MODULE 4

Preparing the proper ethical and legal foundation

Initial ethical and legal issues facing a new firm
Introduction
New ventures must deal with important ethical and legal issues at the time of
their launching. Ethical and legal errors made early on can be extremely costly
for a new venture down the road. And there is a tendency for entrepreneurs to
overestimate their knowledge of the law. , in one study 254 small retailers and
service company owners were asked to judge the legality of several business
practices. A sample of the practices included in the survey is shown next. Which
practices do you think are legal and which ones do you think aren’t legal?
Avoiding Social Security payments for independent contractors
Hiring only experienced help
Preempting potential competition with prices below costs
Agreeing to divide a market with rivals
The first two practices are legal, while the second two are illegal.
As a company grows, the legal environment becomes even more complex. A
re-evaluation of a company’s ownership structure usually takes place when
investors become involved.
Establishing a Strong Ethical Culture for a Firm
One of the most important things the founders of an entrepreneurial venture can
do is establish a strong ethical culture for their firms. The data regarding
business ethics are both encouraging and discouraging. The most recent version
of the National Business Ethics Survey was published in 2009. This survey is
the only longitudinal study that tracks the experiences of employees within
organizations regarding business ethics. But strong ethical cultures don’t emerge
by themselves. It takes entrepreneurs who make ethics a priority and
organizational policies and procedures that encourage ethical behavior (and
punish unethical behavior) to make it happen.
The following are specific steps that an entrepreneurial organization can
take to build a strong ethical culture.
1. Lead by Example
Leading by example is the most important thing that any entrepreneur, or team
of entrepreneurs, can do to build a strong ethical culture in their organization.
This is being done in many organizations, as indicated by the transparency and
accountability figures shown previously. Three things are particularly important
in building a strong ethical culture in a firm:
Leaders who intentionally make ethics a part of their daily conversations and
decision making
Supervisors who emphasize integrity when working with their direct reports
Peers who encourage each other to act ethically In companies where these
attributes are present, a stronger ethical culture exists.
This reality demonstrates the important role that everyone involved with a
start-up plays in developing a strong ethical culture for their firm.
2. Establish a Code of Conduct
A code of conduct (or code of ethics) is a formal statement of an organization’s
values on certain ethical and social issues. The advantage of having a code of
conduct is that it provides specific guidance to managers and employees
regarding expectations of them in terms of ethical behavior. Consider what
Google has done in this area. The company’s informal corporate motto is “Don’t
be evil,” but it also has a formal code of conduct, which explicitly states what is
and isn’t permissible in the organization. In practice, some codes of conduct are
very specific, like Google’s. Other codes of conduct set out more general
principles about an organization’s beliefs on issues such as product quality,
respect for customers and employees, and social responsibility. The 2009
National Business Ethics Survey, mentioned previously, found that employees
are much more likely to report ethical misconduct in their firms when specific
compliance mechanisms like codes of conduct are in place.
3. Implement an Ethics Training Program
Firms also use ethics training programs to promote ethical behavior. Ethics
training programs teach business ethics to help employees deal with ethical
dilemmas and improve their overall ethical conduct. An ethical dilemma is a
situation that involves doing something that is beneficial to oneself or the
organization, but may be unethical. Most employees confront ethical dilemmas
at some point during their careers. Ethics training programs can be provided by
outside vendors or can be developed in-house.
In summary, ethical cultures are built through both strong ethical leadership and
administrative tools that reinforce and govern ethical behavior in organizations.
Building an ethical culture motivates employees to behave ethically and
responsibly from the inside out, rather than relying strictly on laws that motivate
behavior from the outside in.
There are many potential payoffs to organizations that act and behave in
an ethical manner. Such as:
Potential Avoidance of Fines
Better Access to Capital
Improved Brand Reputation
Improved Customer Loyalty
Improved Employee Commitment
Decreased Vulnerability

