Six legal issues every small to midsized business owner should address in 2021
Whether your business is new or has been operating for decades, business owners must periodically take time to ensure the business is legally sound. Setting aside a budget for legal services should be one of the business’ top priorities.
Many small and midsized business owners mistakenly believe that they do not have the same legal issues or obligations as large corporations do and prefer to address legal issues as the company scales. However, a significant amount of common but costly legal issues that your business might experience can be completely avoided or significantly mitigated by working with an attorney and paying the upfront costs to get the business in order. The COVID-19 pandemic showed the benefits for those owners who took the time and paid the relatively small upfront costs to properly document their business matters.
1. Entity Formation and Documentation: Is your business set up as a sole proprietorship, partnership, limited liability company or corporation?
It is imperative to understand the benefits and drawbacks of each, especially in regard to profits and liabilities. A sole proprietorship does not offer the separation of personal and business assets. The sole proprietor is personally liable for debts and liabilities.
A limited liability company (LLC) is an entity type that allows members to limit their personal liabilities while taking advantage of the tax benefits of a partnership. Earnings and losses are passed through to members on their personal tax returns. LLC members are shielded from personal liability for the business debts unless they acted in an illegal or knowingly wrongful manner while carrying out business activities.
A partnership allows the partners to share profits and losses as well as make decisions together. However, each partner will be held liable for the decisions made, as well as those actions made by the business partner(s).
A corporation also limits personal liability since the law holds that it is its own entity. Therefore, creditors can sue the corporation, but they cannot gain access to personal assets of the shareholders except in limited circumstances. Typically, the business may be converted from one entity to another. Therefore, in the event the original entity is no longer the best option for the business, an attorney can assist with the conversion. Questions business owners should ask are the following:
- Has the business elected to be treated differently for tax purposes? There may be a tax election available that would be financially beneficial.
- Was an operating agreement prepared or bylaws drafted? If so, is the document legally sound? Often, the business will file formation documents with the state, such as articles of incorporation or formation, but they do not have bylaws or an operating agreement prepared. This is highly unfavorable because the laws of the state of formation would govern the business, which may be unfavorable or unclear. Alternatively, many business owners download a template from the internet and fill in the blanks. These are not the types of documents that are “one size fits all.”
Business owners should engage a business attorney to draft the bylaws or operating agreement, with both working together to determine business issues such as: who ownership interests can be sold or transferred to; the purchase price for such interests; if there is a right of first refusal; how the company is managed and the responsibilities for such manager, director or officer; what business issues require a majority or unanimous vote of all owners; who is in charge of day-to-day business decisions such as hiring and firing, taking out loans and signing business agreements; and how and when distributions are handled. Leaving these issues silent or trusting an internet template is extremely risky and can lead to significant disputes, unfavorable outcomes and costs.
2. Internal customer templates
One of the safest and most professional things you can do for your business is have attorney-prepared company contracts. It is extremely common and preferred for a business to require contracts to be in its own form template. By doing so, you can be in control of the terms of your agreements and can prevent entering into agreement with unfavorable terms. A business attorney can work with you in preparing a custom template contract that includes industry-specific terms, addresses potential issues, fits with your business model and services and includes all desired legal provisions. The contract should include provisions regarding, among many others: the scope and timeline for services; termination with and without cause; late payment penalties; events of default; cure periods for any defaults; dispute resolution; requirements for proper licensing; requirements for insurance policies and limits and which party is responsible for procuring such insurance; liabilities; indemnifications; and financial responsibility in the event of a claim.
Once the template is prepared, the business owners and employees can fill in the applicable customer information, prices, services and any other customer-specific financial provisions and send it out to the customer for review and signature. In the event the customer has requested changes, a business attorney can assist in negotiating the contract. Additionally, an attorney can prepare multiple templates where different provisions are required based upon the type of customer, type of job or agreement terms.
