Chapter 7: Preparing a Proper Ethical and Legal Foundation
7-7.
What are some of the more important criteria to consider when selecting an
attorney for a new firm?
Answer: Table 7.3 in the textbook provides guidelines to consider when
selecting an attorney. 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.
7-8.
What is a founders’ agreement and why is it important for a team of
entrepreneurs to have one in place when launching a venture?
Answer: 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 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.
7-9.
What is the purpose of a nondisclosure agreement and the purpose of a
noncompete agreement?
Answer: A nondisclosure agreement is a promise made by an employee or
another party (such as a supplier) to not disclose a company’s trade secrets. A
noncompete agreement prevents an individual from competing against a former
employer for a specific period of time.
7-10.
How can entrepreneurial ventures avoid legal disputes?
Answer: Meet all contractual obligations on time, avoid undercapitalization, get
everything in writing, and promote business ethics.
7-11.
What is mediation and how do entrepreneurs use it to resolve disputes?
Answer: Mediation is a process in which an impartial third party (usually a
professional mediator) helps those involved in a dispute reach an agreement.
Note: Wikipedia has an excellent page on mediation.
7-12.
At what point, during the process of starting a firm, does a business need to
focus on the business licenses and permits that it needs, and why at that point?
Answer: Almost all licenses and permits must be in place before a business
launches. Business licenses and permits vary by city, so it’s important to check
local rules and ordinances. For example, some cities (and even neighborhoods
within cities) have very strict rules about putting up signs, whereas other cities
have lax rules.
between the two is that a limited partnership includes two classes of owners:
7-13.
Why is it important for the founders of a firm to think carefully about the name
they pick for their company?
MyLab Question.
7-14
Why isn’t choosing a legal entity a one-time event?
Answer: As a business grows and matures, it is necessary to periodically review
whether the current form of business organization remains appropriate.
7-15.
What might trigger a firm’s decision to change how it is legally organized?
Answer: A firm’s decision to change how it is legally organized might be
triggered by a shift in strategy, or by tax or legal issues.
7-16.
What are the advantages and disadvantages of organizing a new firm as a sole
proprietorship?
Answer: Advantages of organizing as a sole proprietorship: (1) creating one is
easy and inexpensive; (2) the owner maintains complete control of the business
and retains all the profits; (3) business losses can be deducted against the sole
proprietor’s other sources of income; (4) the business is not subject to double
taxation; and (5) the business is easy to dissolve.
Disadvantages of a sole proprietorship: (1) liability on the owner’s part is
unlimited; (2) the business relies on the skills and abilities of a single owner; (3)
raising capital can be difficult; (4) the business ends at the owner’s death or loss
of interest in the business; and (5) the liquidity of the owner’s investment is low.
7-17.
Is a sole proprietorship an appropriate form of ownership for an aggressive
entrepreneurial firm? Why or why not?
Answer: A sole proprietorship is not an appropriate form of ownership for an
aggressive entrepreneurial firm. An aggressive firm will probably need to raise
capital early in its life, which is not possible under the sole proprietorship form
of ownership (i.e., equity can’t be shared with others). A sole proprietorship also
needlessly exposes an entrepreneur to personal liability for the actions of the
firm.
7-18.
What are the differences between a general partnership and a limited
partnership?
Chapter 7: Preparing a Proper Ethical and Legal Foundation
general partners and limited partners. The general partner is liable for the
behavior of the firm. The limited partners are liable only up to the amount of
their investment.
7-19.
What are the major advantages and disadvantages of a C corporation?
Answer: 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 on the number of
shareholders; stock is liquid if traded on a major stock exchange; and 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 include: 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; and small shareholders typically have little voice in the
management of the firm.
7-20.
How is a C corporation subject to double taxation?
Answer: 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 income tax returns.
7-21.
What is the difference between preferred stock and common stock?
Answer: 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.
7-22.
What is meant by the term piercing the corporate veil and what are the
implications for the owners of a corporation if the corporate veil is pierced?
regulations pertaining to a corporation. If the owners of a corporation don’t file
their annual paperwork, neglect to pay their annual fees, or commit fraud, a court
Chapter 7: Preparing a Proper Ethical and Legal Foundation
could be held personally liable for actions of the corporation. This chain of
events is referred to as piercing the corporate veil.
7-23.