Choosing an Attorney for a Firm

It is important for an entrepreneur to select an attorney as early as possible when
developing a business venture. 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.
It is not wise to select an attorney just because she is a friend or because you
were pleased with the way he prepared your will.
For issues dealing with intellectual property protection, it is essential to use an
attorney who specializes in this field, such as a patent attorney, when filing a
patent application.
Entrepreneurs often object to the expense of hiring an attorney when there are
many books, Web sites, and other resources that can help them address legal
issues on their own. However, these alternatives should be chosen with extreme
caution.
Many attorneys recognize that start-ups are short on cash and will work out an
instalment plan or other payment arrangement to get the firm the legal help it
needs without starving it of cash. This is particularly true if the attorney senses
that the new venture has strong commercial potential and may develop into a
steady client in the future. There are also ways for entrepreneurs to save on
legal fees and to increase the value of their relationship with their attorney.
Here are several ways for entrepreneurs to achieve these dual objectives:
Group together legal matters: It is typically cheaper to consult with an
attorney on several matters at one time rather than schedule several separate
meetings. For example, in one conference, a team of start-up entrepreneurs and
their attorney could draft a founders’ agreement, decide on a form of business
organization, and discuss how to best draft nondisclosure and noncompete
agreements for new employees. (We discuss these issues later in the chapter.)
Offer to assist the attorney: There are excellent resources available to help
entrepreneurs acquaint themselves with legal matters. An entrepreneur could
help the attorney save time by writing the first few drafts of a founders’
agreement or a contract or by helping gather the documents needed to deal with
a legal issue.
Ask your attorney to join your advisory board: Many start-ups form advisory
boards. Advisory board members typically serve as volunteers to help young
firms get off to a good start. An attorney serving on an advisory board becomes
a coach and a confidant as well as a paid service provider. However,
entrepreneurs must be careful not to give the impression that the attorney was
asked to serve on the advisory board as a way of getting free legal advice.
Use non lawyer professionals: Non lawyer professionals can perform some
tasks at a much lower fee than a lawyer would charge. Examples include
management consultants for business planning, tax preparation services for tax
work, and insurance agents for advice on insurance planning.
One thing entrepreneurs should guard themselves against is ceding too much
control to an attorney. While an attorney should be sought out and relied upon
for legal advice, the major decisions pertaining to the firm should be made by
the entrepreneurs. Entrepreneurs should also develop a good working
knowledge of business law. The manager and entrepreneur need to have some
knowledge of legal nomenclature and the legal principles most relevant to their
business.
HOW TO SELECT AN ATTORNEY
 1. Contact the local bar association and ask for a list of attorneys who
specialize in business start-ups in your area.
2. Interview several attorneys. Check references. Ask your prospective attorney
whom he or she has guided through the start-up process before and talk to the
attorney’s clients. If an attorney is reluctant to give you the names of past or
present clients, select another attorney.
3. Select an attorney who is familiar with the start-up process. Make sure that
the attorney is more than just a legal technician. Most entrepreneurs need an
attorney who is patient and is willing to guide them through the start-up process.
4. Select an attorney who can assist you in raising money for your venture. This
is a challenging issue for most entrepreneurs, and help in this area can be
invaluable.
5. Make sure your attorney has a track record of completing his or her work on
time. It can be very frustrating to be prepared to move forward with a business
venture, only to be stymied by delays on the part of an attorney.
6. Talk about fees. If your attorney won’t give you a good idea of what the
start-up process will cost, keep looking.
7. Trust your intuition. Select an attorney who you think understands your
business and with whom you will be comfortable spending time and having
open discussions about the dreams you have for your entrepreneurial venture.
8. Learn as much about the process of starting a business yourself as possible. It
will help you identify any problems that may exist or any aspect that may have
been overlooked. Remember, it’s your business start-up, not your attorney’s.
Stay in control.

