CHAPTER

1. 14 CHAPTER Business Organization and Cybercompanies

2. Business Organization • The traditional choices of business organization have been • Sole Proprietorship, Partnership, and Corporation • More recently hybrids have emerged that combine desirable features of partnerships and corporations • Cybercompanies are companies that do business on the Internet • These companies are created by contract between web hosts and a business • The distinctiveness of cybercompanies is diminishing

3. Sole Proprietorships • The simplest and most common form of business ownership • Owned and operated by one person • Can have many employees, but generally does not • Virtually no formalities required other than filing for taxes • and paying local business fees • There is no separation between the SP and the business for tax and liability purposes • Profits of the company are attributed to the owner • Unlimited liability of the owner for business debts

4. Sole Proprietorships • Other Disadvantages of Sole Proprietorships • More difficult to raise capital • Must be a jack of all trades • Selling the business is more difficult • On the other hand if initial losses are expected, SP can be tax shelter

5. Partnerships • A partnership is formed when two or more partners agree to form a business and operate it together for profit • Formalities associated with forming a partnership are minimal • A partnership agreement need not be in writing • Virtually all states have passed the Uniform Partnership Act • If nothing is stated in the partnership agreement, the provisions of the UPA will control

6. Uniform Partnership Agreement • Among the provisions of the UPA • If nothing is said each partner is entitled to an equal share of profits and losses • Each partner has an equal vote in management • Partnerships have entity status • Can own property and can sue and be sued • Partnership will terminate with the death or incapacity of a partner • Except for very small partnership, a written partnership agreement should be composed

7. Types of Partnerships • General partnership • Each partner is both principal and agent • Each partner has a fiduciary responsibilities to the partnership and the other partners • Each partner is unlimitedly liable for partnership debts • Limited partnership • General partners have unlimited liability • Limited partners have limited liability as long as they do not participate in management--same position as shareholders

8. Advantages of Partnerships • If a partner dies a continuation agreement in the partnership agreement allows the business to continue • Relative to sole proprietorships, partnerships find it easier to raise capital and borrow from banks • Partnerships have been used as tax shelters • Profits and losses of the partnership are attributable pro rata to partners • In many ventures there are initial losses followed by gains

9. Fiduciary Duties of Partners to Each Other • While the partnership exists, partners owe the partnership and each other fiduciary duties, which include • Avoidance of conflicts of interest • Full disclosure of possible conflicts of interest • Not competing against the partnership • Not accepting secret monies while doing partnership business • Partnerships are based on consent. • When a partner no longer consents to be a partner, the partnership is over for that person

10. Termination of Partnerships • A well written partnership agreement that has provisions regarding termination of the partnership is wise investment • Dissolution occurs when the stop taking on new business • When a partnership dissolves because of death of the partner or incapacity, survivors are entitled to the FMV of the ex-partner’s interest • Winding up occurs then the partnership pays off partnership debts and liquidates assets

11. Termination of Partnerships • Limited Partnerships • Death of a limited partner does not end the partnership • Virtually all limited partnerships have continuation agreements if a general partner dies, resigns, or becomes incapacitated • In winding up, limited partners have higher priority to assets than general partners

12. Corporations • Entity status • In law a corp. is a person • Must file taxes, can own property, can sue and be sued, can contract with other persons • Potentially infinite existence • Corps. are owned by shareholders • Managed by a board of directors that is elected by shareholders • Directors select chief corp. officers who manage day to day affairs of the corp.

13. SmallCorporations • Small corps. are a lot like partnerships • The large shareholders tend to be on the board of directors and the chief corp. officers • Small corps. can elect to be taxed like partnerships, if they become S corps. • S corps have fewer than 75 shareholders • Can only have one class of stock • If the business anticipates initial losses, then the election to become an S corp. has tax advantages

14. Advantages of Corporations • Limited liability • Shareholders have limited liability with few exceptions • Transferability of ownership • For large corps., disposing of ownership is easily accomplished in the stock market • Corps. are effective vehicles for raising capital • Disadvantages • Double taxation of dividends • Corp. income is taxed and dividends to shareholders are also taxed

15. Corporate Formation • In order to incorporate, the corp. promoters must comply with state incorporation statutes • When the corp. certificate is issued by the state, a first meeting is held at which time • Board of Directors is elected • Corp. bylaws are passed • Corp. bylaws are functionally equivalent to a partnership agreement