What are the differences among a public corporation, a closely held corporation,
and a private corporation?
Answer: Public corporations are firms that are listed on a major stock exchange,
such as the New York Stock Exchange or the Nasdaq. Closely held corporations
are firms that are owned by a small number of individuals and the corporation’s
stock is very thinly or infrequently traded. Private corporations are firms in
which all the shares are held by a few shareholders, such as management and
family members, and are not publicly traded. Public corporations enjoy the
highest level of liquidity for its stock.
7-24.
What are stock options and why would a corporation offer stock options to its
employees?
Answer: Stock options are a special form of incentive compensation. These plans
provide employees the option or right to buy a certain number of shares of their
company’s stock at a stated price over a certain period of time. The most
compelling advantage of stock options is the potential rewards to participants
when (and if) the stock price increases. As employees accumulate stock options,
the link between their potential reward and their company’s stock price becomes
increasingly clear. This link provides a powerful inducement for employees to
exert extra effort on behalf of their firms in hopes of positively affecting the
stock price.
7-25.
What are the advantages and disadvantages of a limited liability company?
Answer: 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;
and because profits are taxed only at the shareholder level, there is no double
taxation.
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 limited liability companies vary by state; because LLCs
are a relatively new type of business entity, there is not as much legal precedent
and some states level a franchise tax on LLCs—which is essentially a fee the
LLC pays the state for the benefit of limited liability.
Chapter 7: Preparing a Proper Ethical and Legal Foundation
Answer: A limited liability company is an appropriate form of ownership for an
aggressive entrepreneurial firm. It is a more suitable form of ownership than a
sole proprietorship or a general partnership for raising money, it shields its
owners from personal liability, and it avoids the double taxation complication of
a C corporation.
APPLICATION QUESTIONS
7-27.
Under what circumstances should ethical considerations be part of a company’s
business plan? Should a company periodically measure its ethical performance?
If so, what are the best ways for a firm to do this?
Answer: Ethical considerations should be an integral part of a company’s
business plan. Particularly if the company deals with client privacy, public
safety, is safeguarding clients’ money or other resources, or is involved in a
similar activity. It’s important for a company to assert that it plans to adopt high
ethical standards and explain how high ethical standards will be implemented
and institutionalized. There are various methods that a company can utilize to
measure its ethical performance. One set of methods is based on external
feedback, such as counting the number of complaints it receives or the number of
fines it is subject to. Other methods are based on internal feedback, such as
administering confidential surveys to ask employees how many times they’ve
committed ethical breaches or how many times they’ve observed coworkers
committing ethical breaches.
7-28.
Tom Andersen owns an electronics firm in Wichita, Kansas. He has told you that
he has been suffering some cash flow problems recently, but has avoided having
to borrow money by letting some of his firm’s bills run late. When you raised
your eyebrows in response to hearing these comments from Tom, he said, “Don’t
worry. I’m really not nervous about this situation in that I have some large orders
coming in soon. I’ll use the cash from these orders to catch up on my bills.”
Does what Tom told you seem to be a sound strategy for him to follow? What
are the downsides associated with how Tom is approaching his cash flow issues?
Answer: Tom does not have a good strategy. One way to avoid legal disputes,
and keep one’s reputation intact, is to pay all of your bills on time. If an
obligation can’t be met on time, the problem should be communicated to the
affected parties as soon as possible. Tom’s strategy will irritate everyone
involved, and it’s just not good business—even if he ultimately makes good on
his obligations.
S corporation or an LLC; however, Kimberly does not know if the article’s
Chapter 7: Preparing a Proper Ethical and Legal Foundation
contents apply to her and her situation or not. Currently, she is organized as a
sole proprietorship and doesn’t know if it is appropriate or advisable for a
freelance journalist to set up a subchapter S corporation or an LLC. Kimberly
has turned to you for advice. What advice would you offer to her regarding the
issue at hand?
Answer: Kimberly should set up a subchapter S corporation or an LLC. There is
no downside and substantial upside to a subchapter S corporation or an LLC
over a sole proprietorship.
7-30.
DipJar is the focus of the “You Be the VC 7.1” feature. Assume that this firm’s
founders have asked you to help them write a code of conduct for their firm.
Given your understanding of how DipJar operates as an entrepreneurial venture,
put together a table of contents for the firm’s code of conduct.