Drafting a Founders’ Agreement

It is important to ensure that founders are in agreement regarding their interests
in the venture and their commitment to its future. It is easy for a team of
entrepreneurs to get caught up in the excitement of launching a venture and fail
to put in writing their initial agreements regarding the ownership of the firm.
A founders’ agreement (or shareholders’ 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. Example. Having a founders’
agreement served the initial founders of XploSafe well when shortly after the
agreement was signed one of the founders left the firm. The exit of the departing
founder went smoothly and didn’t result in any hard feelings because the exit
was handled in accordance with the written agreement.
An important issue addressed by most founders’ agreements is what happens to
the equity of a founder if the founder dies or decides to leave the firm. Most
founders’ agreements include a buyback clause, which legally obligates
departing founders to sell to the remaining founders their interest in the firm if
the remaining founders are interested. In most cases, the agreement also
specifies the formula for computing the value to be paid. 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 disgruntled, the buyback
clause provides the remaining founders a mechanism to keep the shares of the
firm in the hands of people who are fully committed to a positive future for the
venture.
Vesting ownership in company stock is another topic most founders’ agreements
address. The idea behind vesting is that when a firm is launched, instead of
issuing stock outright to the founder or founders, it is distributed over a period
of time, typically three to four years, as the founder or founders “earn” the
stock. Not only does vesting keep employees motivated and engaged, but it also
solves a host of potential problems that can result if employees are given their
stock all at once.
ITEMS INCLUDED IN A FOUNDERS’ (OR SHAREHOLDERS’)
AGREEMENT
Nature of the prospective business
Identity and proposed titles of the founders
Legal form of business ownership
Apportionment of stock (or division of ownership)
Consideration paid for stock or ownership share of each of the founders (may
be cash or “sweat equity”)
Identification of any intellectual property signed over to the business by any of
the founders
Description of the initial operating capital
Buyback clause, which explains how a founder’s shares will be disposed of if
she or he dies, wants to sell, or is forced to sell by court order

Avoiding Legal Disputes

Most legal disputes are the result of misunderstandings, sloppiness, or a simple
lack of knowledge of the law. Getting bogged down in legal disputes is
something that an entrepreneur should work hard to avoid. It is important early
in the life of a new business to establish practices and procedures to help avoid
legal disputes. Legal snafus, particularly if they are coupled with management
mistakes, can be extremely damaging to a new firm, feature. There are several
steps entrepreneurs can take to avoid legal disputes and complications, as
discussed next.

1. Meet All Contractual Obligations

It is important to meet all contractual obligations on time. This includes paying
vendors, contractors, and employees as agreed and delivering goods or services
as promised. If an obligation cannot be met on time, the problem should be
communicated to the affected parties as soon as possible. It is irritating for
vendors for example, when they are not paid on time, largely because of the
other problems the lack of prompt payments create. Being forthright with
vendors or creditors if an obligation cannot be met and providing the affected
party or parties a realistic plan for repaying the money is an appropriate path to
take and tends to maintain productive relationships between suppliers and
vendors.
2. Avoid Undercapitalization (adequate finance is required)
If a new business is starved for money, it is much more likely to experience
financial problems that will lead to litigation. A new business should raise the
money it needs to effectively conduct business or should stem its growth to
conserve cash. Many entrepreneurs face a dilemma regarding this issue. Most
entrepreneurs have a goal of retaining as much of the equity in their firms as
possible, but equity must often be shared with investors to obtain sufficient
investment capital to support the firm’s growth.
3. Get Everything in Writing
Many business disputes arise because of the lack of a written agreement or
because poorly prepared written agreements do not anticipate potential areas of
dispute. Although it is tempting to try to show business partners or employees
that they are “trusted” by downplaying the need for a written agreement, this
approach is usually a mistake. Disputes are much easier to resolve if the rights
and obligations of the parties involved are in writing. A non -compete
agreement prevents an individual from competing against a former employer for
a specific period of time.
4. Set Standards
Organizations should also set standards that govern employees’ behavior
beyond what can be expressed via a code of conduct. For example, four of the
most common ethical problem areas that occur in an organization are human
resource ethical problems, conflicts of interest, customer confidence, and
inappropriate use of corporate resources. Policies and procedures should be
established to deal with these issues. A firm falls short in terms of establishing
high ethical standards if it is willing to partner with firms that behave in a
contrary manner.
When legal disputes do occur, they can often be settled through negotiation
or mediation, rather than more expensive and potentially damaging litigation.
Mediation is a process in which an impartial third party (usually a professional
mediator) helps those involved in a dispute reach an agreement. At times, legal
disputes can also be avoided by a simple apology and a sincere pledge on
the part of the offending party to make amends. A final issue important in
promoting business ethics involves the manner in which entrepreneurs and
managers demonstrate accountability to their investors and shareholders.

