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CHAPTER 7
PREPARING THE PROPER ETHICAL AND LEGAL FOUNDATION
LEARNING OBJECTIVES
1.
Discuss the actions founders can take to establish a strong ethical culture in their
entrepreneurial ventures.
2.
Describe actions taken in new firms to effectively deal with legal issues.
3.
Provide an overview of the business licenses and permits that a start-up must
obtain before it begins operating.
4.
Identify and describe the different forms of organization available to new firms.
CHAPTER OVERVIEW
This chapter focuses on the ethical and legal challenges involved with starting a firm.
Most entrepreneurs overestimate their knowledge of the legal issues involved with
starting and running a business. As a result, it is necessary for an entrepreneur to
thoroughly review the legal issues involved to make sure that a costly mistake isn’t made.
The chapter begins by discussing the most important ethical and legal issues facing a new
firm, including establishing a strong ethical culture for the firm, choosing an attorney,
drafting a founder’s (or shareholder’s) agreement, and avoiding legal disputes. The
chapter next discusses the licenses and permits that businesses need before they can start
conducting business. The chapter ends with a discussion of the different forms of
business organization available to new firms, including sole proprietorships, partnerships,
corporations, and limited liability companies.
CHAPTER OUTLINE
I. Establishing a Strong Ethical Culture for a Firm
A. Lead by Example
B. Establish a Code of Conduct
C. Implement an Ethics Training Program
II. Dealing Effectively with Legal Issues
A. Choosing an Attorney for a Firm
B. Drafting a Founders Agreement
C. Avoiding Legal Disputes
1. Meet All Contractual Obligations
2. Avoid Undercapitalization
3. Get Everything in Writing
4. Set Standards
III. Obtaining Business Licenses and Permits
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A. Federal Licenses and Permits
B. State Licenses and Permits
1. Business Registration Requirements
2. Sales Tax Permits
3. Professional and Occupational Licenses and Permits
C. Local Licenses and Permits
IV. Choosing a Form of Business Organization
A. Sole Proprietorship
1. Advantages of a Sole Proprietorship
2. Disadvantages of a Sole Proprietorship
B. Partnerships
1. General Partnerships
2. Advantages of a General Partnership
3. Disadvantages of a General Partnership
4. Limited Partnerships
C. Corporations
1. C Corporations
2. Advantages of a C Corporation
4. Subchapter S Corporation
D. Limited Liability Company
1. Advantages of a Limited Liability Company
2. Disadvantages of a Limited Liability Company
CHAPTER NOTES
I. Establishing a Strong Ethical Culture for a Firm
As the opening case suggests, new ventures must deal with important ethical and
• And there is a tendency for entrepreneurs to overestimate their knowledge of the
law.
A. Lead by Example
1. Leading by example is the most important thing that any entrepreneur,
manager, or supervisor can do to build an ethical culture in their organization.
B. Establish a Code of Conduct
1. A code of conduct is a formal statement of an organization’s values on
certain ethical and social issues.
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2. 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.
C. Implement an Ethics Training Program
1. Ethics training programs teach business ethics to help employees deal with
ethical dilemmas and improve overall ethical conduct.
a. An ethical dilemma is a situation that involves doing something that is
beneficial to oneself or the organization, but may be unethical. Ethics
training programs are designed to help employees resolve ethical
dilemmas in an appropriate manner.
b. Ethics training programs can be provided by outside vendors or can be
developed in-house.
II. Dealing Effectively with Legal Issues
A. Choosing an Attorney for a Firm
1. It is important for an entrepreneur to select an attorney as early as possible
when developing a business venture. Table 7.3 in the textbook provides
guidelines to consider when selecting an attorney.
2. 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.
3. Many attorneys recognize that start-ups are short on cash and will work out an
installment plan or other payment arrangement to get the firm the legal help it
needs without starving it of cash.
4. The following are several ways for entrepreneurs to save on legal fees.
a. Group together legal matters.
B. Drafting a Founders’ Agreement
1. 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
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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.