Answer: DipJar provides devices to enable money collection via credit or debit
cards. As an example, a DipJar device will help a Salvation Army volunteer who
collects money from passersby. Since fewer people are carrying cash in an
increasingly cashless society, DipJar enables people without cash to contribute
via their card.
This is a good exercise for a team project. Table 7.2 in the chapter is a helpful
resource because it outlines Facebook’s code of conduct’s table of contents.
7-31.
Nancy Wills is purchasing a business named Niagara Laser Optics that is located
near Buffalo, New York. The business has had several brushes with the law
during the past several years, dealing with claims of false advertising and
wrongful termination of employees. As a result, Nancy is quite concerned about
the firm’s ethical culture. What specific techniques could Nancy use to increase
the emphasis placed on business ethics when she takes control of the firm she
has purchased?
Answer: There are at least four techniques that Nancy could use.
Put in place a set of procedures to help avoid legal complications. These
procedures are explained in the chapter, and include meeting contractual
obligations, avoiding undercapitalization, getting everything in writing, and
setting ethical standards.
Develop a code of ethics and stick to it.
Provide employees ethics training on an ongoing basis.
Consult with an attorney on any ethics-related issues that are worrisome or
unclear.
7-32.
You have been approached by a close family friend who is putting together a
Chapter 7: Preparing a Proper Ethical and Legal Foundation
each invest $10,000 in his company. The condominium complex is for sale for
$5 million. Your friend hopes to convince 50 people to invest $10,000 apiece,
which will raise $500,000; he intends to borrow the remaining $4.5 million to
close the deal. “I don’t mind investing the $10,000, but I’m really nervous about
being on the hook for a $4.5 million loan if the deal goes bad,” you note to your
friend. In response, he insists that all you would have at risk is $10,000 and that
you would not be liable for anything else. Is your friend right or wrong about
this?
Answer: Your friend is right. If the LLC is set up right, you are only liable up to
the amount of your investment.
7-33.
Laura Simpson just took a job with Cisco Systems in San Jose, CA. One of the
attractions of this job is the stock option plan Cisco offers to its employees. What
is meant by the term stock option? Why would Cisco, as well as other
companies, choose to offer stock options to its employees?
Answer: Stock options are a special form of incentive compensation. These plans
provide employees the option or right to buy a certain number of shares of their
company’s stock at a stated price over a certain period of time. The most
compelling advantage of stock options is the potential rewards to participants
when (and if) the stock price increases. Many employees receive stock options at
the time they are hired and then periodically receive additional options. As
employees accumulate stock options, the link between their potential reward and
their company’s stock becomes increasingly clear. This link provides a powerful
inducement for employees to exert extra effort on behalf of their firm in hopes of
positively affecting the stock price.
7-34.
If you launched a start-up venture before graduating with your degree, why
would you or why would you not offer stock options to your employees?
Answer: Most students will say that they would offer stock options. The case in
favor of issuing stock options is that it helps a firm attract high quality
employees. It’s also a form of employee motivation. As employees accumulate
stock options, the link between their potential rewards and their company’s stock
price becomes increasingly clear.
YOU BE THE VC 7.1
Company: GiveForward (www.giveforward.com)
Business Idea: Launch a crowdfunding platform that allows people to send financial
Chapter 7: Preparing a Proper Ethical and Legal Foundation
155
You Be the VC Scorecard
GiveForward
(www.giveforward.com)
Score/Comments
1 2 3 4 5
GiveForward was started by Desiree Vargas Wrigley
and Ethan Austin. Wrigley graduated from Yale in 2004,
and prior to GiveForward worked at the Kauffman
Foundation. Austin previously worked for DealGooder,
a Web-based platform that connects socially conscious
shoppers, businesses, and charitable organizations and
Climate Cycle, a nonprofit focused on climate and
sustainability issues.
1 2 3 4 5
The opportunity is large. Uncertainties surrounding
health insurance coverages and the aging of the
population suggest that an increasing number of people
will experience financial stress paying for medical
procedures and emergencies. By creating a
crowdfunding platform that is restricted to medical
fundraising, GiveForward has become the #1 site in its
niche. It is also the only medical fundraising site that
provides guidance and coaching for how to raise money
via its site. Since 2009, the site has helped its users raise
more than $15 million in donations.
