Summary Week 6 Preparing the Proper Ethical and Legal Foundation

Establishing a Strong Ethical Culture for a Firm

One of the most important things the founders of an entrepreneurial venture can do is establish a strong ethical culture for their firms. The data regarding business ethics are both encouraging and discouraging. The most recent version of the National Business Ethics Survey was published in 2013.  According to the survey, 41 percent of the 6,420 employees surveyed reported that they had observed misconduct or unethical behavior in the past year. Of the employees who observed misconduct, 63 percent reported their observation to a supervisor or another authority in their firm. While the percentage of employees who have observed misconduct or unethical behavior (41 percent) is discouraging, it’s encouraging that 63 percent of employees reported the behavior. Support, trust, and transparency also make a difference. In analyzing the results of its survey, the Ethics Resource Center concluded that the most important thing an organization can do to combat ethical misconduct is to establish a strong ethical culture. But strong ethical cultures don’t emerge by themselves. It takes entrepreneurs who make ethics a priority and organizational policies and procedures that encourage ethical behavior (and punish unethical behavior) to make it happen. The following are specific steps that an entrepreneurial organization can take to build a strong ethical culture.

Lead by Example

Leading by example is the most important thing that any entrepreneur, manager, or supervisor can do to build a strong ethical culture in their organization. In strong ethical cultures, entrepreneurs, managers, and supervisors:

■ Communicate ethics as a priority

■ Set a good example of ethical conduct

■ Keep commitments

■ Provide information about what is going on

■ Support following organizational standards

Employees also have responsibilities. The most important things that employees can do to support a strong ethical culture in an organization are to:

■ Consider ethics in making decisions

■ Talk about ethics in the work (they) do

■ Set a good example of ethical conduct

■ Support following organizational standards

Establish a Code of Conduct

A code of conduct (or code of ethics) is a formal statement of an organization’s values on certain ethical and social issues. The advantage of having a code of conduct is that it provides specific guidance to entrepreneurs, managers, and employees regarding expectations of them in terms of ethical behavior. Other codes of conduct set out more general principles about an organization’s beliefs on issues such as product quality, respect for customers and employees, and social responsibility. In all cases though, codes of conduct are intended to influence people to behave in ways that are consistent with a firm’s ethical orientation.

Implement an Ethics Training Program

Firms also use ethics training programs to promote ethical behavior. Ethics training program teach business ethics to help employees deal with ethical dilemmas and improve their overall ethical conduct. An ethical dilemma is a situation that involves doing something that is beneficial to oneself or the organization, but may be unethical. Most employees confront ethical dilemmas at some point during their careers. Ethics training programs can be provided by outside vendors or can be developed in-house.

Dealing Effectively with Legal Issues

Those leading entrepreneurial ventures can also expect to encounter a number of important legal issues when launching and then, at least initially, operating their firm.

Choosing an Attorney for a Firm

It is important for an entrepreneur to select an attorney as early as possible when developing a business venture. Selecting an attorney was instrumental in helping Tempered Mind, the company profiled in the opening feature, establish a firm legal foundation. It is critically important that the attorney be familiar with start-up issues and that he or she has successfully shepherded entrepreneurs through the start-up process before. It is not wise to select an attorney just because she is a friend or because you were pleased with the way she prepared your will.

Drafting a Founders’ Agreement

If two or more people start a business, it is important that they have a founders’ (or shareholders’) agreement. A founders agreement is a written document that deals with issues such as the relative split of the equity among the founders of the firm, how individual founders will be compensated for the cash how long the founders will have to remain with the firm for their shares to fully vest.

Avoiding Legal Disputes

Most legal disputes are the result of misunderstandings, sloppiness, or a simple lack of knowledge of the law. Getting bogged down in legal disputes is something that an entrepreneur should work hard to avoid. It is important early in the life of a new business to establish practices and procedures to help avoid legal disputes. Legal snafus, particularly if they are coupled with management mistakes, can be extremely damaging to a new firm. There are several steps entrepreneurs can take to avoid legal disputes and complications :

Meet All Contractual Obligations

It is important to meet all contractual obligations on time. This includes paying vendors, contractors, and employees as agreed and delivering goods or services as promised. If an obligation cannot be met on time, the problem should be communicated to the affected parties as soon as possible.

Avoid Undercapitalization

If a new business is starved for money, it is much more likely to experience financial problems that will lead to litigation. A new business should raise the money it needs to effectively conduct business or should stem its growth to conserve cash.