2. Most founders’ agreements include a buyback clause, which legally obligates
the departing founder to sell his or her interest in the firm to the remaining
founders if they are interested.
3. The presence of a buyback clause is important for at least two reasons. First, if
a founder leaves the firm, the remaining founders may need the shares to offer
C. 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. There are several steps
entrepreneurs can take to avoid legal disputes and complications.
1. 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.
2. Avoid undercapitalization. If a new business is starved for money, it is much
more likely to experience financial problems that will lead to litigation.
3. 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.
4. Set standards. Organizations should also set standards that govern employees’
behavior beyond what can be expressed via a code of conduct.
a. When legal disputes do occur, they can often be settled through
negotiation or mediation, rather than more expensive and potentially
damaging litigation.
b. Mediation is a process in which an impartial third party (usually a
professional mediator) helps those involved in a dispute reach an
agreement.
III. Obtaining Business Licenses and Permits
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Before a business is launched, a number of licenses and permits are typically needed.
What is actually needed varies by city, country, and state, as well as by type of
business, so it’s important for the entrepreneur to study local regulations carefully.
A. Federal Licenses and Permits
1. Most businesses do not require a federal license to operate, although some do.
Table 7.5 in the chapter contains a partial list of the business activities that
require a federal license or permit, along with the federal agency to contact
and its Web site address.
2. Seemingly simple businesses sometimes require more licenses and permits
B. State Licenses and Permits
1. Business Registration Requirements
a. Some states require all new businesses to register with the state.
2. Sales Tax Permits
a. Most states and communities require businesses that sell goods, and in
3. Professional and Occupational Licenses and Permits
a. 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.
b. Examples include barbers, chiropractors, nurses, tattoo artists, land
C. Local Licenses and Permits
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1. On the local level, there are two categories of licenses and permits that may be
needed.
2. The first is a permit to operate a certain type of business. Examples include
childcare, barber shops and salons, automotive repair, and hotels and motels.
3. In addition to obtaining the proper licenses and permits, if you plan to use a
IV. Choosing a Form of Business Organization
• When a business is launched, a form of legal entity must be chosen. The most
common legal entities are sole proprietorship, partnership, corporations, and
limited liability companies.
• There is no single form of business ownership that works best in all situations. It
is up to the owners of a firm and their attorney to select the legal entity that best
meets their needs.
• The decision typically hinges on several factors, including the following:
• The cost of setting up and maintaining the legal form
A. Sole Proprietorship
2. Setting up a sole proprietorship is cheap and relatively easy compared to the
3. A sole proprietorship is not a separate legal entity. For tax purposes, the
profits or losses of the business flow through to the owner’s personal tax
return.
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4. The primary advantages and disadvantages of a sole proprietorship are as
follows:
a. Advantages of a Sole Proprietorship
i. Creating one is easy and inexpensive.
ii. The owner maintains complete control of the business and retains all
the profits.
b. Disadvantages of a Sole Proprietorship
i. Liability on the owner’s part is unlimited.
ii. The business relies on the skills and abilities of a single owner to be
successful.
B. Partnerships
1. Partnerships are organized as either general or limited partnership.
a. 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 advantages and disadvantages of a general partnership are as
follows:
i. Advantages of a General Partnership
a) Creating one is relatively easy and inexpensive compared to a
corporation or limited liability company.
b) The skills and abilities of more than one individual are available to
the firm.
ii. Disadvantages of a General Partnership
a) Liability on the part of each general partner is unlimited.
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b) The business relies on the skills and ability of a fixed number of
partners.
c) Raising capital can be difficult.
d) Because decision making among the partners is shared,
disagreements can occur.
2. 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.
a. Similar to a general partnership, the general partners are liable for the
debts and obligations of the partnership, but the limited partners are liable
C. Corporations
1. A corporation is a separate legal entity organized under the authority of a
state.