Obtaining Business licenses and Business permits

Before a business is launched, a number of licenses and permits are typically
needed. What is actually needed varies by city, county, and state, as well as by
type of business, so it’s important for the entrepreneur to study local regulations
carefully. Some licenses are difficult to get—such as liquor licenses. For
example, in some states, the only way to get a liquor license is to buy a
pre-existing license. This stipulation often results in a bidding war when a
business is willing to give up its liquor license, which increases the price.
Business Licenses
In most communities, a business needs a license to operate. A business license
can be obtained at the city clerk’s office in the community where the business
will be located. If the business will be run out of the founder’s home, a separate
home occupation business license is often required. When a business license is
applied for, the city planning and zoning departments usually check to make
sure the business’s address is zoned for the type of business that is being
planned. If a business will be located outside a city or town’s jurisdiction,
the county courthouse will issue the business license. If a business is a sole
proprietorship, it can usually stop here, as far as obtaining a business
license goes. If a business has employees, or is a corporation, limited
liability company, or limited partnership, it will usually need a state
business license in addition to its local one. Individual states may have
additional provisions with which you might need to comply. If you’re
starting a retail business or a service business, you’ll need to obtain a sales
tax license, which enables you to collect taxes on the state’s behalf. Special
licenses are needed to sell liquor, lottery tickets, gasoline, or firearms.
People in certain professions, such as barbers, chiropractors, nurses, and real
estate agents, must normally pass a state examination and maintain a
professional license to conduct business. Certain businesses also require special
state licenses. Examples of these types of businesses include child care, health
care facilities, hotels, and restaurants. It’s important to check to see which
licenses your business needs.
Nearly all businesses are required to obtain an identification number, also
known as a tax identification number (GSTIN), which is used in filing various
business tax returns.
Business Permits
Along with obtaining the appropriate licenses, some businesses may need to
obtain one or more permits. The need to obtain a permit or permits depends on
the nature and location of the business. For example, if you plan to sell food,
either as a restaurateur or as a wholesaler to other retail businesses, you’ll need
a city or county health permit. If your business will be open to the public or will
use flammable material, you may need a fire department permit. Some
communities require businesses to obtain a permit to put up a sign. If you’re
occupying a building, there may also be building code requirements that need to
be complied with. Several resources are available to assist business founders in
identifying the proper licenses and permits to apply for. Government websites
are there.

Choosing a Form of Business Organization

When a business is launched, a form of legal entity must be chosen. Sole
proprietorship, partnerships, corporations, and limited liability companies
are the most common legal entities from which entrepreneurs make a choice.
Choosing a legal entity is not a one-time event. As a business grows and
matures, it is necessary to periodically review whether the current form of
business organization remains appropriate. In most cases, a firm’s form of
business entity can be changed without triggering adverse tax implications.
There is no single form of business organization that works best in all situations.
It’s up to the owners of a firm and their attorney to select the legal entity that
best meets their needs.
REST OF THE MATERAL LEARN FROM THE PPT UPLOADED IN
CLASSROOM