Strength of the Industry
1 2 3 4 5
Medical fundraising is a growing industry.
1 2 3 4 5
GiveForward takes a 7 percent commission on funds
raised via its site. Of that amount, it keeps 4.5 percent
and 2.5 percent goes to PayPal. The site is a rallying
point for those in need. As the GiveForward brand
becomes better known, it is hosting increasingly high-
profile fundraising drives. For example, the family of
Canadian freestyle skier Sarah Burke, who died in a
training accident, raised more than $250,000 via
Chapter 7: Preparing a Proper Ethical and Legal Foundation
156
GiveForward in just one day to cover expenses related to
her care.
GiveForward is a for-profit organization. Its founders
believe in a dual purpose of doing good and making
money. In addition, if GiveForward were a nonprofit
organization, it would not be able to help individuals
(who are not affiliated with a nonprofit organization)
raise funds to pay for personal expenses.
We do worry about the sustainability of GiveForward’s
7 percent commission. That number seems high to us.
Average Score
3.5/5.0
Decision: This is a tough one. There is a lot to like about GiveForward. Although its
management team is inexperienced, we like their backgrounds and their obvious passion
for what they are doing. Crowdfunding is growing in importance and popularity, and we
like the niche that GiveForward is in. At the end of the day, we decided not to fund the
YOU BE THE VC 7.2
Company: DipJar (www.dipjar.com)
Business Idea: Create a hardware device that makes it easy for people to use credit or
debit cards to leave tips for service workers or donate to a nonprofit organization, such as
the Salvation Army or the public library.
You Be the VC Scorecard
DipJar
(www.dipjar.com)
Score/Comments
1 2 3 4 5
Ryder and Judd Kessler and Jordan Bar Am founded
DipJar in 2012. They have raised seed capital of $2.82
Chapter 7: Preparing a Proper Ethical and Legal Foundation
million through two rounds. Ryder has a corporate
background, Judd has an academic background and it
appears that this is Jordan’s first management job. They
have hired an outsider as the COO.
Strength of the Opportunity
1 2 3 4 5
The opportunity is moderate at best. From their Web site
it appears that they are pushing the fund raising side
more than sales of their device to restaurants and other
for-profit outlets. Their product works best for an
organization like the Salvation Army that collects small
amounts from multiple donors. It is unclear how big an
opportunity is from other types of charity organizations.
1 2 3 4 5
There is no formal industry to speak of as DipJar has
entered a space where the option is dropping bills or
coins into a jar. It is hard to evaluate the industry when
DipJar is a pioneer.
1 2 3 4 5
DipJar is rolling out a disruptive business model, with
the disruptee being the jar for people to deposit money
in! It charges charity organizations to buy the device.
This may be an obstacle as such organizations have
resource constraints.
3.25/5.0
CASES
Case 7.1
Chapter 7: Preparing a Proper Ethical and Legal Foundation
DISCUSSION QUESTIONS
7-39.
Complete Jack and Sarah’s list for them, including the issues you think they will
place on the list along with their recommendations. Which of the issues do you
think will stimulate the most discussion with the attorney, and which issues do
you think will stimulate the least?
Answer: This is an excellent question for an individual or group assignment.
Jack and Sarah’s list will invariably include topics pertaining to drafting a
founders’ agreement, writing nondisclosure and noncompete agreements for
future employees, deciding how the initial ownership in the company will be
divided, determining the business licenses and permits they will need, and
choosing a form of business ownership. They may also talk about ethics-related
issues.
7-40.
What are some of the actions Jack and Sarah took prior to meeting with the
attorney that are appropriate for them to have taken?
Answer: Most students will argue that Jack and Sarah did the following things
right for their meeting with the attorney:
They obtained a referral before they selected an attorney.
They picked an attorney that specializes in small business.
They scheduled an appointment with the attorney.
They were well prepared for their meeting with the attorney.
They e-mailed the attorney a list of the issues they wanted to talk about
ahead of the meeting.
7-41.
Is it too early for Jack and Sarah to begin laying an ethical foundation for their
proposed venture? If not, what steps could they take now as a foundation for an
ethical culture within their firm?