Get Everything in Writing

Many business disputes arise because of the lack of a written agreement or because poorly prepared written agreements do not anticipate potential areas of dispute. Although it is tempting to try to show business partners or employees that they are “trusted” by downplaying the need for a written agreement, this approach is usually a mistake. Disputes are much easier to resolve if the rights and obligations of the parties involved are in writing.

Set Standards

Organizations should also set standards that govern employees’ behavior beyond what can be expressed via a code of conduct. When legal disputes do occur, they can often be settled through negotiation or mediation, rather than more expensive and potentially damaging litigation. Mediation is a process in which an impartial third party (usually a professional mediator) helps those involved in a dispute reach an agreement.

Obtaining Business Licenses and Permits

Many businesses require licenses and permits to operate. Depending on the nature of the business, licenses and permits may be required at the federal, state, and/or local levels. There are three ways for those leading a business to determine the licenses and permits that are necessary. The first is to ask someone who is running a similar business, and they will usually be able to point you in the right direction. The second is to contact the secretary of state’s office in the state where the business will be launched. The third is to use one of the search tools available online.  The following is an overview of the licenses and permits that are required in the United States at the federal, state, and local levels for business organizations.

Federal Licenses and Permits

Most businesses do not require a federal license to operate, although some do. Seemingly simple businesses sometimes require more licenses and permits than one might think.

State Licenses and Permits

In most states, there are three different categories of licenses and permits that you may need to operate a business. Most states have start-up guides that walk you through the steps of setting up a business in the state.

Business Registration Requirements

Some states require all new businesses to register with the state. For example, the State of Oklahoma requires new businesses to complete a document titled “Oklahoma Business Registration Application” prior to commencing business. The purpose of the document is to (1) register the business, (2) place the business on the radar screen of the tax authorities, and (3) make sure the business is aware of and complies with certain regulations, such as the need to withhold state and federal taxes from the paychecks of employees.

Sales Tax Permits

Most states and communities require businesses that sell goods, and in some cases services, to collect sales tax and submit the tax to the proper state authorities. If you’re obligated to collect sales tax, you must get a permit from your state. Most states have online portals that make it easy to obtain a sales tax permit.

Professional and Occupational Licenses and Permits

In all states, there are laws that require people in certain professions to pass a state examination and maintain a professional license to conduct business. Examples include barbers, chiropractors, nurses, tattoo artists, land surveyors, and real estate agents.

Local Licenses and Permits

On the local level, there are two categories of licenses and permits that may be needed. The first is a permit to operate a certain type of business. Examples include child care, barber shops and salons, automotive repair, and hotels and motels. The second category is permits for engaging in certain types of activities. Examples include the following:

■ Building permit: Typically required if you are constructing or modifying your place of business

■ Health permit: Normally required if you are involved in preparing or selling food

■ Signage permit: May be required to erect a sign

■ Street vendor permit: May be required for anyone wanting to sell food products or merchandise on a city street

■ Sidewalk café permit: May be required if tables and chairs are placed in a city right-of-way

■ Alarm permit: Sometimes required if you have installed a burglar or fire alarm

■ Fire permit: May be required if a business sells or stores highly flammable material or handles hazardous substances

Choosing a Form of Business Organization

When a business is launched, a form of legal entity must be chosen. Sole proprietorships, partnerships, corporations, and limited liability companies are the most common legal entities from which entrepreneurs make a choice. Choosing a legal entity is not a one-time event. As a business grows and matures, it is necessary to periodically review whether the current form of business organization remains appropriate.

Sole Proprietorship

The simplest form of business entity is the sole proprietorship. A sole proprietroship is a form of business organization involving one person, and the person and the business are essentially the same. Sole proprietorships are the most prevalent form of business organization. The two most important advantages of a sole proprietorship are that the owner maintains complete control over the business and that business losses can be deducted against the owner’s personal tax return.

Advantages of a Sole Proprietorship

■ Creating one is easy and inexpensive.

■ The owner maintains complete control of the business and retains all the profits.

■ Business losses can be deducted against the sole proprietor’s other sources of income.

■ It is not subject to double taxation (explained later).

■ The business is easy to dissolve.

Disadvantages of a Sole Proprietorship

■ Liability on the owner’s part is unlimited.

■ The business relies on the skills and abilities of a single owner to be successful. Of course, the owner can hire employees who have additional skills and abilities.

