Selecting a Legal Structure: Revisiting the Strategic Issues and Views of Small and Micro Business Owners

By Hertz, Giles T.; Beasley, Fred et al. | Journal of Small Business Strategy, Spring 2009 | Go to article overview

Selecting a Legal Structure: Revisiting the Strategic Issues and Views of Small and Micro Business Owners


Hertz, Giles T., Beasley, Fred, White, Rebecca J., Journal of Small Business Strategy


ABSTRACT

Entrepreneurs often make decisions about the legal structure of their new business without fully considering the effect of the decision on other strategically important concerns. The question of whether the new venture should be formed as a sole proprietorship, partnership, corporation, limited liability company or one of several other legal forms is a complex one. To effectively answer that question requires the founder to consider the advantages and disadvantages of each, and how the choice will affect four primary areas of concern: startup costs; the firm's exposure to legal liability; tax position; and finance options. This research addresses a gap in the literature and investigates the decision-making process of 513 founders of small and micro businesses in selecting a legal structure and clarifies other related concerns such as the source of entity structure advice, the factors influencing entity selection and the resultant confidence and satisfaction with the chosen legal structure. Findings suggest that small business owners who obtain counsel from accountants and/or attorneys are more likely to consider the full spectrum of implications of legal entity type and are generally more satisfied that their choice will positively affect firm profitability.

Keywords: legal entity selection, legal structure, business formation, legal liability, business risk, insurance

INTRODUCTION

The study of legal issues and their effect on the development of new ventures has received insufficient consideration in the existing literature (Malach et al, 2006). In their study of legal issues and new venture formation, Malach et al (2006) found that the number one legal issue for early stage entrepreneurs is choosing the legal entity type. Choice of legal entity as a "strategic" decision for an entrepreneur is not an entirely new notion, however. More than two decades ago, Khandekar and Young (1985) argued that strategic planning is important early in the new venture creation process. The authors suggested these early strategic decisions are often complex ones that require the ability to work effectively with outside experts and, in fact, they suggested that the first strategic decision the founder of a new business venture often makes is the selection of the most appropriate legal structure for the company. At the same time, Ireland et al (1985) reported findings on the use of, and satisfaction with, external legal services by entrepreneurs in Oklahoma as compared to earlier findings by Davies (1979) among entrepreneurs located in Connecticut. Collectively, these studies suggested patterns of interactions between businesses and their legal advisors and provided interesting findings for entrepreneurs regarding how to effectively seek advice and make strategic decisions about legal entity choice.

More recently, Bagley (2008) argued that "legal astuteness," which she defines as "the ability of a top TMT [top management team] to communicate effectively with counsel and to work together to solve complex problems (p.378)," is a valuable resource that can ultimately be translated into increased profitability and competitiveness for an individual firm. In her discussion of legal astuteness, she specifically identifies choice of legal entity as an example of a "legal tool" that can be used to increase value and manage risks of a firm.

While the nomenclature for the concept of "legal form" may vary (e.g. entity form, entity type, legal structure or legal format), the foundation of the inquiry remains fixed in that the founder must choose between one of several legal forms for their business. In recent years the variety of legal forms of doing business has increased. Some of these relatively new entity types include limited liability partnerships, family limited liability partnerships and, limited liability limited partnerships. Because many of these new entity types have not yet been adopted in a majority of the states, this paper focuses on the most common, and most utilized, legal forms of doing business. …

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