand exactly what the differences are between the two stock classes and how each is used.

Common Stock for Startups

Of the three types of equity financing discussed in this article, common stock is probably the one you’re most likely familiar with. When you form a corporation at the beginning of a venture, this is most likely the stock you’re issuing to yourself and your cofounders. This type of stock is used throughout the early stages of fundraising, and is mostly given to the friends and family members who have helped you out when you’re just getting started.

From your perspective, this is the best type of equity to give to investors. It keeps everyone on the same playing field in terms of voting rights and special privileges, and you don’t have to worry (as much) about running afoul of some securities law by issuing something other than the common stock you started with. It’s the perfect way to get smaller investments from a larger number of individuals in a Kickstarter, crowdfunded kind of way. In short, if all investors are given common stock, everyone has the same rights, and that usually means the founders get to keep control over the company they built.

However, investors do not share the same perspective you do as the founder of your company. Investors are putting large amounts of their money on the line in hopes they’ll see some big profits in the future—and that’s why they hate common stock. When an investor comes calling, they want to have more control over the way the company is run, and common stock simply doesn’t grant them the ability to run the business in a way they’ve determined is the most prudent manner. Ultimately, because the investor will be negotiating with you at a time when your company needs the money, they’re going to have all of the leverage and you’re going to have to give up and accept you’re going to have to give them a class of stock better than common.

Preferred Stock for Startups

And that’s where preferred stock comes in. Preferred stock doesn’t really do much for the company itself, but means the world to the investors because of all of the additional bells and whistles that come attached to the stock to help increase investors’ reward while decreasing their risk. The main factor is that most of the preferences and rights associated with preferred stock go into effect at the time of a liquidation event—often purchase of the company, merger, public offering, or closure.

When it comes to preferred stock, all are not created equal. There are a number of different features that separate one class of preferred stock from another. It is important to keep in mind that a company’s preferred stock may have one of the following additional rights or all of the following rights—it really just depends on how well negotiations went and who the company has as its investors.

Conversion Rights: These are rights given to an investor designed to protect that investor from having her shares diluted by future financing rounds. After all, as more shares are issued, the fixed number of shares an early investor purchased becomes a lower overall percentage of the company’s equity. Generally, what happens with conversion rights is the investor is given the right to convert each share of their preferred stock into a larger number of shares of common stock.

Dividend Preference: While finding a dividend-paying startup is like discovering a dodo on your front lawn, dividend rights ensure a preferred stockholder gets their dividends before anyone else does—even if they have to wait years. The key here is some investors require dividends accrue even if they’ve not been officially declared by the board of directors. If this is the case, the dividends, which should have been paid out on a regular basis, grow in the background and are then paid to the preferred stockholder at the time of a liquidation event, thereby increasing the money made by the investor beyond just an increase in value of her stock.

Liquidation Preference: What happens with a liquidation preference is the investor gets her investment back before any of the common stockholders get a dime. These are triggered by any liquidation event (liquidity event). Something to look out for are liquidation preferences that provide a return on 1x the amount invested, though that’s a topic for another post.

Redemption Rights: The redemption right gives the preferred stockholder the right to force the company to repurchase its preferred shares. Generally, these are only activated after a specified amount of time and, for the most part, most redemption rights go completely unused—particularly in early investment rounds.

Voting Rights: Now here’s a big right for preferred stockholders that can mean a lot of different things. Voting rights can range from the ability to have the investor installed on the board of directors. They can also mean that each vote from a preferred share is worth more than that of a common share. Or, there can be protective provisions in place that give the investor the right to veto certain decisions made on the company’s behalf. Needless to say, the voting rights of a preferred stockholder are far beyond those of a common stockholder.

And those are the most common preferences and rights of preferred stock. Whenever you seek investor financing, always, and I mean always, consult with a startup lawyer to read the terms provided by the investor and help negotiate the deal.

Photo courtesy: Robert S. Donovan

3 Problems with Single-Member LLCs and How You Can Easily Solve Them

I help my clients form lots of business entities. While many of them are corporations, LLCs (Limited Liability Company) are, without a doubt, the most popular. It seems everyone these days wants to start their own LLC, and that’s not necessarily a bad thing—but there are drawbacks to having what is known as a single-member LLC.

