Why Business Formation is a Key to Your Success

By Nina Kaufman, Esq.

I was recently contacted by an entrepreneur (“Marie”) for a “rush job”: She had formed an S-Corporation about a year ago, and now a couple of investors were waiting in the wings to take an equity piece of her company. She needed the deal signed, sealed and delivered within two weeks.

Now I won’t say that’s impossible (although given my current caseload, I couldn’t fit her in). And you certainly don’t want attorneys dragging their heels when you have a deal that needs to get done. But bringing on an equity investor is not something to take lightly. Leaving aside the legal issues, there are a number of tax and valuation issues that need to be addressed.

And here’s what smelled fishy:

  • If these were sophisticated investors, they’d know that these kinds of deals take time (and they’d want their own counsel to review it).
  • If they were pressuring Marie to do the deal fast, there could be something about it that could come back to bite her in the future.
  • And if these were just “friends and family investors,” what’s the rush?

Here’s another problem. Marie had formed an S-Corporation. But an S-Corporation is not a legal form of business that permits passive investors. In order to accommodate them, they’d either have to become active participants in the business (which they probably wouldn’t want), or Marie would have to change her tax status to a C-Corporation (which takes time and could affect the timing of the deal).

The moral of the story: Even assuming Marie had found the right investors, she didn’t have the right legal foundation for inviting them into her company.  Sometimes it’s not so much understanding the details (like “entity-level taxation” or “limitations of liability”), but knowing where you want your business to go.  Have a look at  my article, “Uncover the Stories Behind Business Entities,” which tries to put a human face on a sometimes complicated and technical decision.

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