Let’s say your family decides to set up a lemonade stand on a random Saturday. You get the ingredients, set up a table and signs, and start selling. You are operating as a sole proprietor. A sole proprietor is simply the name given to someone who starts engaging in a business by herself without setting up a formal corporate structure. You run your business and you keep your profits. You and your kids run the successful stand for the summer. However, that fall, you get hit with a lawsuit. It turns out your lemonade was tainted with E. coli and made some of the neighborhood kids sick. You lose the lawsuit, and they collect the judgment by taking money out of your personal bank account and by seizing and selling your car.
The next summer, you decide you need to change the way your lemonade stand operates. This time, instead of setting up your own lemonade stand, you talk to the neighbors and you agree that you are going to team up to run the stand. You have created a general partnership (“GP”). A GP is a relationship between two or more people who engage in a common business purpose and agree to share profits equally. A GP is sort of like a sole proprietor, but with more than one person — in other words, the partners need not do anything formal to create a partnership, nor do they even need to understand that they are creating a GP.
The neighbors buy the ingredients and mix up the lemonade (since your family did such a bang up job the summer before). You get the cups and ice, setup the signs and card table, and deal with schlepping your refreshing concoction. At the end of the summer, you split the profits 50/50 with the neighbors. Unfortunately, that fall you learn that the neighbor kids weren’t good at washing their hands either. Another lawsuit ensues and this time, even though it was your partner’s fault, they decided to collect the judgment by seizing both your car and the neighbor’s car. GPs have no limitations of liability — each partner is responsible for the partnership’s liabilities.
The following summer, you decide to move back to a family-run operation. You decide to get grandma to contribute start-up costs (namely a gas-powered generator, a BlendTec blender, and some cushy chairs and shade structure for mom and dad). And grandma insists on having a formal partnership agreement prepared in writing. (Smart woman!) You and grandma form a limited partnership (“LP”).
A limited partnership (“LP”) is a relationship where one or more people are “general” partners and one or more people are “limited” partners. As the names suggest, the general partners have broad powers to run the business — buy and sell things, hire and fire people, etc. The general partners are also liable for any debts of the LP, which means that if the LP gets sued but doesn’t have any money, the general partners pay. The limited partners, on the other hand, have no power to run the business — they are in effect “passive” investors (although they can play an advisory role). The limited partners on the other hand are not liable for the debts of the LP, so if the LP gets sued, they do not have to pay.
So you set up your LP with grandma by filing your partnership agreement with the State under the name Grandma’s Lemonade Slushies LP and by paying the $100 fee. Your lemonade slushies are a big hit. You split your copious profits 50/50 with grandma but, as you might have guessed by now, it turns out your youngest again forgot to wash his hands, the lemonade gets tainted with E. coli, everyone gets sick, and there is a lawsuit. You lose the lawsuit, and have to sell the generator, blender, and furniture. That’s not enough to pay off the debt, so they take your car again, too. However, because grandma was a limited partner, they don’t get her car. (At least you and the kids have a way to get around while you get back on your feet!)
The next summer, you’re back on your feet and you’re ready to try it again. You convince grandma to pony up for another blender (this time she springs for the commercial edition!), but this time (perhaps because you see the inevitable coming) you decide that another LP is not the way to go. Perhaps you should find a way to protect your personal assets from the liabilities of the company. Enter the limited liability partnership (“LLP”).
An LLP is sort of like a GP, in that all the partners are empowered with the management of the business, and sort of like an LP, in that all of the partners receive the benefit of limited liability for the debts of the partnership or the negligence of other partners. This structure is almost always preferable to an LP or GP because of the limitation of liability, so this has become one of the more popular structures, particularly for groups of professionals like dentists or architects.
You and grandma enter into a partnership agreement, file the one-page LLP form with the state (“Grandma’s Lemonade Yummy-drinks LLP”), and pay the $100 fee. This time, the novelty of the lemonade stand has worn off (plus you don’t trust your kids to remember to wash their hands), so you and grandma decide to hire one of the (older and more responsible) neighbor boys to man the stand for minimum wage. Everything goes swimmingly for the summer, with you and grandma again spliting your profits 50/50. That fall (you guessed it) it comes to light that the neighbor boy also is lacking in hygiene. Another lawsuit ensues, but this time all they can take are the assets of the business (here, your very powerful blender). You and grandma both keep your cars and other personal assets safe.
Summer five. Okay, this is getting ridiculous. You and grandma decide you need to get serious about doing this the right way. People love your blended lemonade recipe, but you have to get the hygiene under control. You decide to go industrial, but you need investors. You solicit your brother Steve in Des Moines, your cousin Janet in DC, and your crazy uncle Zeke in Detroit. Steve puts up $10,000, Janet puts up $12,000, and crazy Zeke puts up $78,000. Grandma puts up $50,000, and you put up $50,000. You all form a limited liability company (“LLC”) by entering into an operating agreement, filing the one-pager with the State, and pay the $100 fee, naming your new company “Crazy Zeke’s Blended Lemonade LLC.”
In the operating agreement, you spell out that you will be the manager of the company and you will draw an annual salary of $50,000 for your services. You also specify that profits will be shared on a percentage basis based on your initial investment (Steve 5%, Janet 6%, crazy Zeke 39%, and you and grandma 25% each). You buy a storefront, a bunch of blenders, hire a bunch of staff, and make lots of money. And you implement a hand-washing incentive program that keeps you from getting sued (although your personal assets as well as those of your investors would have been safe in any event). Crazy Zeke’s makes you all millions.
Now that Crazy Zeke’s has become a household name, you decide you want to raise capital to go nationwide. But you don’t want to have to amend your LLC’s operating agreement with all those investors coming in. So you create a new corporation (Crazy Zeke’s, Inc.), which “buys” Crazy Zeke’s Blended Lemonade LLC by issuing 1,000,000 shares of stock to you, Grandma, crazy Zeke, Steve, and Janet in the correct percentages. You then offer an additional 1,000,000 shares of stock to the public. The shareholders elect Crazy Zeke as Chairman of the Board and the Board names you CEO. You and the family retain strong control of the organization, observing all the corporate formalities of annual meetings and reports. Crazy Zeke’s, Inc. goes on to make millions for its investors with over 300 stores worldwide.
The moral of the story. When setting up any sort of business venture, you ought to take a moment to think through what form of corporate structure you want to use. There are several good options that take little effort to establish and maintain, but that can keep you protected in the event something bad happens to your business.