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Chapter 3

ORGANIZING AND FINANCING A NEW

VENTURE

© 2003 South-Western College Publishing

ENTREPRENEURIAL FINANCE Leach & Melicher

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Chapter 3: Learning Objectives

Describe the proprietorship, partnership, & corporate forms of business

Identify a limited liability company (LLC) Describe the benefits, risks, & basic tax

aspects of various organizational forms Discuss the use of patents & trade

secrets to protect intellectual property

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Chapter 3: Learning Objectives (continued)

Discuss the use of trademarks & copyrights to protect intellectual property

Describe how confidential disclosure agreements & employment contracts are used to protect intellectual property rights

Explain how financing is obtained via financial bootstrapping & through business angels

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Forms of Business Organization

Proprietorships Partnerships

>General >Limited

Corporations >C corporations >S (or Subchapter S) corporations

Limited Liability Companies (LLCs)

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Proprietorships

Proprietorship >business venture owned by an individual who is personally liable for the venture’s liabilities

Unlimited liability >personal obligation to pay a venture’s liabilities not covered by the venture’s assets

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Partnerships

Partnership >business venture owned by two or more individuals who are jointly and personally liable for the venture’s liabilities

Joint Liability >legal action treats all partners equally as a group in a general partnership

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Partnerships (continued)

Joint and Several Liability >allows subsets of partners to be the object of legal action related to the partnership

Limited Partnership >limits limited partner liabilities in a partnership to the amount of their equity capital contribution to the partnership

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Corporations

Corporation >a legal entity that separates personal assets of the owners (shareholders) from the firm’s assets

Limited Liability >creditors can seize the corporation’s assets but have no recourse against the shareholders’ personal assets

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Corporations (continued)

Corporate Charter >legal document that establishes the corporation

S Corporation >provides limited liability for shareholders plus corporate income is taxed as personal income to the shareholders

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Limited Liability Companies (LLCs)

Limited Liability Company (LLC) >a business organization owned by “members” (shareholders) with limited liability

Major Incentive for Organizing as an LLC >its earnings are taxed at the personal income tax rates of the members

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Bases for Comparing Various Business Organizational Forms

Number of Owner’s & Ease of Startup Investor Liability Equity Capital Sources Firm life & Liquidity of Ownership Taxation

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Number of Owners & Ease of Startup Proprietorship

>one; low time & legal costs Partnership (general)

>two or more; moderate time & legal costs

Limited Partnership >one or more general & one or more limited partners; moderate time & legal costs

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Number of Owners & Ease of Startup (continued) Corporation (C)

>one or more, with no limit; high time & legal costs

S (Subchapter S) Corporation >less than 75 owners; high time & legal costs

Limited Liability Company (LLC) >one or more, with no limit; high time & legal costs

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Investor Liability

Proprietorship >unlimited

Partnership (general) >unlimited (joint & several liability)

Limited Partnership >limited partners’ liability limited to their investments

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Investor Liability (continued)

Corporation (C) >limited to shareholders’ investments

S (Subchapter S) Corporation >limited to shareholders’ investments

Limited Liability Company (LLC) >limited to owners’ investments

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Equity Capital Sources

Proprietorship >owner, family, & friends

Partnership (general) >partners, families, & friends

Limited Partnership >general and limited partners

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Equity Capital Sources (continued)

Corporation (C) >venture investors & common shareholders

S (Subchapter S) Corporation >venture investors & Subchapter S investors

Limited Liability Company (LLC) >venture investors & equity offerings to owners

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Firm Life & Liquidity of Ownership Partnership >life

determined by owner; often difficult to transfer ownership

Partnership (general) >life determined by partners; often difficult to transfer ownership

Limited Partnership >life determined by general partner; often difficult to transfer ownership

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Firm Life & Liquidity of Ownership (continued) Corporation (C)

>unlimited life; usually easy to transfer ownership

S (Subchapter S) Corporation >unlimited life; often difficult to transfer ownership

Limited Liability Company (LLC) >life set by owners; often difficult to transfer ownership

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Taxation

Proprietorship >personal tax rate

Partnership (general) >personal tax rates

Limited Partnership >personal tax rates

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Taxation (continued)

Corporation (C) >corporate taxation; dividends subject to personal tax rates

S (Subchapter S) Corporation >income flows to shareholders; taxed at personal tax rates

Limited Liability Company (LLC) >income flows to owners; taxed at personal tax rates

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What is Intellectual Property?

Intellectual Property Intellectual Property >a venture’s intangible assets and >a venture’s intangible assets and human capital and includes inventions human capital and includes inventions and innovations that can be protected and innovations that can be protected from being freely used or copied by from being freely used or copied by othersothers

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Protecting Valuable Intangible Assets

There are Four Forms of Protection: Patents Trade Secrets Trademarks Copyrights

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Intellectual Property Protection Methods: Basic Definitions

Patents >intellectual property rights granted for inventions that are useful, novel, and non-obvious

Trade Secrets >intellectual property rights in the form of inventions and information not generally known to others that convey economic advantages to the holders

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Intellectual Property Protection Methods: Basic Definitions (cont’d)

Trademarks >intellectual property rights that allow firms to differentiate their products & services through the use of unique marks

Copyrights >intellectual property rights to writings in written and electronically stored forms

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Patent Basics

Intellectual property rights granted for inventions that are “useful,” “novel,” and “non-obvious.”