Answer: No, it is not too early for Jack and Sarah to begin laying an ethical
foundation for their proposed venture. The steps they can take are the ones
articulated in the chapter: Lead by Example, Establish a Code of Conduct, and
Implement an Ethics Training Program. They already have an attorney, which is
an excellent step. It will help their company get off to a good legal start. They
should also have a founders’ agreement and take steps to avoid legal disputes.
7-42.
What advantages do Jack and Sarah have starting iUser Accessories together,
rather than one of them starting it as a sole entrepreneur?
Answer: It is generally believed that new ventures started by a team have an
advantage over those started by an individual because a team brings more talent,
resources, ideas, and professional contacts to a new venture than does a sole
entrepreneur. The difficulties Jack and Sarah might encounter are deciding how
Chapter 7: Preparing a Proper Ethical and Legal Foundation
to split ownership in the firm (50/50 ownership leaves no one clearly in charge)
and deciding how to resolve differences in opinion that will invariably emerge.
7-43.
Based on information featured in the case, what challenges do you think Jack
and Sarah will have keeping their partnership active?
Answer: Jack and Sarah are young, so their interests may diverge over time. This
is all the more reason to have a founders’ agreement. If a business’s founders
anticipate up-front that there may come a day when they will go their separate
ways, the founders’ agreement will spell out how their individual shares in the
firm will be dealt with. Jack and Sarah may also feel pressure from their
individual families. Recall, they each received investments of $30,000 apiece
from family members. If the businesses doesn’t pan out as well as expected,
either Jack or Sarah’s family may urge them to sell the business or to ask the
remaining partner to buy them out.
Case 7.2
Peloton Cycle and DonorsChoose: How For-Profit and Nonprofit Start-Ups Build
Credibility and Trust
DISCUSSION QUESTIONS
7-44.
Why is building credibility, legitimacy, and trust particularly important for a
start-up venture, regardless of whether it is a for-profit or a nonprofit
organization?
Answer: Take the case of Peloton. It is a new product that is quite pricey ($1,195
for the bike plus a monthly subscription for the service) and a key aspect of it is
the community-type benefit it enables. Both for selling the product and for
growing as a start-up, an organization – be it Peloton or DonorsChoose – needs
credibility for it to interact with stakeholders.
7-45.
How can building trust and credibility help start-up organizations avoid legal
disputes and problems?
Answer: There are at least two ways that building credibility or trust can help a
firm or organization avoid legal disputes. First, there is evidence to suggest that
when firms present themselves as being very credible and are willing to say
they’re “sorry” when mishaps happen, they are less likely to get sued. In
particular, a May 8, 2008 article in the New York Times titled “Doctors Say ‘I’m
Sorry’ Before ‘See You in Court’” reported that doctors and hospitals that
readily admit mistakes see dramatic drops in lawsuits and legal costs. Second,
the process of building credibility and trust is likely to make a firm more
sensitive to ethics-related issues and instills a culture of high ethical standards in
Chapter 7: Preparing a Proper Ethical and Legal Foundation
a firm. It is even better if a firm puts actual accountability measures in place to
track ethics-related compliance.
7-46.
As related to ethics and ethical behavior, what are the characteristics you
anticipate are associated with the cultures at Peloton Cycle and DonorsChoose?
Answer: Both Peloton and DonorsChoose place their core values front and
center in everything they do. Peloton has allowed many news outlets and reports
to ask questions and examine its operations. Its Web site features video
testimonials of real clients telling their stories. It also offers a 100 percent
money-back guarantee on all its products. All of these actions depict an
organization that has firm beliefs and is not at all reluctant to have others
examine what it is doing.
DonorsChoose’s core belief is that donors have priorities to funding specific
types of projects and they are more likely to fund if they know where their
money is going. DonorsChoose is not reluctant to have others examine what it is
doing, as evidenced by the number of news outlets and reporters who have
written about the company and its projects. It has aligned itself with high profile
people, who have placed their stamp of approval on its cause and the
organization itself. It also disseminates statistics about the various projects,
which legitimizes the cause it is working so hard to positively impact. All of
these actions depict an organization with a strong ethical culture that it is
consistently reinforcing.
7-47.
Do some additional research on Peloton Cycle and DonorsChoose, and describe
some of the actions its founder or founders have taken (focus on John Foley for
Peloton and Charles Best for DonorsChoose) to lead by example in terms of
helping their organizations build credibility and trust.
Answer: This is a good project for student teams.