Every entrepreneur dreams of the day his or her fledgling startup becomes a going concern, but you could end up losing everything — including your house and your car — unless you take steps to separate and protect your personal assets.
“Owners should have limited liability for business debts and obligations,” says François G. Laugier, partner and director for Ropers Majeski Kohn & Bentley PC. “Incorporating sooner rather than later offers considerable protection with virtually no downside.”
Smart Business spoke with Laugier about the benefits of incorporating at the right time.
When is the right time to incorporate?
Owners expose themselves to liability for their company’s actions and debts the minute their venture becomes operational or starts hiring employees. So, it’s time to incorporate when your startup begins interacting with third parties or logs its first sale. Whether you manufacture food products or develop software, you could lose everything unless you form a legal business structure to safeguard your personal assets.
What are the advantages of incorporation?
Incorporating not only keeps creditors from attacking your own assets and employees from suing you personally, but it also increases a company’s credibility and raises the valuation you can expect to receive from a prospective acquirer. A corporation is always perceived as a safe and familiar recipient where a business can accumulate intellectual property and other assets such as patents, trademarks and copyrights to subsequently transfer them to a new owner or heir. And consumers, vendors and partners often prefer doing business with an incorporated company. Incorporated businesses can also offer stock options to employees and contractors, thereby attracting the best technical talent and, in turn, the most influential investors. And, history shows that buyers are willing to pay more for a business that is incorporated, has a well-maintained corporate book, complete with up-to-date annual records and government filings, and that has received guidance from reputable and competent lawyers, accountants and advisers.
What are the different legal vehicles available for incorporation?
Entrepreneurs of for-profit ventures usually consider a limited liability company (LLC) or a corporation when selecting a legal entity. For budding companies, a LLC is often the preferred choice because its shareholders, called members, only pay taxes on profit distributions at the member’s personal income tax level, while profits are otherwise taxed at both the corporate and personal level when generated through the activities of a corporation. For the IRS, a LLC is known as a ‘disregarded entity,’ as its profits and losses essentially pass-through to the owners. But if you soon plan to raise venture capital or offer employees stock options, a corporation is the better vehicle. Get advice from your lawyers and accountants, but remember the conversion of a LLC into a corporation is a relatively simple legal process. Conversely, there will be a host of negative tax consequences if you convert a corporation into a LLC.
How can business owners limit their personal liability by incorporating?
If your budget is so tight that you can’t hire a lawyer, it’s tempting to incorporate on the Internet, but the lack of a formal business structure and legal guidance can leave you just as exposed as if you had not incorporated. To limit liability, you must ensure your company is sufficiently capitalized, has complied with securities regulations when issuing shares and soliciting investment, and you haven’t commingled personal and company funds. You must also record the proper documents on the federal, state and local levels and maintain a good record of all accounting transactions, meeting minutes and periodic filings so savvy creditors can’t attack your assets by piercing the corporate veil.
When shouldn’t a business incorporate?
It may not make sense for an independent consultant or a very small business to go through the incorporation process. Their limited exposure may not require the protection and cost of a corporate entity. But for everyone else, there’s no reason to link your personal assets to the company’s fate.
François G. Laugier is a partner and director at Ropers Majeski Kohn & Bentley PC. Reach him at (650) 780-1691 or email@example.com.
Insights Legal Affairs is brought to you by Ropers Majeski Kohn & Bentley PC
Strategic and financial buyers have different characteristics when purchasing a business, and as a seller, dealing with each has its advantages and disadvantages.
The current deal environment is very robust, and financial buyers have raised a lot of private equity dollars that couldn’t be fully deployed when the economic downturn hit. That money is still out there and now financial buyers are under pressure to put it to work.
In addition, strategic buyers are sitting on record amounts of investable cash, much of which is earmarked for acquisitions, says Kevin W. Bader, an associate at MelCap Partners, LLC.
“It’s a really good time to be a seller,” says Bader. “And if you’re looking to maximize your chances of success in a sale, you want to reach out to both types of buyers.”
Smart Business spoke with Bader about the differences between strategic and financial buyers and how each approaches buying a business.
What is a financial buyer?
A financial buyer is typically what you think of when you hear the term ‘private equity.’ Financial buyers are institutional investors who pool their money together to grow through acquisitions. They raise a fund that typically has a 10-year life put together for the purpose of investing in a portfolio of companies.
The first five years is typically the investing stage, in which they make several investments to establish or supplement the portfolio. They’ll then grow those businesses by bringing in resources such as alternate sources of capital, improved financial disciplines, or increased operating efficiencies.
The second five years is the ‘harvest’ phase, in which they hopefully have a larger and more profitable business to sell to another private equity group or to a strategic buyer who sees value in the company.
Financial buyers typically maximize their returns by leveraging the assets of the companies they acquire, which minimizes the amount of equity investors have to put in at the outset.
Many times in a leveraged buyout, financial buyers will require that they have a controlling stake in the business. However, there’s often an opportunity for the seller to co-invest back into the new business alongside the buyers, in effect rolling over some of the equity. If the investment is successful, the seller has a portion, usually a minority stake, which gets sold down the road. We call this a ‘second bite at the apple,’ and it can be a very powerful wealth creation opportunity for the seller.
What is a strategic buyer?
Unlike financial buyers, strategic buyers are not in business solely to buy other businesses. Instead, they can often operate in a similar industry, or in the same industry, as a selling company. Their mandate is to grow the business by acquisition if it makes sense, but they also have a core business to run.
Because of the business cycle we’ve just come through, operations are typically getting better across the board and strategic buyers are doing better with fewer resources. We’re seeing that strategic buyers are being very active in M&A because of the excess cash they have on their balance sheets and the pressure they have to show a return on that cash for their shareholders.
Strategic buyers create value by realizing synergies through acquisitions because of their similarities with the target and the ability to eliminate redundant functions. Sometimes this can mean they’ll pay a higher price than a financial buyer will, but this is not always the case. Often, strategic buyers use less leverage than a financial buyer, which can create a cleaner and quicker deal for the seller. In addition, a strategic buyer will typically hold the business indefinitely, so there’s no pressure to sell in five to seven years.
It’s possible that the new company, beyond a transition period, would employ the seller, but there’s definitely a change of control and the seller may have concerns over what happens to its employees. Depending on the synergies and the overlap with a strategic buyer, there can sometimes be less of a need for the company’s employees, as opposed to a financial buyer.
Why would businesses choose one type of buyer over the other?
One consideration is confidentiality, another is the speed of the deal. Regarding confidentiality, strategic buyers can often be from the same small industry and there could be concern over word getting out about the sale prematurely. However, confidentiality agreements can cover those risks.
With regard to speed, strategic buyers — if they’re big enough or have enough cash on their balance sheet — may be able to close more quickly because they may not need a bank to get a deal done. However, strategic buyers might need a little more hand holding to keep them moving along in the sales process because they also have a business to run and don’t solely focus on acquiring companies.
From a sale standpoint, reaching out to both types of buyers allows you to cast the widest net possible in order to identify the best buyer for you and your business.
Kevin W. Bader is an associate at MelCap Partners, LLC. Reach him at (330) 239-1990 or firstname.lastname@example.org.
Insights Mergers & Acquisitions is brought to you by MelCap