2. Corporations are organized as either C corporations or subchapter S
corporations.
a. A C corporation is a separate legal entity that, in the eyes of the law, is
separate from its owners.
b. A corporation is formed by filing articles of incorporation with the
secretary of state’s office in the state of incorporation.
c. If the owners of a corporation don’t file their annual paperwork, neglect to
pay their annual fees, or commit fraud, a court could ignore the fact that a
corporation has been established, and the owners could be held personally
again on shareholders’ personal income tax returns.
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e. The following are the advantages and disadvantages of a C corporation.
i. Advantages of a C Corporation
a) Owners are liable only for the debts and obligations of the
corporation up to the amount of their investment.
b) The mechanics of raising capital is easier.
c) No restrictions exist on the number of shareholders, which differs
motivation.
ii. Disadvantages of a C Corporation
a) Setting up and maintaining one is more difficult than for a sole
proprietorship or a partnership.
b) Business losses cannot be deducted against the shareholders’ other
sources of income.
c) Income is subject to double taxation, meaning that it is taxed at the
corporate and the shareholder levels.
d) Small shareholders typically have little voice in the management of
the firm.
f. 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.
i. Standards to Qualify for a Subchapter S Corporation
a) The business cannot be a subsidiary of another corporation.
b) 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 C corporation.
c) It can have only one class of stock issued and outstanding (either
preferred stock or common stock).
D. Limited Liability Company
1. The limited liability company is a form of business organization that is rapidly
gaining popularity in the United States.
Chapter 7: Preparing a Proper Ethical and Legal Foundation
2. 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.
3. 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.
4. The advantages and disadvantages of an LLC are as follows:
a. Advantages of a Limited Liability Company
i. Members are liable for the debts and obligations of the business only
up to the amount of their investment.
ii. The number of shareholders is unlimited.
iii. An LLC can elect to be taxed as a sole proprietor, partnership, S
b. Disadvantages of a Limited Liability Company
i. Setting up and maintaining one is more difficult and expensive.
as much legal precedent available for owners to anticipate how legal
disputes might affect their business.
v. Some states levy a franchise tax on LLCs—which is essentially a fee
the LLC pays the state for the benefit of limited liability.
BOXED FEATURES: QUESTIONS FOR CRITICAL THINKING
What Went Wrong?
How Flytenow Got Grounded by Government Regulations
1.
Which side do you agree with in this case – Flytenow or the FAA? Explain your
answer.
Answer: Students will vary in their responses to this question. On the one hand,
Flytenow should have gotten a ruling from the FAA before launching its business.
Some students will argue, though, that Flytenow is only organizing what was an
unorganized practice in the industry (pilots posting for riders to share costs) and
therefore, should be allowed to continue. It comes down to an interpretation of
law.
Chapter 7: Preparing a Proper Ethical and Legal Foundation
2.
If you started a business in an industry you weren’t intimately familiar with, how
would you go about determining the proper licenses and permits to obtain, and
whether there are additional government regulations that affect the product or
service you plan to offer?
Answer: The best approach would be engage the services of an industry consultant
or an attorney who practices in that area. In today’s age, a lot of the information is
available on the Web.
3.
If you were starting an aviation-related company, how would you go about
locating an attorney that specialized in aviation law?
Answer: One approach is to contact the local bar association and find out if they
have a database of lawyers specializing in aviation law. The trade association for
the aviation industry may also be a good source.
4.
Do you think the founders of Flytenow will find a way to resurrect the service, or
do you think the company is permanently out of business? Explain your answer.
Answer: Answers will vary. Flytenow’s future may depend on changes in
regulations and laws or having a good team of lawyers to appeal the court’s ruling.
Savvy Entrepreneurial Firm
Don’t Hesitate to Say “We’re Sorry”
1.
On a scale of 1-10 (10 is high), how important is transparency, fairness, and
honesty for a firm such as Zendesk? What does a firm have to lose if its customers
feel it is subpar on these qualities?
