Entrepreneurship:

Successfully Launching
New Ventures, 2/e
Bruce R. Barringer
R. Duane Ireland

Chapter 7

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 Chapter Objectives
(1 of 2)

1. Describe how to create a strong ethical culture in an

entrepreneurial venture.
2. Explain the importance of having a code of conduct
and an ethics training program.
3. Explain the criteria important to selecting an
attorney for a new firm.
4. Discuss the steps necessary to ethically depart from
an employer.
5. Discuss the importance of nondisclosure and
noncompete agreements.

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 Chapter Objectives
(2 of 2)

6. Discuss the importance of a founders’ agreement.

7. Provide several suggestions for how entrepreneurial
ventures can avoid litigation.
8. Discuss the differences among sole proprietorships,
partnerships, corporations, and limited liability
companies.
9. Explain why most fast-growth entrepreneurial ventures
organize as corporations or limited liability companies
rather than sole proprietorships or partnerships.
10. Explain double taxation.
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 Initial Ethical and Legal Issues
Facing a New Firm

Establishing a strong Ethically departing

Choosing an attorney
ethical culture from an employer

Drafting a founder’s Choosing a form of

Avoiding litigation
agreement business ownership

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 Establishing a Strong Ethical Culture
(1 of 2)

• Lead By Example
– The most important thing that any entrepreneur, or team of
entrepreneurs, can do to build a strong ethical culture in
their organization is to lead by example.
• 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.

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 Establishing a Strong Ethical Culture
(2 of 2)

• Implement an Ethics Training Program

– Ethics training programs 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.

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 Potential Payoffs for Establishing a
Strong Ethical Culture

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 Choosing an Attorney for a Firm

• Select an Attorney Early

– It is important for an entrepreneur to select an attorney as
early as possible when developing a business venture.
– It is critically important that the attorney be familiar with
start-up issues.
• Intellectual Property
– For issues dealing with intellectual property (patents,
trademarks, and copyrights) it is essential to use an
attorney who specializes in this field.

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 How to Select an Attorney

• Contact the local bar association and ask for a list of attorneys who specialize in
start-ups in your area.
• Interview several attorneys.
• Select an attorney who is familiar with the start-up process.
• Select an attorney who can assist you in raising money for your new venture.
• Make sure your attorney has a track record of completing his or her work on time.
• Talk about fees.
• Select an attorney that you think understands your business and that you think you
will feel comfortable spending time with.
• Learn as much about the process of starting a business yourself as possible.

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Ethically Departing From a Former Employer
(1 of 2)

• Ethically Departing from an Employer

– Behave in a Professional Manner
• First, it is important that an employee give proper notice of an
intention to quit and that the employee perform all assigned duties
until the day of departure.
• If an employee is leaving a job to start a firm in the same industry,
it is vital that he or she not take information that belongs to the
current employer.
– Honor All Employment Agreements
• Honor all nondisclosure and noncompete agreements entered into
at the time of employment. (See next slide)

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Ethically Departing From a Former Employer
(2 of 2)

Nondisclosure Agreement Noncompete Agreement

Is a promise made by Prevents an individual

an employee or another from competing against
party to not disclose the a former employer for a
company’s trade specified period of
secrets. time.

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 Draft a Founders’ Agreement

• Founders’ Agreement
– A founders’ agreement (or shareholders’ 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 or the
“sweat equity” they put into the firm, and how long the
founders will have to remain with the firm for their shares
to fully vest.
– The items to include in the founders agreement are shown
on the following slide.

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Items to Include in a Founders’ Agreement

• Nature of the prospective business.

• A brief business plan.
• Identity and proposed titles of the founders.
• Legal form of business ownership.
• Apportionment of stock.
• Consideration paid for stock or ownership share of each of the founders.
• Identification of any intellectual property signed over to the business.
• Description of the initial operating capital.
• Buyback clause.

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 Avoiding Legal Disputes

• 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 an
entrepreneur should work hard to avoid.
– There are several steps that an entrepreneur can take to
avoid legal disputes:
• Meet all contractual obligations.
• Avoid undercapitalization.
• Get everything in writing.
• Promote business ethics.

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Choosing a Form of Business Ownership
When a business is launched, a form of legal entity must be chosen.
The most common legal entities are…

Sole Proprietorship Partnership

Limited Liability
Corporation
Company

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 Issues to Consider in Choosing a Legal
Form of Business Ownership
• The cost of setting up and maintaining the legal form
of ownership.
• The extent to which an entrepreneur can shield his or
her personal assets form the liabilities of the business.
• Tax considerations.
• The ease of raising capital.