Patents are granted by the U.S. Patent and Trademark Office

Patent law is very complex (you need to hire a patent applications specialist lawyer)

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Three Kinds of Patents:

1. Utility Patents

>cover mechanical or general inventions, chemical inventions, & electrical inventions

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Three Kinds of Patents (cont’d):

2. Design Patents

>cover the “appearance” of items (e.g.,

sports uniforms, electronic products, & autos)

3. Plant Patents

>protect discoveries of asexual reproduction methods of new plant varieties

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Utility Patents: Basic Information

A new idea by itself cannot be patented The idea must be part of an invention that

has a “physical form” such as a product The physical form also can exist as a

sequence of steps contained in a process or the delivery of a service

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Utility Patents: Application Process Develop or conceive an Invention Prepare (you, or a registered patent

attorney on your behalf) a patent application

File the application in U.S. Patent & Trademark Office

If successful, the utility patent life will be 20 years (prior to mid-1995 the life was 17 years)

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Utility Patents: Provisional Patent Application

Beginning in mid-1995, inventors were permitted to file a provisional application

Filing dates can be established more quickly & at lower costs, & small entities are charged lower filing fees

Allows the inventor to use the term “patent pending” on the invention

However, patent rights & protection occur only when a patent is issued

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Provisional Patent Application Requirements & Conditions

An invention title, the inventor’s name, residence, & address for correspondence

Clearly written description and “drawings” A person skilled in the art of the

invention’s area should be able to use or practice the invention

Has a life of 12 months & will be abandoned unless a regular patent application is filed

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Regular Patent Application Requirements

A detailed written description of the invention & detailed drawings of how the invention works

One or more claims justifying why the invention should be patented

Inventor must indicate the “best use” or method of practicing or carrying out the invention

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Why Might Your Patent Application be Rejected?

1. For a patent application to be accepted, the invention must be:

Useful

>the invention cannot just “do nothing” Novel

>the invention was not previously produced, described in a publication, or patented

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Why Might Your Patent Application be Rejected (cont’d)?

Non-Obvious >invention should be “non-obvious” to a person with ordinary skills in the art of the invention’s area or subject

2. Timing of filing the application >must be filed within one year of first introduction to the public >in the future, it may be necessary to file prior to any public disclosure or use

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What Does Having a Patent do for the Inventor?

The government does not enforce your rights

The burden of enforcing the patent lies with the inventor and enforcement can be costly

Records indicate that over one-half of patent infringement suits taken to court are not upheld on behalf of the inventor

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Trade Secrets

What are Trade Secrets? >intellectual property rights in the form of inventions & information (e.g., formulas, processes, customer lists, etc.) >trade secrets are not generally known to others & convey economic advantages to the holders

Other Methods

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Trade Secrets (continued)

Why Consider Protection as a Trade Secret instead of as a Patent? >trade secret law can sometimes protect inventions that did not qualify for patents >some inventors want to avoid the detailed disclosure required by the U.S. Patent and Trademark Office >there are no time restrictions on trade secrets (in contrast to patents)

Other Methods

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Trade Secrets (continued)

What are Drawbacks of Seeking Protection under Trade Secrets Law? >there is no formal procedure for obtaining protection as a trade secret >protection is established by the secret’s characteristics & efforts to protect it >holders do not have exclusive “rights” to what comprises the secret (someone could independently replicate the secret)

Other Methods

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Trademarks

What are Trademarks? >Intellectual property rights that allow firms or others to differentiate their products & services through the use of unique “marks”

Marks allow consumers to easily identify the source & quality of products/services

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Trademarks (continued)

Most trademarks take the form of names, words, or graphic designs

Trademarks also can be on the shape of packages, colors, odors, & sounds

Trademarks are the most valuable form of intellectual property for many firms

A trademark should be suggestive of (but not describe) a product or product line

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Trademarks (continued)

How do You Obtain or Disclose a Trademark (or ™)? >no formal government procedure exists for establishing a trademark >ownership is established by being first to use the mark on products >a trademark can be lost if the mark becomes a generic term or label (e.g., “aspirin” or “cellophane”)

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Trademarks (continued)

How do You Register a Trademark? >a trademark can be registered in individual states or with the U.S. Patent and Trademark Office >a federal registration should be used if a product is sold in more than one state >products with federally registered trademarks show the trademark accompanied by ®

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Copyrights

Intellectual property rights to “writings” in written and electronically-stored forms

Protects the “form of expression of an idea” and not just words themselves

Traditional way to establish a copyright is to “publish” your book or other work accompanied by a copyright notice using the word “Copyright” or the symbol ©

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Other Methods for Protecting Intellectual Property Rights

Confidential Disclosure Agreements >documents used to protect an idea or other forms of intellectual property when disclosure must be made to another individual or organization

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Other Methods for Protecting Intellectual Property Rights

Employment Contracts

>agreements between an employer and employee whereby the employer employs the employee in exchange for the employee agreeing to keep confidential information secret and to assign ideas and inventions to the employer

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Seed & Startup Financing

Financial Bootstrapping

>minimizing need for financial capital & finding unique ways of financing a new venture

Business Angel Funding

>wealthy individuals who invest money in fledgling ventures in exchange for the excitement of launching a business & a share in any financial rewards