Before we get into the reasons why a single-member LLC is not necessarily a good thing, we need to go over some of the background on LLCs in general. Time for a history lesson. The LLC was developed as an alternative form of corporate entity from the classic C-Corp, or corporation. Structured based on partnership rules, the LLC is technically just that, a fancy partnership recognized by state law and given added liability protection than what was provided by the typical general partner/limited partner model used by partnerships. If you have an understanding of the difference between partnerships and sole proprietorships, you may see where I’m going with this.

Partnerships all require more than one member. That’s why they’re partnerships, right? You can’t be a partner to yourself. If an LLC is considered to be highly similar to a partnership, then if you’re operating a single-member LLC, it’s like you’re operating a partnership with only one partner—and that’s a no-no. Traditionally, a partnership with only one partner, then, was a sole proprietorship, a type of business entity with undoubtedly the least amount of liability protection you could have. Therefore, if you’re operating an LLC as a single-member LLC, which makes you more like a sole proprietor than a partnership, that means you have less liability protection than if you have an LLC with multiple members. Which, of course, is why I, as a business attorney, always recommend including a second member when forming an LLC. People don’t always listen, but at least we can say we warned them.

OK, so back to the problems with the single-member LLC. Considering the above, we know these types of LLCs have less liability protection than if there were multiple members—but did you know that in some places they’re completely disregarded? Take the IRS, for example. When you register for an EIN (Employment Identification Number), they tell you your LLC will be taxed as a disregarded entity—just like a sole proprietorship. Not like a partnership. Not like a corporation. You have to affirmatively select one of those options. Even more amazingly, some states don’t even allow you to form a single-member LLC. California isn’t one of them, in case you were wondering. Though California will definitely disregard your single-member LLC (and hold you personally liable for damages) if your LLC is ever sued and doesn’t have enough capital to cover the damages if the other party wins.

To recap, the single-member LLC is problematic because it can be so easily disregarded. This means less liability protection, possibly less tax benefits, and the risk of personal liability if your LLC is undercapitalized.

So How Do I Solve This Problem? I Thought My LLC Was Supposed To Protect Me From Liability

The solution is easy: add another member to your LLC. We always recommend a family member, such as your spouse, partner, parent, or child. You don’t have to give them a 50% stake in the company, just a couple percent will do. You still get to make all of the important company decisions while they are just entitled to a very small share of the profits (and losses).

But I Don’t Want To Share!

There’s always those people who feel the’ve built their company by themselves, with their own hard work and capital, and they don’t want to share the membership interest in their LLC with anyone else. A completely valid point that I can definitely accept. If you’re one of those people, just keep in mind that you’re never going to insulate yourself from liability as well as you could by adding another member, but here are a few tips that may help you protect yourself slightly more.

Elect corporate tax treatment with the IRS instead of “disregarded entity” tax treatment that is default with a single-member LLC.

Keep unbelievably perfect records of all meetings and resolutions for your company. Even though you’re only one member, vote on everything. Document all major events. The more records your company keeps, the better.

Never personally sign for any LLC-related purchases or contracts. Always sign your name on behalf of your company.

Never mix money in your personal bank account with your company’s bank account. Keep them totally separate and keep excellent records regarding your LLC’s assets and liabilities.

Use your LLC’s EIN on all tax filings.

So there you have it, some reasons why a single-member LLC is not necessarily the best idea for forming your business entity, and some tips on how to get around the problems it presents.

Photo courtesy: Bob Jagendorf

Why Your Business Needs a Trade Secret Audit

One of the biggest, and often most overlooked, assets your business owns are its trade secrets. A lot of time and energy go into talking about the big boys of intellectual property, like patents, trademarks, and copyrights—so much so that you’re probably wondering what a trade secret is. These are essentially the secrets a company keeps about things like inventions, secret formulas, customer lists, supplier contacts, and generally those bits of information that keep the company special, unique, and give it that edge against the competition. Famous examples include the formula for Coca-Cola and the KFC secret recipe.

