1.2.20 Summary – Legal Forms of the Enterprise


This session is on legal forms of the enterprise. When I was recently visiting Istanbul I bought a sandwich from the fish bread guy shown here. Almost certainly this entrepreneur is operating as what’s commonly known as a soul proprietorship. Meaning there’s no difference between him and his business. All of the flows of money are in and out of his pocket. He may have a checking account associated with his activities, but he has no separate legal entity. This is probably true for the majority of new ventures on the planet. They’re operated as sole proprietorship’s. But we’re going to consider in this session the alternatives to that, and why you might be motivated to do something other than operate as a sole proprietor. Tthis is another example of a company called SawStop, and SawStop makes a table saw and their benefit proposition is that if you accidentally run your finger into the saw, it won’t cut your finger off. It will immediately stop the blade within millimeters. Now I want you to reflect a little bit about some of the issues that you might face as an entrepreneur if you were trying to pursue the business Sawstop as a sole proprietor.
1:14
One of the key issues you would face is legal liability. So let’s image that one day this didn’t work for some reason and somebody cut off their finger. Under a sole proprietorship the person who suffered those damages could sue you and could sue you personally perhaps taking everything you have. And so one critical purpose for creating a separate legal entity is to limit the liability of the entity to the entity itself rather than to you personally. The second issue around SawStop is that it might need have some outside investment in order to grow and to become successful. In fact it did have outside investment. Almost always outside investors will require that your business is separate legal entity. Because they want to know what they have an ownership interest in and the whole legal system around new business, around forming new entities was established in part so that you could allocate the profit interest. Or the value of the business, the equity, to others including investors. A third reason for doing something other than a sole proprietorship is that you often want to create incentives for your managers and employees. And so you want to allocate to them profit interests or sharers in the company. And to do that you really need the machinery of sharers and of a new legal entity. So those are the primary motives for forming a new legal entity in entrepreneurship. Now I want to be very clear that the law around new business varies widely according to your jurisdiction, according to your geography. By country and even by state within country. And so you really have to consult with a lawyer and I can’t emphasize that enough. You can’t do this yourself. You really have to consult with a lawyer in order to get this right based on the details of your location and jurisdiction. Let me give you a sense of what that involves. A relatively simple incorporation of a new business that’s owned solely by the founder and without any outside investment will probably incur about $1,000 to $5,000 in legal fees in order to establish the new venture. That’s probably what you can expect to spend. If you need to raise capital from an outside investor, that typically requires significant additional legal expense. It’s often between $10,000 and $50,000 in legal fees with venture financing, where you have an institutional investor who will demand a lot of legal assurances in association with that investment.
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Now the good news is that many lawyers who specialize in new ventures are used to dealing with companies who don’t have very much money, who are just getting started. They will often defer or discount their fees for startup companies, often deferring payment until the first round of financing is received from an outsider.
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The last thing I want to note is that, the cross-border issues are particularly challenging. And so if you are for instance a U.S. company that plans to be selling product in China, that can be quite challenging if you’re not using an intermediary in China as your distribution partner. And so you really do need to consult with a lawyer that has expertise in those cross-border transactions. There are many different legal forms and the specifics vary by country and so I can’t possibly describe them all. Having said that, there are typically two main differentiating attributes that you see in different legal forms around the world. The first is how income is taxed. And the two main options are that the entity itself is taxed and the alternative is that the entity passes through its income, passes through its profits to the owners of the entity and that they pay taxes then on the passed-through income. Of course the disadvantage of an entity that’s taxed separately is that that may result in double taxation. So the corporation may first pay taxes then it may pay dividends to its shareholders, and then they then in turn will pay taxes on the dividends. And so that results in double taxation. And that’s the reason that in most countries, in most jurisdictions there is a so-called pass through entity. A form of business that allows the company to pass through it’s income to the owners in the way that they pay taxes on it only once.
5:58
The second distinction that’s often made among different legal forms, is whether the equity is traded on public markets, or whether the company is owned entirely privately, by private individuals. And so what I want to do is just show you some representative entity types in five different regions. Of course we can’t cover all regions of the world but this gives you a sense of the relative equivalence, the approximate equivalence across the different types of entities in different jurisdictions in different geographic regions. And I’ve shown here three types of entities. Sole proprietorship’s, that’s like the fish bread guy, corporations and limited liability pass-through entities. And the distinction between corporations and the limited liability pass-through entities Is the distinction around taxation. Corporations are typically taxed at the entity level and then at the shareholder level as they’re taxed twice, and limited liability pass-through entities are taxed only once. They’re taxed only by the eventual owner of the profit interest. So in the United States the standard names for these different categories are a sole proprietor is called a sole proprietor but they often have something called a d.b.a or doing business as. And so the fish bread guy if he were located in the United States could actually call his business Fish Bread Guy. He could actually get a checking account. He could use that on his business cards. That’s called a d.b.a. It can be registered with the government but it doesn’t give any legal protection and it doesn’t allow you to allocate profit interest to other people other than yourself. For that purpose in the United States you ‘ll typically see corporations which are just labeled by the abbreviation inc, meaning, short for incorporated. I-N-C period. In the United States, Inc applies to both corporations that are owned by the public, where equity is traded on public markets, on the stock market. And for privately held companies. They both are what are called C corps.
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And then in the US, the Limited Liability Pass-Through Entity is usually called an LLC. There are also LLPs and S-Corps, but they’re used less commonly today. More typically you’ll see an LLC. So those are the typical types that you’ll see in the US. I won’t go through all the details on the other entities. But virtually every country has analogues to those three categories of legal entity. Although some countries don’t have a pass-through entity, for instance, India doesn’t have a pass-through entity that’s exactly the same as an LLC is in the United States.
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So you need, typically, to form a legal entity. You typically do that to limit your liability so that the entity itself might be liable for any damages that might be incurred with a supplier or customer and not you personally. Secondly, the legal entity gives you the currency, typically shares in the company, To provide incentives for your team members and employees, and lastly a legal entity will typically be a requirement for outside investment. So for those reasons you will typically need to form a legal entity. The exact type of legal entity will depend on how you want taxes to be treated and on what legal In what legal jurisdiction you reside. And for those details, you really need to consult with a lawyer who has expertise in your own region.

Jim Rohn