Efimch 03Ed5 - Practical questions and answers for chapter3 PDF

Preview

Summary

Practical questions and answers for chapter3...

Description

Chapter 3: Organizing and Financing A New Venture

35

Chapter 3 ORGANIZING AND FINANCING A NEW VENTURE

FOCUS In this chapter, we focus on organizing the venture, obtaining and protecting intellectual property, and early stage financing. Although an entrepreneur can change the legal form of the venture in the future, the initial choice should carefully consider tax effects, liability implications, and the amount of financial capital needed to start and initially operate the firm. Entrepreneurs who possess and protect intellectual property will increase the chance that their ventures will survive and create value.

LEARNING OBJECTIVES 1. 2. 3. 4. 5. 6.

Describe the proprietorship, partnership, and corporate forms of business organization. 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. 7. Explain how financing is obtained via financial bootstrapping and through business angels. 8. Describe first-round financing sources.

CHAPTER OUTLINE 3.1 3.2

3.3 3.4

3.5

PROGRESSING THROUGH THE VENTURE LIFE CYCLE FORMS OF BUSINESS ORGANIZATION A. Proprietorships B. General and Limited Partnerships C. Corporations D. Limited Liability Companies CHOOSING THE FORM OF ORGANIZATION: TAX AND OTHER CONSIDERATIONS INTELLECTUAL PROPERTY A. Protecting Valuable Intangible Assets B. What Kinds of Intellectual Property can be Protected? C. Other Methods for Protecting Intellectual Property Rights SEED, STARTUP, AND FIRST-ROUND FINANCING SOURCES A. Financial Bootstrapping B. Business Angel Funding C. First-Round Financing Opportunities SUMMARY

DISCUSSION QUESTIONS AND ANSWERS 1. Describe the major differences between a proprietorship and a partnership.

36

Chapter 3: Organizing and Financing A New Venture A proprietorship is individually owned while a partnership has two or more owners. Little time and low legal costs are involved with starting a proprietorship whereas a partnership requires moderate time and legal costs to start.

2. What is a limited partnership? A limited partnership consists of at least one general partner with unlimited investor liability and limits limited partner liabilities to the amount of their equity capital contribution to the partnership. 3. Briefly describe the corporate form of business organization. What is meant by limited liability? In a corporation the firm’s assets are separated from the owners’ personal assets. It provides for an unlimited life and it is usually easy to transfer ownership. Income taxes are paid at the corporate level and dividends are subject to personal tax rates. The limited investor liability of a corporation provides that the owners are only liable for the amount of their equity investments in the business and their other personal assets are not at risk for any business debts. 4. How does a subchapter S corporation differ from a regular corporation? A subchapter S (or just S) corporation must have less than 75 owners [note: the limit has recently been increased to 100 or fewer owners]. An S corporation provides the same limited liability as a regular (or C) corporation but income flows through to the shareholders and is taxed at the personal tax rates of the owners instead of at a regular corporation’s tax rate. 5. Describe the major characteristics of a limited liability company. A limited liability company (LLC) is owned by its “members” or shareholders who have limited investor liability. Its earnings flow through to the members with the earnings being taxed at the personal income tax rates of the members. High time and legal costs are involved in setting up an LLC. 6. Describe the major taxation advantages of a limited liability company or a subchapter S corporation over a regular corporation. For LLCs and S corporations income flows to the shareholders or owners and is taxed at their personal tax rates. Regular or C corporations pay corporate taxes and any cash dividend distributions to shareholders are also subject to personal income tax rates. 7. What is meant by the term “intellectual property”? Intellectual property is a venture’s intangible assets and human capital, including inventions that can be protected from being freely used or copied by others. Intangible assets can be protected through patents, trade secrets, trademarks, and copyrights. 8. Identify and briefly describe the types of patents used to protect valuable intangible assets. Patents: intellectual property rights granted for inventions that are useful, novel, and non-obvious. There are four kinds of patents: (1) utility, (2) design, (3) plant, and (4) business method. Utility patents cover most inventions pertaining to new products, services, and processes. Design patents protect the ornamental designs of products.