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 Sole Proprietorship

• Sole Proprietorship
– The simplest form of business entity is the sole
proprietorship.
– A sole proprietorship is a form of business organization
involving one person, and the person and the business are
essentially the same.
– A sole proprietorship is not a separate legal entity. The
sole proprietor is responsible for all the liabilities of the
business, and this is a significant drawback.

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 Advantages and Disadvantages of a
Sole Proprietorship
(1 of 2)

Advantages of a Sole Proprietorship

 Creating one is easy and inexpensive.
 The owner maintains complete control of the business and retains all of 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.

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 Advantages and Disadvantages of a
Sole Proprietorship
(2 of 2)

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.

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 Partnerships

• 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.
• A general partnership is a form of business organization where two
or more people pool their skills, abilities, and resources to run a
business.
• A limited partnership is a modified form of general partnership.
The major difference between the two is that a limited partnership
includes two classes of owners: general partners and limited
partners. The general partners are liable for the debts and
obligations of the partnership, but the limited partners are liable
only up to the amount of their investment.

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 Advantages and Disadvantages of a
General Partnership
(1 of 2)

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).

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 Advantages and Disadvantages of a
General Partnership
(2 of 2)

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, the owners 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 with the death or withdrawal of one partner unless otherwise
stated in the partnership agreement.
 The liquidity of each partner’s investment is low.

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 Corporations
(1 of 2)

• Corporations
– A corporation 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 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 of
the corporation.

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 Corporations
(2 of 2)

• C Corporations (continued)
– A corporation is governed by a board of directors, which is
elected by the shareholders.
– A corporation is formed by filing articles of incorporation
with the secretary of state’s office in the state of
incorporation.
– A corporation is taxed as a separate legal entity.
• A disadvantage of corporations is that they are subject to double-
taxation, which means that a corporation is taxed on its net income
and, when the same income is distributed to shareholders in the
form of dividends, is taxed again on shareholders’ personal tax
returns.
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 Advantages and Disadvantages of a
C Corporation
(1 of 2)

Advantages of a C Corporation
 Owners are liable only for the debts and obligations of the corporation up 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 options or other
incentive plans can be a powerful form of employee motivation.

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 Advantages and Disadvantages of a
C Corporation
(2 of 2)

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.

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 Subchapter S Corporations
(1 of 2)

• 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.
– It is similar to a corporation in that the owners are not
subject to personal liability for the behavior of the
business.
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 Subchapter S Corporations
(2 of 2)

There are strict standards that a business must meet to qualify for status as a
subchapter S corporation. These standards are shown below.

 The business cannot be a subsidiary of another corporation.

 The shareholders must be U.S. citizens. Partnerships and C corporations may
not own shares in a subchapter S corporation. Certain types of trusts and
estates
are eligible to own shares in a subchapter S corporation.
 It can only have one class of stock issued and outstanding (either preferred
stock or common stock).
 It can have no more than 100 members. Husbands and wives count as one
member, even if they own separate shares of stock.
 All shareholders must agree to have the corporation formed as a subchapter
S corporation.

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 Limited Liability Company

• Limited Liability Company

– The limited liability company (LLC) is a form of business
organization that is rapidly gaining popularity in the U.S.
– Along with the subchapter S corporation, it is a popular
choice for start-up firms.
• 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.
– The LLC combines the limited liability advantage of the
corporation with the tax advantages of the partnership.
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 Advantages and Disadvantages of a
Limited Liability Company
(1 of 2)

Advantages of a Limited Liability Company

 Members are liable for the debts and obligations of the business only up to
the
amount of their investment.
 The number of shareholders is unlimited.
 An LLC can elect to be taxed as a sole proprietor, partnership, S corporation,
or corporation, providing much flexibility.
 Because profits are taxed only at the shareholder level, there is no double
taxation.

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 Advantages and Disadvantages of a
Limited Liability Company
(2 of 2)

Disadvantages of a Limited Liability Company

 Setting up and maintaining one is more difficult and expensive.
 Tax accounting can be complicated.
 Some of the regulations governing LLCs vary by state.
 Because LLCs are a relatively new type of business entity, there is not as
much legal precedent available for owners to anticipate how legal disputes
might affect their business.
 Some states levy a franchise tax on LLCs—which is essentially a fee the LLC
pays the state for the benefit of limited liability.

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