3. Agreements used in the course of business
Every business should have a process for reviewing and approving contracts entered into during usual business operations, such as contracts with vendors, suppliers and other service providers. Often times, extremely harsh or one-sided provisions are included and overlooked. For example, there may be steep late fees, the ability for only one party to terminate the contract at its sole discretion and for any reason, arbitrary or subjective default provisions, anti-assignment provisions, one-sided indemnification terms or dispute resolution requirements. Additionally, many vendor contracts limit their liability to the total amount paid by the customer under the contract, which can be significantly unfair and insufficient to cover any damages.
Many contracts include provisions forbidding the other party from assigning the contract to another business, including by a merger, acquisition or change in majority owner. Often, contract language puts all of the insurance or indemnification burdens on one party. Further, the contract could allow one party to terminate the contract at its complete discretion while the other party is locked in for the entire term of the contract. This is unfavorable in the event the business is not satisfied with the vendor and would like to terminate the agreement or if the vendor services are necessary for the day-to-day operations of the business. As a business owner, you do not want to be in a position where the contract is terminated with little or no notice leaving the business scrambling for an alternative vendor.
A business should consider sending all outside contracts to a business attorney for review prior to signing. Depending on the business’ budget or size or significance of the contract, the attorney can perform an in-depth review and markup of the agreement and enter into negotiations with the third party on the business’ behalf or the attorney can review and point out the potential issues or obviously unfavorable terms for the business owner to consider.
4. Commercial leases
There is no such thing as a “standard commercial lease” and landlords typically do not have the tenant’s best interests in mind when drafting a lease. Additionally, commercial real estate contracts and leases are not required to provide the legal consumer protections of residential leases. The financial terms and legal provisions of most commercial leases are specialized and often difficult to understand for individuals outside the commercial real estate industry.
When entering into a new lease, modifying an existing lease or renegotiating a lease for another term, prospective tenants should focus not only on the rent amount and financial terms but other key provisions that can have a significant legal impact on the business. Examples are: whether there will be improvements, modifications or fixtures added to the premises and which party is financially responsible for them; whether there is an option to renew the lease or expand the rented premises; if and how the lease may be terminated, including notice requirements, and whether there are penalties for early termination; whether disputes must be mediated or arbitrated as an alternative to litigation in court; whether the lease may be assigned or subleased to another tenant or subtenant and, if so, if there are any requirements (such as notice or consent) to do so; whether a lease may be assigned to a purchaser of your business; and whether the lease is still valid if there is a change of control of the business, such as if there is a new owner. A business or real estate attorney can assist the business owner in reviewing the lease and addressing any issues that may arise.
5. Shareholders agreements
A shareholders’ agreement is strongly recommended if the business has more than one shareholder. A shareholders’ agreement is a contract between the shareholders of a company and the company which sets out agreed matters between them. One day, the business may be sold or the shareholder will want to transfer shares. If no agreement exists, litigation is likely to occur. A shareholders’ agreement will address issues such as: share transfer provisions, including the process in the event of a shareholder’s death, rights of first refusal, compulsory transfer provisions (when certain actions are deemed a transfer of shares) and permitted transfers (the ability to transfer shares to family members, permitted third-parties or to other shareholders); other exit plans; specific policies regarding dividend payments; restrictive covenants on the shareholders to restrict their ability to be involved in any competing business; deadlock provisions in the event a business decision cannot be agreed upon; and confidentiality restrictions placed upon the shareholders to agree to protect valuable business information both while the individual owns shares and thereafter.
6. Nondisclosure and non-compete agreements
Once a business has built its brand it is time to make sure any intellectual property is properly owned and protected. If there is confidential or proprietary information that belongs to the company, such as customer lists or special formulas, anyone who works for the business and has access to this valuable information should be legally bound by non-disclosure and non-compete agreements. It is imperative to have an attorney draft such agreements as the relevant laws vary by state and any terms that do not comply with the applicable state law can be deemed unenforceable. A business attorney can provide such agreements for your business to pass along to employees.
Contact one of Chuhak & Tecson’s Corporate Transactions & Business Law attorneys to discuss any of the above and develop a plan to prioritize these legal issues.
This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.