But what are you supposed to do about these trade secrets? Firstly, you need to keep them secret. They’re only protected by law if nobody knows about them. Secondly, you need to know what they are, how they’re used, and how their protected—and you find all of that out through a trade secret audit. A trade secret audit is good to perform at any time, even when your business is in its prime, if you just want to know which trade secrets are the most important and how to best ensure they’re not going to get out into the wild. After all, because these secrets are so valuable to your business, you do not want them to be discovered by the prying eyes of your competition or released to the public by a disgruntled former employee.

So how does a trade secret audit work? It starts out with your business attorney putting together the party, an Avengers-like team, who will work on the audit. This team will be given access to the company’s trade secrets to determine what are the company’s secrets and how best to secure them. Once the team is assembled, they will be tasked with auditing the secrets. The first step to the actual audit, then, is to identify what assets/resources are trade secrets and what are not. This requires a comprehensive review based on the rules regarding trade secrets, and ultimately the team should determine exactly what constitutes a trade secret in the context of your unique business structure.

Once the trade secrets have been identified, the team is tasked with determining how well protected those secrets are and how many people know about them. Are they stored out in the open for everyone (including customers) to see? Are they sheltered away in a vault somewhere offsite? Are they stored on computers? In the cloud? Who has access to them? Are those employees with access to them governed by non-disclosure agreements? These are just a few of the questions the audit team should be asking. And once they have answered all of these main questions, the team should move on to figuring out where problem areas are, how to solve them, and how to use technological innovations to even further secure your company’s secrets.

As Benjamin Franklin once famously wrote, three can keep a secret if two of them are dead. (I’m not advocating killing people you tell secrets to, but just be aware of who you share your trade secrets with.) Trade secrets are incredibly important to your business, whether you know it or not, and you must do everything you can to keep them secret.

Photo courtesy: kennymatic

7 Tests to Determine if that Independent Contractor You’ve Hired is Actually an Employee

Now that’s a long title.

But you’re not here for the title. You’re here for the content.

It happens to even the most careful of employers. You think you have hired an independent contractor only to find out later on that the person you hired should have been classified as an employee. You did your research. You read the California statute for independent contractors. The language is simple, right? “Any person who renders service for a specified recompense for a specified result, under the control of his principal as to the result of his work only and not as to the means by which such result is accomplished.” California Labor Code §3353. You figured that just meant a person who performs work independently and isn’t subject to your company’s rules. Or, to make matters worse, you thought that meant anyone who is not exclusively your employee but can work for other employers at the same time. However, while you may think this misclassification between independent contractor and employee is just an honest mistake, the difference can have a huge impact on your business—and your finances. After all, one simple misclassification can mean that you may owe back workers compensation, taxes, benefits, and unemployment insurance.

So what’s the point here?

Don’t misclassify your employees as independent contractors—or you will greatly regret it later on.

But what is an employer to do? Well, the best thing you can do is hire an attorney who can help you with employer protection, or someone similar. Before you contact that lawyer, though, there are a few questions you should ask about the employment relationship to help you see if you really have hired an independent contractor or if you’ve actually just hired a new employee.

  • Is the person performing the services engaged in a distinct occupation or business?
  • In the person’s occupation or business, considering factors such as the locality, is the kind of work usually done under the direction or supervision of the principal or is the work usually done by a specialist without supervision?
  • How much skill is required for the person’s occupation?
  • Does the person supply their own tools, instrumentalities, and place of work, or are the tools, instrumentalities, and place of work supplied by you?
  • How long will the services be performed?
  • Is the type of work you’re hiring the person for of the same type of work your business regularly does?
  • Do you believe you are creating an employer-employee relationship? Does the person you’re hiring believe they are entering into an employer-employee relationship?

The foregoing questions come from S.G. Borello & Son, Inc. v. Dept. of Industrial Relations (1989) 48 Cal.3d 341, 351, and the following should not be construed as legal advice in any way. I am providing you a very generalized look at California law on the topic. Also keep in mind that the Federal tests for an independent contractor relationship are different.

Image Courtesy: Victor1558

Is it OK to Spy On Your Employees?

Ah, the digital age. So much progress. So much productivity. So many more ways for your employees to avoid doing their jobs while they’re on the clock. And that’s where employee-tracking software comes in. For those who don’t know, this is perfectly legal software you install on your office’s computers to track what your employees are doing on the computer throughout the day. But as a manager, officer, director, or whatever position of power you hold in your company, you need to make sure you are implementing your employee-monitoring policies in a proper way. And here are three key points to keep in mind that can go a long way to properly implementing your policies.