16. Corporate Bylaws • Corp. bylaws are an operating manual and discuss the following: • Issuance of stock and possible restrictions on transfer of stock, which is common in small corps. • When more than a majority of directors is required, such as mergers • Mechanisms for resolving deadlocks • shareholders are owners but do not owe fiduciary duties to the corp., in general • Directors and corp. officers do owe fiduciary duties to put the interest of the corp. above their own

17. Shareholder Agreements, Proxies, and Voting Trusts • In small corps. agreements among shareholders are common to maintain balances of power • In such agreements, there are frequently protections built into to corp. bylaws for minority interests • Agreements among shareholders to vote in ways so as to preserve minority shareholders on Bd. of Directors • Agreements to maintain jobs at a salary • Sometimes protection of minority interest are accomplished through a voting trust • The trustee of a voting trust is given proxies of shareholders right to vote with instructions on how to vote • Voting trusts are often time limited

18. Shareholder Agreements, Proxies, and Voting Trusts • Basically all of these agreements are designed to prevents squeeze-outs and deadlocks • If deadlocks cannot be resolved, a member of the Bd. of Dirs. can petition the courts to dissolve the corp. • Preemptive rights • At CL shareholders are entitled to be offered shares of offerings of stock equal to their percentage of ownership • As corps. become larger, preemptive rights are a nuisance and the corp. bylaws are generally amended to abolish preemptive rights within that corp. • Cumulative voting—shareholders can cast all of their votes in one election of a member of the Board of Dirs. • another means of preserving minority representation on the board of directors.

19. Mergers • Fundamental changes in a corp. • Such as mergers, liquidation, and termination • Require a majority of the Bd. of Dirs. but also of the shareholders • Mergers • The acquiring firm seeks to obtain a majority of stock ownership so as to elect a new Board • At times there have been legal battles between an acquiring firm and management of the target firm • Sometimes aid from a white knight is enlisted by existing management to combat takeovers by outside firms

20. Termination of a Corporation • Termination of a corp. requires approval of a majority of shareholders • shareholders of a corp. that has been acquired are entitled to CL rights of appraisal • These shareholders are entitled to go to court if they cannot get the acquiring corp. to purchase their stock at FMV • Minority shareholder rights occur when the acquiring corp. acquires more than 90% of the common stock

21. Dissolution of a Corp. • Requires a majority vote of both the Board of Directors and shareholders • As with partnerships, • Dissolution occurs when the corp. stops taking on new business • Winding up occurs when creditors are paid and assets, if any, are distributed to shareholders • Sale of Assets • When a corp. sells most of its assets it is substantively the same as terminating the business • Generally requires approval of both shareholders and Directors

22. Hybrid Organizations • Limited partnerships • As with corps. LP’s must comply with state statutes in order that limited partners have limited liability • In order to maintain limited liability, limited partners must not engage in management • The Revised Uniform Limited Partnership Act allows a number of activities by limited partners that are not considered participating in management, including • Guaranteeing partnership debt, serving as a consultant, acting as an agent of the LP, attending partnership meetings, and even voting on some issues

23. Hybrid Organizations • Limited Liability Companies • Allowed in all 50 states • have the tax advantages of S corps. • Multiple classes of stock allowed • No limit on number of shareholders • Limited Liability Partnerships • Professionals in most states are required to be unlimitedly liable to clients, but • LLP’s allow professionals not be unlimitedly liable for malpractice of partners or other employees

24. Other Forms of Business Organization • Joint ventures • Basically a general partnership for a specific purpose • Both parties are unlimitedly liable for debts of the joint venture even though they may be corps. • Does not create a separate entity, and therefore the joint venture itself cannot own property, sue or be sued • It terminates once the purpose for the joint venture is accomplished

25. Cooperatives • Cooperatives are associations of individuals joined together to provide economic service to members • Often used by farmers to add bargaining power to their contracts with suppliers or processors • Net revenues that are distributed to members are not taxed • Avoids double taxation

26. Franchises • Very common form or business organization • Typically the parent company supplies a TM • and supervises franchisees to insure uniformity of service • Investing in a franchise is a major investment for small business people • The franchise agreement is subject to federal and state regulation • Parent companies are required to disclose to prospective franchisees pertinent facts, particularly the grounds for termination