Chapter 3: Organizing and Financing A New Venture

37

Plant patents protect discoveries of asexual reproduction methods of new plant varieties. Business method patents protect a specific way of doing business and the underlying computer codes, programs, and technology. 9. What are trade secrets and trademarks? How are they used to protect valuable intangible assets? Trade secrets: intellectual property rights in the form of inventions and information not generally known to others that convey economic advantages to the holders. There is no formal procedure for obtaining protection for an invention or information as a trade secret. Rather, protection under trade secrets law is established by the characteristics of the secret and efforts to protect it. 10. What are trademarks? Identify the four types of “marks” used to protect intellectual property. Trademarks: intellectual property rights that allow firms to differentiate their products and services through the use of unique marks. The four types of “marks” are: trademarks, service marks, collective marks, and certification marks. There is no formal government procedure for establishing a trademark. Rather, ownership is acquired by being first to use the mark on products. 11. What are copyrights and how are they used? Copyrights: intellectual property rights to writings in written and electronically stored forms. In a broad sense, copyright law protects the form of expression of an idea, not just words. Today, the fact that a work was “created” is enough to provide copyright protection. However, a copyright can be registered with the U.S. Copyright Office. A registered copyright provides for an amount of statutory damages that can be recovered without proof of actual damages. 12. What are confidential disclosure agreements? What are employment contracts? 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: employer employs the employee in exchange for the employee’s agreeing to keep confidential information secret and to assign ideas and inventions to the employer. 13. What is seed and startup financing? Seed and startup financing are sources of financing available during the development and startup stages of a venture’s life cycle. Included are the entrepreneur’s physical and financial assets, family and friends, and business angels. Other venture investors, including venture capitalists, may also be sources of financial capital during the very early-stages of a venture’s development and operation. 14. Describe the meaning of financial bootstrapping. Financial bootstrapping involves minimizing the need for financial capital and finding unique ways of financing a new venture. The entrepreneur attempts to minimize costs during the very early stages of the venture in order to minimize the need for additional capital.

38

Chapter 3: Organizing and Financing A New Venture

15. Describe some major characteristics of business angels. Business angels are wealthy individuals who invest in early stage ventures in exchange for the excitement of launching a business and a share in any financial rewards. Business angels are self made, wealthy individuals with substantial business and financial experience who enjoy the thrill of being involved in new ventures.

16. What is first-round financing that occurs during the survival life cycle stage? Refer to Figure 3.7. First-round financing, which occurs during the survival stage, includes financing from: business operations, venture capitalists, suppliers and customers, government assistance programs, and commercial banks. 17. From the Headlines – The Fantasticks: Describe the fundraising tactic for the producers of The Fantasticks. What were the driving motivations for the angel investors? Answers will vary: Many of the original investors in 1960 were friends and neighbors of the artists and executives for the show. Their approach was the common one in the industry – seeking funding from (Off-) Broadway angels who had an affinity for the artistic endeavor, but also knew they would be buying tickets to the production.

INTERNET ACTIVITIES 1.

Access the Inc. magazine Web site at http://www.inc.com. Identify a list of recent articles that relate to how to finance new ventures. Web-researched results vary due to constant updating of the related web sites.

2. Access the http://www.garage.com Web site. Identify the angel matchmaking services that are provided. Determine the site’s focus in terms of early stage versus later stage financing, as well as the typical range of financing that is provided. Web-researched results vary due to constant updating of the related web sites. 3. Access the Web sites of http://www.angeldeals.com, http://gatheringofangels.com, and http://www.vcfodder.com. Determine the scope and focus of these sites in terms of matchmaking financing services that are available for entrepreneurs. Web-researched results vary due to constant updating of the related web sites.

EXERCISES/PROBLEMS AND ANSWERS Figure 3.6 in the chapter is repeated here to support problem calculations involving federal income taxes. We also provide in Table A incremental and cumulative income tax

Chapter 3: Organizing and Financing A New Venture

39

calculations for corporate income taxes and for personal income taxes (for single filers and married filing jointly).

FI GURE36 2 01 2Pe r s o n a la n dCo r p o r a t eFe de r a lI n c o meTa xRa t e s

So u r c e :I n t e r n a lRe v e n u eSe r v i c e , h t t p : / / www. I RS. g o v .

40

Chapter 3: Organizing and Financing A New Venture

1. [Business Organization and Intellectual Property] Phil Young, founder of the Pedal Pushers Company, has developed several prototypes of a pedal replacement for children’s bicycles.

Chapter 3: Organizing and Financing A New Venture

41

The Pedal Pusher will replace existing bicycle pedals with an easy release stirrup to help smaller children hold their feet on the pedals. The Pedal Pusher will glow in the dark and will provide a musical sound as the bicycle is pedaled. Phil plans to purchase materials for making the product from others, assemble the products at the venture’s facilities, and hire product sales representatives to sell the Pedal Pushers through local retail and discount stores that sell children bicycles. Phil will need to purchase plastic pedals and extensions, bolts, washers and nuts, reflective material, and a “micro-chip” to provide the “music” when the bicycle is pedaled. A. How should Phil organize his new venture? In developing your answer consider such factors as amount of equity capital needed, business liability, and taxation of the venture. Phil’s proposed business is not likely to be very capital intensive. That is, little investment will be required for equipment and a production facility. The investment in inventories can probably be kept relatively low. Thus, organizing as a proprietorship will probably work due to a need for relatively low amounts of equity capital. Being taxed as a proprietorship also may be advantageous. Of course, the major advantage to Phil by choosing to organize as a corporation is to limit his liability to his business investment. If Phil has substantial personal assets, organizing as a corporation would help protect these assets in the event the business fails. B. Phil is concerned about trying to protect the intellectual property embedded in his Pedal Pusher product idea and prototype. How might Phil consider protecting his intellectual property? Possible ways to protect his intellectual property might include: applying for a utility patent to protect his product; a utility patent to protect his design; and a trademark to protect his company name. 2.