Anonymity

While you may think the best policy is to hunt down those time-wasters so you can single them out for termination, a much better policy is to analyze the employee-tracking readouts in bulk to get a better feel for what your employees are doing on the whole—not necessarily individually. This way you can keep morale high since you’re not on a warpath to eliminate jobs, and you can avoid all kinds of wrongful termination suits that may spring up from disgruntled employees where terminated after you were spying on them.

Transparency

As with any company-wide policies—and especially ones with such negative connotations as employee-tracking—you need to be as transparent as possible when it comes to monitoring your employees. The more they know, the more at ease they will feel about the whole process. And the more at ease they feel, the more accurate the data you’ll be able to collect and analyze. And again, be clear with your employees you’re using that tracking information as a learning tool instead of a tool used to eliminate your staff based on their on the job browsing habits.

Good Judgment

Finally, the best way to properly institute an employee-tracking program is to make sure you use your best judgment. If something seems wrong, it probably is and you should not do it. Keep in mind whether you would like to be in the employee’s position and whether if you, in that position, would feel like your privacy was being completely violated by your employer’s actions. As long as you use your best judgment in implementing employee tracking, you’re already on the right track to staying out of trouble.

Image Courtesy: kevin dooley

2 Important Questions To Ask Before Electing S-Corp Status For Your LLC

I’ve been getting a number of questions regarding what’s best for a person’s business. The S-Corp or C-Corp? The LLC? A B-Corp, perhaps? When it all comes down to it, there’s really no perfect answer, and every case has to be looked at on an individualized basis. But one thing is for sure, there are bound to be questions as soon as a client learns about the possibility of electing S-Corp status for their LLC. For some reason, this idea of having an LLC that is treated like an S-Corp is some kind of revelation for our clients who feel like maybe, just maybe, this is a way to dodge the tax man or somehow outsmart the IRS.

While there are a number of important factors to consider, this is a quick blog post—not a one-on-one discussion with a business attorney, accountant, or tax attorney regarding your company. Accordingly, we’ve distilled the numerous factors down to just two of the most important.

  1. What is the Difference Between Electing S-Corp Status and Organizing as an S-Corp? The most important fact to keep in mind when considering an S-Corp election for your LLC is to remember that you are not reorganizing your LLC as an S-Corp—you are simply choosing a different tax treatment. The type of business entity you are organized as is a legal distinction while the type of entity you choose for taxation purposes is a tax distinction. So, if you have a single-member LLC without the S-Corp election, your business will be considered an LLC for legal purposes and a disregarded entity (or sole proprietorship) for tax purposes. Further, if you have a multi-member LLC without S-Corp election, your business will be considered an LLC for legal purposes and a partnership for tax purposes. Finally, no matter how many members your LLC has, if you elect S-Corp status, your business will be considered an LLC for legal purposes and an S-Corp for tax purposes.
  2. What are the Tax Benefits to Electing S-Corp Status? Well, the tax benefits depend on the number of members you currently have in your LLC. Most prominently, for all LLCs, being classified as an S-Corp for tax purposes can mean you no longer have to pay individual self-employment tax, which can turn out to be big savings. However, choosing S-Corp status also reduces your tax flexibility for a multi-member LLC because the partnership style tax status multi-member LLCs enjoy gives the members a lot more leeway. If tax benefits are the main focus of your reason to elect S-Corp status for your LLC, which they should be, you have to consider your individual needs and definitely talk to an accountant before making the election (but always have an attorney draft the necessary formation documents).

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6 Must-Include Items in an Employee Termination Letter

Wrongful termination. Those two words should strike fear into the heart of any employer. And while they can often mean a big payout for a disgruntled employee (and her attorney), employers shudder at the fact that the person they just fired may end up being an even bigger thorn in their side once they’re no longer employed. However, a well-drafted termination letter can go a long way to helping avoid dealing with a wrongful termination claim—but here’s the catch—the employee termination letter has to be as close to perfect as possible. And here are six items you should make sure your lawyer includes in her termination letter.