27. Franchises • Federal Trade Commission has enacted a Franchise Rule that • Requires extensive disclosures and • Creates liability for misrepresentation by the franchisor • A number of states have additional disclosure requirements for franchises

28. Termination of Franchises • Much of the litigation involving franchises takes place when a franchise is terminated • The FTC Franchise Rule requires franchisors to disclose the grounds for termination • Congress and the states have passed laws protecting franchisees from arbitrary terminations of franchises • Some states require franchisors to notify franchisees before the franchise is terminated and to give reasons • Some states require franchisors to give franchisees an opportunity to correct the problems

29. Cyber Companies • The distinction between .coms and bricks and mortar companies is becoming irrelevant • Virtually all .coms have physical assets and vice versa • Legal liabilities associated with establishing a web site include • IP law issues, especially CR and TM, peculiarities of E-Commerce contract law, cyber torts and product liability

30. Adequacy of web site development • It is critical that a web site have adequate bandwidth to fulfill and accommodate the orders it receives • Typically web hosting agreements have ironclad limitation of liability clauses • Web hosts are unwilling to assume risk of lost profits if web site is not functioning temporarily • FTC Legal Constraints on web sites • Generally the same constraints apply as apply to other businesses • FTC has authority to prohibit unfair and deceptive trade practices regardless of the source

31. FTC Enforcement • FTC has power to prohibit • Practices that are unfair • The practice must have a substantial impact • That is not outweighed by other benefits and • That are not reasonably avoidable, or • Practices that are deceptive, that is practices • That contain a material misrepresentation or omission that is • Likely to deceive consumers generally • Among the practices that the FTC regulates are:

32. FTC Enforcement • Reasonable substantiation • Unsubstantiated advertising claims are subject to FTC enforcement actions • FTC could go to court and obtain a cease and desist order • To avoid such claims, web sites (and other businesses) should have reasonable substantiation for claims made in their advertisements • E.g., celebrities should actually use the products they endorse • Surveys should use statistical principles that are recognized as appropriate for obtaining accurate results

33. FTC Enforcement • For shipments of tangible physical goods, UCC warranty constraints are applicable • The FTC has enforced its Mail or Telephone Order Merchandise Trade Regulation Rule against web sites • The Rule requires on-time shipment of merchandise, or shipment within 30 days of the order by consumers, if no shipment is stated • FTC sued ToysRus.com for failing to fulfill Christmas orders in 1999.

34. Legal Protections Used by Web Sites • Web sites continue to protect themselves using click-wrap agreements • In most click-wrap agreements, the web site dictates which courts have jurisdiction, or • Whether an arbitrator has jurisdiction • Such agreements avoid minimum contact tests as to jurisdiction • The Internet Tax Freedom Act is set to expire in Nov. of 2003 • Payment of income tax may be required for out of state sales

35. Other Legal Issues Faced by Web Sites • Who owns the web site • Often in contracts between small businesses and web site designers, the designer retains the CR • At a minimum the web site should require the designer to sign a Non-Disclosure Agreement • What about web site imitators? • Imitations could be TM or CR infringements • Note that web sites are changed frequently, probably precluding suits based on “look and feel” tests. • It is clear that “suck” sites are protected by the First Amendment

36. Other Legal Issues Faced by Web Sites • Posting of the name or likeness of celebrities for commercial purposes generates liability unless permission is granted • By and large links to other web sites are legal unless the linked web site objects • For commercial web sites, privacy policies are expected • For web sites that are geared towards children, special precautions are required to comply with COPPA

37. Web Hosting Agreements • Main provisions of concern is whether the site can grow with the business • Knowledgeable IT professionals are required to negotiate with web hosting firms • Web hosting issues include • Reliability, domain name integrity, site updates, • Web hosts will typically insist that the web site only conduct legal business • Web hosts will typically try to protect themselves from being used by web sites to obtain web host software

38. Other Legal Issues Faced by Web Sites • Games and contests • Legality varies from state to state • May have to specifically exclude residents of certain states • There are a lot of disclosures required in order to comply with the laws of states that do allow such contests • Out of date offers • A contract is made when the consumer clicks the “I agree” button • Reasonable attribution procedures • Encryption to protect against hackers who intercept transmissions