Article on Securities Law Relevant to Startups
A series of articles provided by Michael T. Raymond, a securities attorney with the Detroit, MI, law firm Raymond & Walsh, and an Adjunct Professor at the Wayne State University Law School.
The purpose of this series is to acquaint readers with the basics of securities law. Securities law governs the raising of capital for business purposes.
2. Forms of Business Organization Once an entrepreneur has conceptualized a commercially viable technology or product, he should begin to conceptualize the proper business form in which to pursue product development. The selection of the most advantageous form of legal organization involves weighing many practical and legal considerations.
The most important distinctions among the available forms of business include — cost and formality of organization, transferability of ownership interests, continuity of existence, management, and control, ability to obtain capital and credit, method of participation in profits, vulnerability to personal liability, and taxation of the enterprise.
In general, the available forms of business include the sole proprietorship, the general partnership, the limited partnership, and the corporation. Each of these forms of business enterprise are recognized in the State of Michigan and are generally adaptable to the specific needs of a start-up or emerging business. The impact of certain of these important considerations among the available forms of business are discussed below.
The sole proprietorship is a simple form of business enterprise which is the most widely used. The distinguishing characteristic of a sole proprietorship is that it is owned and managed by one person. The individual proprietor has the ultimate responsibility and authority for all decisions affecting the business. Generally, no legal formalities are necessary to create an enterprise in this form. With the exception of a very nominal filing and publication cost associated with an assumed name certificate, there are no state or local taxes or fees payable for the privilege of organizing as a sole proprietorship. Sole proprietors are personally liable for the debts of the proprietorship.
A general partnership is created by agreement, either oral or written, and the relations of the partners are governed by that understanding. To the extent the partners’ agreement does not address a particular matter, the Michigan Uniform Partnership Act will govern their activities. Partners typically agree to share in the profits, losses, and assets of the partnership. Apart from the agreed upon duties and liabilities of the partners, a fiduciary relationship also exists between the partners. Each partner is personally liable for the debts of the partnership, a feature which makes this business form undesirable to many entrepreneurs.
A limited partnership is similar to a general partnership in certain respects and similar to a corporation in others. A limited partnership is a business form in which, by complying with certain statutory requirements, one or more of the partners has only limited liability for partnership debts and obligations. The price for this liability protection is a limitation on participation in management.A corporation is a legal entity created under a particular business statute. The entity may be owned by one or more shareholders, who, in turn, may be natural persons or other legal entities. A corporation is regarded, in law, as having a personality and existence entirely distinct from that of its owners. Accordingly, shareholders are generally not liable for corporate obligations. However, the statutory formalities concerning the formation and operation of a corporation must be strictly observed. Failure to properly follow corporate formalities may cause the shareholders to become personally liable for the obligations of the corporation.
Continuity Of Existence The sole proprietorship terminates by law upon the death of the sole proprietor, with very few exceptions. Estate planning documents for the sole proprietor may grant the heirs of the sole proprietor the right to continue the business.
The death or withdrawal of a general partner, or the expiration of the term of the general partnership, will dissolve the partnership. Continuation of the partnership following such events may be dealt with, however, in the partnership agreement. Since a partnership is generally a “voluntary” association, any general partner who no longer desires to be associated with the partnership may withdraw and force a dissolution. Dissolution of a partnership, as a general rule, requires winding up of its affairs and a liquidation of the partnership’s assets.
The relationship between the general partner and limited partner in a limited partnership is different than that of a general partnership. If there is at least one general partner, the death or withdraw of another general partner in a limited partnership will not result in a termination of the partnership. Moreover, a limited partner, as a passive investor, is like a shareholder of a corporation and his withdrawal or death will not affect the continuity of the partnership.
The corporation is the most suitable form of business if continuity is desired. The Articles of Incorporation can provide for perpetual existence and, as a result, the corporation can continue without interruption upon the death or withdrawal of any of its shareholders, officers, or directors.
Transferability Of Ownership Interest Since a sole proprietor owns his business directly, his ownership interest may be transferred at any time. The ownership interest of a general partner receives different treatment. A general partner’s interest in the partnership is an intangible interest that includes his proportionate share of assets and liabilities. This intangible interest may be assigned or transferred freely.
Unless otherwise provided in the partnership agreement, the ownership interest in a limited partnership held by a limited partner is freely transferable. Depending upon the circumstances under which a limited partnership interest was obtained, securities laws may limit the otherwise free transferability of this ownership interest.
Shareholders’ interests in a corporation are evidenced by share certificates, which are generally freely transferable. The corporation permits the greatest flexibility in the transfer of ownership interests. However, as is the case with limited partnerships, securities laws may otherwise restrict the transferability of shares.
Capital And Credit Requirements The sole proprietor is limited to his own personal resources in his ability to obtain loans to capitalize his enterprise. For general partnerships, the partners’ contributions of cash or property will constitute the initial capital investment. The general partnership is, from a practical standpoint, equally as limited in the sources available for obtaining funds. In order to borrow money, partners typically must pledge their personal assets as collateral.
Limited partnerships often obtain capital from the contributions of limited partners. In this sense, the capital infusion mechanism of a limited partnership is analogous to that of a corporation. A pledge of partnership assets may be sufficient for borrowings, although general partner guarantees are not uncommon.
The corporation’s ability to attract capital and facilitate credit is another strong advantage for this legal form. The corporate financial structure lends itself to a wide variety of securities such as debt and equity instruments.The sale of shares in a corporation is a relatively convenient mechanism for capital formation.
Tax Considerations The federal and state laws regarding taxation of sole proprietorships may be an advantage in many instances. All business income or loss is treated as the individual’s income or loss and taxed accordingly.
Similarly, a general partnership pays no federal income tax. Each general partner is required to declare his share of partnership income or loss on his individual tax return.
For the most part, limited partnerships are treated like general partnerships for tax purposes, with tax events proportionately passing through to general and limited partners. This is one reason that limited partnerships are a favored form of enterprise to conduct certain types of tax sensitive business activities.
Unlike sole proprietorships, a corporation files its own tax return. A disadvantage to the corporate form is that “double taxation” may occur since income received by the corporation will be taxed at the corporate level and, if distributed to its shareholders as dividends, will be taxed again for their personal income tax reporting purposes. There are several methods which can be employed to minimize the impact of this double taxation such as salaries to officers, loans from shareholders, and a Subchapter S election (whereby the corporation elects not to be taxed at the corporate level and instead to have its income channeled through directly to its shareholders).
Conclusion In summary, an entrepreneur should carefully evaluate these and other important considerations when choosing to form a business enterprise. An informed choice should enable flexibility in raising capital, address investors’ tax needs, and provide liability protection whenever possible.