Answer: Most students will make the point that transparency, fairness and honesty
is important for all firms, and not just those like Zendesk. Zendesk is a start-up and
it sells its service via subscriptions. It is a software company that works closely
with customers and customer data. It goes to say that the three attributes are
extremely important for the long-term viability of Zendesk.
2.
Why do you think Svane’s first message to Zendesk’s customers didn’t work?
Why do you think the second message did?
Answer: As Svane indicates in the case, relationships are not about reasoning, but
about being receptive to feelings. The first letter’s tone was likely all logical
reasoning to justify the price increase. The second one focused on relationship
building.
3.
In the end, to what degree do you think Zendesk handled its crisis appropriately?
Answer: It did handle the crisis appropriately because it got over it and grew as a
company.
4.
What can entrepreneurial firms learn from Zendesk’s experience? What did you
learn from it?
Answer: The key take away is that a firm’s relationship with its customers is
critical and a firm has to be honest, fair, and transparent in dealing with them.
Partnering for Success
Vesting Ownership in Company Stock: A Sound Strategy for Start-Ups
1.
Investors are often criticized for insisting that a vesting schedule be put in place
for stock that’s issued to employees. After reading this feature, do you think this
criticism is justified? If a company anticipated that it will never take money from
an investor, is it still a good idea to establish a vesting schedule? Explain your
answer.
Answer: Most students will see the value in a vesting schedule, side with
investors, and state that they don’t agree that the criticism is justified.
Additionally, the first two of the three reasons vesting makes sense articulated in
the article apply whether a firm takes money from an investor or not. Vesting helps
keep employees motivated and engaged. In addition, if an employee’s departure is
acrimonious, there isn’t any squabbling about how many shares the employee will
leave with—the answer to this question is spelled out in the vesting schedule.
2.
Why do you think start-ups launch and distribute stock to founders and others
members of their new-venture team without vesting schedules?
Answer: Typically, this would happen only if (1) the people involved were
uninformed or (2) the people involved wanted their shares vested all at once. The
second reason is ill-advised, for the reasons described in the feature.
3.
Is it typically necessary to hire an attorney to establish a vesting schedule for an
entrepreneurial venture or can the new firm do it on its own?
Answer: A firm can do it on its own, but it is best to hire an attorney to do it.
4.
Given your reading of this feature, explain how you think employees who own
shares of a newly-launched firm would view themselves as partners in such a
situation?
Chapter 7: Preparing a Proper Ethical and Legal Foundation
Answer: The idea of vesting is that shares of stock are given gradually when they
are “earned.” This means employees who get vested stock can view themselves as
partners who help the firm grow and are rewarded for it.
REVIEW QUESTIONS
7-1
When should your friend, who is considering launching a consulting firm to
provide financial services to small businesses, think about the ethical climate she
wants to establish in her venture?
Answer: Before the firm is launched.
7-2.
Based on the information included in this chapter, in general, do entrepreneurs
tend to overestimate or underestimate their knowledge of the laws that pertain to
starting a new firm, and why?
Answer: In general, entrepreneurs tend to overestimate their knowledge of the
law. As a result, entrepreneurs should seek legal advice before they start a firm,
and also read books and study Web sites to acquaint themselves with the most
pertinent legal issues they will confront.
7-3.
Why is it important for an entrepreneur to build a strong ethical culture for his or
her firm?
Answer: Ethical errors early on can be extremely costly for a new firm, in terms
of its reputation and its ability to forge favorable business partnerships.
7-4.
What are some of the specific steps that can be taken in an entrepreneurial
venture for the purpose of building a strong ethical culture?
Answer: Some specific steps an entrepreneurial venture can take to build a
strong ethical culture are: lead by example, establish a code of conduct, and
implement an ethics training program.
7-5
What is the purpose of a code of conduct?
Answer: A code of conduct describes the firm’s general value system, moral
principles, and specific ethical rules that apply in a particular business. The
purpose is to promote a healthy climate of business ethics in a firm. It can also
help a firm avoid litigation.
7-6.
What is the purpose of establishing and using an ethics training program in an
entrepreneurial firm?
MyLab Question.