Chapter 3ORGANIZING AND FINANCING A NEW VENTURE

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© 2012 South-Western Cengage Learning

ENTREPRENEURIAL FINANCE Leach & Melicher

Chapter 3: Learning Objectives Describe the

proprietorship, partnership, and corporate forms of business

Identify the differentiating characteristics of a limited liability company (LLC)

Describe the benefits, risks, and basic tax aspects of various organizational forms

Discuss the use of patents and trade secrets to protect intellectual property

Discuss the use of trademarks and copyrights to protect intellectual property

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

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

Describe first-round financing sources

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Forms of Business Organization Sole 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

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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 assets of the business

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

Corporate Charter:legal document that establishes the corporation

S Corporation:provides limited liability for shareholders; plus, corporate income is taxed like 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 earnings can be taxed at the personal income tax

rates of the members

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Bases for Comparing Various Business Organizational Forms

Number of Owners and Ease of Startup

Investor Liability Equity Capital Sources Firm Life and Liquidity of

Ownership Taxation

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Number of Owners & Ease of Startup

Proprietorshipone; low time and legal costs

Partnership (general)two or more; moderate time and legal costs

Limited Partnershipone or more general and one or more limited partners; moderate time and legal costs

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Number of Owners & Ease of Startup (continued)

Corporation (C)one or more, with no limit; high time and legal costs

S (Subchapter S) Corporationless than 100 owners (since 2005); high time and

legal costs Limited Liability Company (LLC)

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

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Investor Liability

Proprietorshipunlimited

Partnership (general)unlimited (joint and several liability)

Limited Partnershiplimited partners’ liability limited to their investments

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Investor Liability (continued)

Corporation (C)limited to shareholders’ investments

S (Subchapter S) Corporationlimited to shareholders’ investments

Limited Liability Company (LLC)limited to owners’ investments

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Equity Capital Sources

Proprietorshipowner

Partnership (general)partners, families, and friends

Limited Partnershipgeneral and limited partners

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Equity Capital Sources (continued)

Corporation (C)venture investors and common shareholders

S (Subchapter S) Corporationventure investors and Subchapter S investors

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

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Firm Life & Liquidity of Ownership

Proprietorshiplife determined by owner; often difficult to transfer ownership

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

Limited Partnershiplife 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) Corporationunlimited life; often difficult to transfer ownership

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

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Taxation

Proprietorshippersonal tax rate

Partnership (general)personal tax rates

Limited Partnershippersonal tax rates

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Taxation (continued)

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

S (Subchapter S) Corporationincome 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:

a venture’s intangible assets and human capital, including inventions that can be protected from being freely used or copied by others

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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 printed 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 most likely need to hire a patent applications specialist lawyer)

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Four Kinds of Patents:1. Utility Patents:

cover mechanical or general inventions, chemical inventions, and electrical inventions

2. Design Patents:cover the “appearance” of items (e.g., sports uniforms, electronic products, and autos)

3. Plant Patents:protect discoveries of asexual reproduction methods of new plant varieties

4. Business Method Patents:protect specific ways of doing business and the underlying computer codes and technology

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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 and 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, and small entities are charged lower filing fees

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

However, patent rights and 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, and 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 and 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 and 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?

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

Usefulthe invention cannot just “do nothing”

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

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

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

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 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

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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)

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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 and efforts to protect it holders do not have exclusive “rights” to what

comprises the secret (someone could independently replicate the secret)

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Trademarks

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

Marks allow consumers to easily identify the source and 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, and 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

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 and finding unique ways of financing a new venture

Business Angelswealthy individuals who invest money in fledgling ventures in exchange for the excitement of launching a business and a share in any financial rewards

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