■ Raising capital can be difficult.

■ The business ends at the owner’s death or loss of interest in the business.

■ The liquidity of the owner’s investment is low.

Partnerships

If two or more people start a business, they must organize as a partnership, corporation, or limited liability company. Partnerships are organized as either general or limited partnerships.

General Partnerships

A general partnership is a form of business organization where two or more people pool their skills, abilities, and resources to run a business. The primary advantage of a general partnership over a sole proprietorship is that the business isn’t dependent on a single person for its survival and success.

Advantages of a General Partnership

■ Creating one is relatively easy and inexpensive compared to a corporation or limited liability company.

■ The skills and abilities of more than one individual are available to the firm.

■ Having more than one owner may make it easier to raise funds.

■ Business losses can be deducted against the partners’ other sources of income.

■ It is not subject to double taxation (explained later).

Disadvantages of a General Partnership

■ Liability on the part of each general partner is unlimited.

■ The business relies on the skills and abilities of a fixed number of partners. Of course, similar to a sole proprietorship, the partners can hire employees who have additional skills and abilities.

■ Raising capital can be difficult.

■ Because decision making among the partners is shared, disagreements can occur.

■ The business ends at the death or withdrawal of one partner unless otherwise stated in the partnership agreement.

■ The liquidity of each partner’s investment is low.

Limited Partnerships

A limited partnership is a modified form of a general partnership. The major difference between the two is that a limited partnership includes two classes of owners: general partners and limited partners. There are no limits on the number of general or limited partners permitted in a limited partnership. Similar to general partnerships, most limited partnerships have partnership agreements. A limited partnership agreement sets forth the rights and duties of the general and limited partners, along with the details of how the partnership will be managed and eventually dissolved.

Corporations

A corporations is a separate legal entity organized under the authority of a state. Corporations are organized as either C corporations or subchapter S corporations.

C Corporations

A C corporation is a separate legal entity that, in the eyes of the law, is separate from its owners. In most cases, the corporation shields its owners, who are called shareholders, from personal liability for the debts and obligations of the corporation. A corporation is governed by a board of directors, which is elected by the shareholders. Most C corporations have two classes of stock: common and preferred. Preferred stock is typically issued to conservative investors who have preferential rights over common stockholders in regard to dividends and to the assets of the corporation in the event of liquidation. Common stock is issued more broadly than preferred stock. The common stockholders have voting rights and elect the board of directors of the firm. The common stockholders are typically the last to get paid in the event of the liquidation of the corporation; that is, after the creditors and the preferred stockholders.

Advantages of a C Corporation

■ Owners are liable only for the debts and obligations of the corporation up to the amount of their investment.

■ The mechanics of raising capital is easier.

■ No restrictions exist on the number of shareholders, which differs from subchapter S corporations.

■ Stock is liquid if traded on a major stock exchange.

■ The ability to share stock with employees through stock option or other incentive plans can be a powerful form of employee motivation.

Disadvantages of a C Corporation

■ Setting up and maintaining one is more difficult than for a sole proprietorship or a partnership.

■ Business losses cannot be deducted against the shareholders’ other sources of income.

■ Income is subject to double taxation, meaning that it is taxed at the corporate and the shareholder levels.

■ Small shareholders typically have little voice in the management of the firm.

Subchapter S Corporation

A subchapter S corporation combines the advantages of a partnership and a C corporation. It is similar to a partnership in that the profits and losses of the business are not subject to double taxation. The subchapter S corporation does not pay taxes; instead, the profits or losses of the business are passed through to the individual tax returns of the owners. An S corporation is similar to a C corporation in that the owners are not subject to personal liability for the behavior of the business. An additional advantage of the subchapter S corporation pertains to self-employment tax. By electing the subchapter S corporate status, only the earnings actually paid out as salary are subject to payroll taxes. The ordinary income that is disbursed by the business to the shareholders is not subject to payroll taxes or self-employment tax.

Limited Liability Company

The limited liability company (LLC) is a form of business organization that is rapidly gaining popularity in the United States. As with partnerships and corporations, the profits of an LLC flow through to the tax returns of the owners and are not subject to double taxation. The main advantage of the LLC is that all partners enjoy limited liability. This differs from regular and limited partnerships, where at least one partner is liable for the debts of the partnership. The LLC combines the limited liability advantage of the corporation with the tax advantages of the partnership.

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