of 26
Chapter 7: Preparing a Proper Ethical and Legal Foundation
CHAPTER 7
PREPARING THE PROPER ETHICAL AND LEGAL FOUNDATION
LEARNING OBJECTIVES
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
4. Set Standards
III. Obtaining Business Licenses and Permits
Chapter 7: Preparing a Proper Ethical and Legal Foundation
2. Disadvantages of a Limited Liability Company
CHAPTER NOTES
• And there is a tendency for entrepreneurs to overestimate their knowledge of the
law.
A. Lead by Example
1. A code of conduct is a formal statement of an organization’s values on
Chapter 7: Preparing a Proper Ethical and Legal Foundation
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
4. The following are several ways for entrepreneurs to save on legal fees.
a. Group together legal matters.
1. A founders’ agreement (or shareholders’ agreement) is a written document
Chapter 7: Preparing a Proper Ethical and Legal Foundation
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
to a replacement person. Second, if founders leave because they are
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.
Chapter 7: Preparing a Proper Ethical and Legal Foundation
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.
Chapter 7: Preparing a Proper Ethical and Legal Foundation
• 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
• The extent to which an entrepreneur can shield his or her personal assets from
the liabilities of the business
• Tax considerations
• The ease of raising capital
A. Sole Proprietorship
Chapter 7: Preparing a Proper Ethical and Legal Foundation
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.
iii. Business losses can be deducted against the sole proprietor’s other
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.
c) Having more than one owner may make it easier to raise funds.
Chapter 7: Preparing a Proper Ethical and Legal Foundation
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
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
liable for actions of the corporation. This chain of events is referred to as
“piercing the corporate veil.”
d. 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
income is distributed to shareholders in the form of dividends, is taxed
again on shareholders’ personal income tax returns.
Chapter 7: Preparing a Proper Ethical and Legal Foundation
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
from subchapter S corporations.
1. The limited liability company is a form of business organization that is rapidly
Chapter 7: Preparing a Proper Ethical and Legal Foundation
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
corporation, or corporation—providing much flexibility.
iv. Because profits are taxed only at the shareholder level, there is no
double taxation.
b. Disadvantages of a Limited Liability Company
i. Setting up and maintaining one is more difficult and expensive.
ii. Tax accounting can be complicated.
iii. Some of the regulations governing LLCs vary by state.
iv. 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.
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
1.
Which side do you agree with in this case – Flytenow or the FAA? Explain your
answer.
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?
3.
If you were starting an aviation-related company, how would you go about
locating an attorney that specialized in aviation law?
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.
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?
2.
Why do you think Svane’s first message to Zendesk’s customers didn’t work?
Why do you think the second message did?
Chapter 7: Preparing a Proper Ethical and Legal Foundation
3.
In the end, to what degree do you think Zendesk handled its crisis appropriately?
4.
What can entrepreneurial firms learn from Zendesk’s experience? What did you
learn from it?
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.
2.
Why do you think start-ups launch and distribute stock to founders and others
members of their new-venture team without vesting schedules?
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?
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
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?
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?
7-3.
Why is it important for an entrepreneur to build a strong ethical culture for his or
her firm?
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?
7-5
What is the purpose of a code of conduct?
7-6.
What is the purpose of establishing and using an ethics training program in an
entrepreneurial firm?
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?
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?
7-9.
What is the purpose of a nondisclosure agreement and the purpose of a
noncompete agreement?
7-10.
How can entrepreneurial ventures avoid legal disputes?
7-11.
What is mediation and how do entrepreneurs use it to resolve disputes?
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?
Chapter 7: Preparing a Proper Ethical and Legal Foundation
7-13.
Why is it important for the founders of a firm to think carefully about the name
they pick for their company?
7-14
Why isn’t choosing a legal entity a one-time event?
7-15.
What might trigger a firm’s decision to change how it is legally organized?
7-16.
What are the advantages and disadvantages of organizing a new firm as a sole
proprietorship?
7-17.
Is a sole proprietorship an appropriate form of ownership for an aggressive
entrepreneurial firm? Why or why not?
7-18.
What are the differences between a general partnership and a limited
partnership?
Chapter 7: Preparing a Proper Ethical and Legal Foundation
7-19.
What are the major advantages and disadvantages of a C corporation?
7-20.
How is a C corporation subject to double taxation?
7-21.
What is the difference between preferred stock and common stock?
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?
Chapter 7: Preparing a Proper Ethical and Legal Foundation
7-23.
What are the differences among a public corporation, a closely held corporation,
and a private corporation?
7-24.
What are stock options and why would a corporation offer stock options to its
employees?
7-25.
What are the advantages and disadvantages of a limited liability company?
7-26.
Is a limited liability company an appropriate form of ownership for an aggressive
entrepreneurial firm? Why or why not?
Chapter 7: Preparing a Proper Ethical and Legal Foundation
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?
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?
7-29.
Kimberly Smith, a friend of yours, is a freelance journalist. She writes articles on
business topics and sells them to business periodicals, newspapers, and online
sites. She just read an article about the advantages of organizing as a subchapter
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?
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.
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?
7-32.
You have been approached by a close family friend who is putting together a
limited liability company to purchase a condominium complex near Cocoa
Beach in Florida. He is asking you, along with a number of family members, to
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?
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?
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?
Chapter 7: Preparing a Proper Ethical and Legal Foundation
Chapter 7: Preparing a Proper Ethical and Legal Foundation
Average Score
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
firm. Our reason is that although we admire what GiveForward is doing, the 7 percent fee
they take causes us pause, making us wonder if GiveForward’s business model is
sustainable. Seven percent seems like a high commission. Also, more ubiquitous sites,
such as Kickstarter, could significantly erode GiveForward’s market share if it opened its
platform to medical fundraising. We plan to follow GiveForward and admire its ideals.
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)
Item
Strength of New-Venture
Team
Chapter 7: Preparing a Proper Ethical and Legal Foundation
Average Score
Chapter 7: Preparing a Proper Ethical and Legal Foundation
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?
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?
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?
7-42.
What advantages do Jack and Sarah have starting iUser Accessories together,
rather than one of them starting it as a sole entrepreneur?
Chapter 7: Preparing a Proper Ethical and Legal Foundation
7-43.
Based on information featured in the case, what challenges do you think Jack
and Sarah will have keeping their partnership active?
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?
7-45.
How can building trust and credibility help start-up organizations avoid legal
disputes and problems?
Chapter 7: Preparing a Proper Ethical and Legal Foundation
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?
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.