  1. The Reason Why the Employee Was Terminated. I’m just going to jump right into the quagmire that scares a lot of employers. “Why include the reason for termination?” the employer asks. “Won’t that just subject me to liability for wrongful termination?” The answer is simple. You should include it because a well drafted reason for termination can go a long way to helping prove the reasons why the employee was terminated in the first place. However, be mindful not to go into too many details regarding the reasons for termination—but don’t be too vague either. If you try to be too specific, you may find you cannot possibly prove this reason in court if the employee does end up suing you for wrongful termination. And if you are too vague, you run the risk of damaging your credibility and looking as though the stated reason for termination is not the actual reason for termination.
  2. The Date of Termination and the Last Day of Work. This really needs no discussion, but these dates should be included so as to document some of the most important dates in the termination process. Also include the date the terminated employee must return all of your belongings and supplies, if necessary.
  3. Information About Any Prior Warnings Given. If you’re the type of employer who feels the need to give a number of prior warnings to employees before terminating them, you should include the dates you gave them and the reasons behind them. A well documented record of pas poor performance (for example), can go a long way in deterring any kind of wrongful termination suit.
  4. A List of the Benefits the Terminated Employee is Entitled To. A number of employers give their employees the right to avail themselves of healthcare benefits, among other things, after they’ve been terminated. If your company is one that allows for such continued benefits, be sure to tell your terminated employee about it. And also don’t forget to include information about unemployment benefits.
  5. Whether the Employee Was Discharged or Terminated. Pretty self-explanatory, all termination letters should state whether the employee was discharged or terminated.
  6. Whether the Employee Could Have Appealed the Termination. The question of whether you should provide some kind of appeal system for employees who have been terminated is a topic for another blog post. However, if you do provide a system for the employee to appeal her termination, make sure you specify the proper method for appeal in your termination letter and if the time to appeal has already passed, then discuss whether the terminated employee took advantage of the appeal system.

Image Courtesy: Thomas Leuthard

Why Your Home State May Be the Best Place to Incorporate a New Business

There’s one question I’m asked more often than any other when I’m counseling clients about business formation. What is the best state to incorporate a new business? There are the usual choices, of course. Delaware, Nevada, and Wyoming. These states all provide a number of benefits to the up and coming entrepreneur. Tax perks, rich history of corporate law, extra protections for corporations and the individuals who incorporate them.

But are those states really right for your business?

Any decision about where to form your new business entity obviously has to be made on a case by case basis. As an attorney, I’d be doing you a disservice to tell you that you absolutely must form your corporation or LLC in one particular state because, let’s face it, different business entities need different things and what works well for one company will be exactly the wrong thing for another.

What I can tell you, however, is to consider your home state as a frontrunner along with the usual top three choices. Our law firm is located in California—a state widely regarded to be, shall we say, less than friendly to small businesses. Except for tech startups. California is plenty friendly to those. In any event, California has high taxes, some foolish laws, and some courts have a penchant for trying to hold the officers and directors liable the debts of the business. Aside from all that—its a perfectly good place to incorporate your business.

So you’re a new business owner who wants to form a corporation. Say its a plumbing company. You live in California, you’re licensed in California, your employees all live and work exclusively in California, your shop is in California. You can see where this is going—you’re totally tied to California for your business. But you decide you want to incorporate your business in Delaware because a friend of a friend told you that’s the place to do it. Tax breaks, good law, whatever reason you have. If you decide you want to incorporate in Delaware, you’re going to have to pay for the incorporation there, file all of their paperwork, pay at least their minimum taxes, and so on. But, because you’re operating your business entirely in California, California is going to require you to register as a foreign corporation in California. Why? Because you’re transacting intrastate business here. And you’re going to have to pay for the registration here, file all of the paperwork, pay California’s taxes, and so on.

Sound like a good idea?

I didn’t think so.

That’s just one situation where it may be better to form your new corporate entity in the state where you’re actually conducting business. There are others, but that’s a topic for a one on one conversation with our clients. If you’re considering starting your own business and are looking for an attorney to help walk you through the process from start to finish, give us a call and we can put you on the right track—no matter what state you’re interested in.

Image courtesy: Robert S. Donovan