[Income Taxes] Assume your new venture, organized as a proprietorship, is in its first year of operation. You expect to have taxable income of $50,000. Use the income tax rate information contained in Figure 3.6 to estimate the amount of income taxes you would have to pay. A.Calculate the amount of your income taxes if you were filing as a single individual. Personal Marginal Tax Rate 0.10 x 0.15 x 0.25 x

Personal Taxable Income $ 8,700 = 26,650 = 14,650 = $50,000

Personal Amount of Taxes $870.00 3,997.50 [Note: 35,350 - 8,700 = 26,650] 3,662.50 [Note: 50,000 – 35,350 = 14,650] $8,530.00

Note: This problem assumes there are no additional sources of personal taxable income.

42

Chapter 3: Organizing and Financing A New Venture Table A also can be used to reduce the number of calculations. The cumulative taxes for taxable income of $35,350 are $4,868 (rounded). Taxes on the additional $16,050 ($50,000 - $35,350) at a 25% rate equal $3,662.50. Total personal federal income taxes would be $8,530 ($4,868 plus $3,662.50). B.

Calculate the amount of your income taxes if you were married and filing jointly. Personal Marginal Tax Rate 0.10 x 0.15 x

Personal Taxable Income $17,400 = 32,600 = $50,000

Personal Amount of Taxes $1,740.00 4,890.00 [Note: 50,000 – 17,400 = 32,600] $6,630.00

C.If your venture had been organized as a standard corporation instead of a proprietorship, calculate your income tax liability. Corporate Marginal Tax Rate 0.15 x

Corporate Corporate Taxable Amount Income of Taxes $50,000 = $7,500.00

3.[Income Taxes] Rework problem 2 under the assumption that in addition to your venture’s taxable income of $50,000, you expect to personally earn another $10,000 from a second job. A. Filing as a single individual: Personal Marginal Tax Rate 0.10 x 0.15 x 0.25 x

Personal Personal Taxable Amount Income of Taxes $ 8,700 = $870.00 26,650 = 3,997.50 [Note: 35,350 - 8,700 = 26,650] 24,650 = 6,162.50 [Note: 60,000 – 35,350 = 24,650] $60,000 $11,030.00

B. Married filing jointly: Personal Marginal Tax Rate 0.10 x 0.15 x

Personal Taxable Income $17,400 = 42,600 = $60,000

Personal Amount of Taxes $1,740.00 6,390.00 [Note: 60,000 – 17,400 = 42,600] $8,130.00

C. Taxed as a Corporation plus personal taxable income:

Chapter 3: Organizing and Financing A New Venture

43

If married filing jointly:

Corporate taxes: Personal taxes: Total taxes

Marginal Tax Rate 0.15 x 0.10

x

Taxable Income $50,000 = 10,000

=

Amount of Taxes $7,500.00 1,000.00 $8,500.00

Note: if filing as a single individual, the personal taxes would be: 0.10 0.15

x x

8,700 1,300

= =

870.00 195.00 $1,065.00

4. [Intellectual Property] As your venture has moved from the development stage to the startup stage, a number of trade secrets have been developed along with an extensive client list. You are in the business of developing and installing computer networks for law firms. A.

Your marketing manager has recently resigned and you are in the process of interviewing new candidates for the position. How might you try to protect your venture’s intellectual property since the marketing manager must have access to the trade secrets and client list? Trade secrets are intellectual property rights in the form of inventions and information (e.g., formulas, processes, customer lists, etc.) not generally known to others. Trade secret misappropriations frequently involve ex-employees. At issue is whether the employee exits with, and makes use of, his/her former firm’s trade secrets. You should inform the new marketing manager that any trade secrets that he/she will come in contact with belong to the firm and must not be taken if he/she leaves the firm. Of course, trying to prove misappropriations in court may be very costly.

B.

Your operations manager has developed a “new” process and you have heard that he plans to personally apply for a business methods patent. What action(s) would you take?

Employment contracts are agreements between an employer and an employee about the terms and conditions of employment, including the employee’s agreement to maintain confidentiality and assign the rights for ideas and inventions to the employer. Assuming an employment contract was previously signed, you should inform the operations manager that the “new” process that was developed, if in the scope of the firm’s activities, likely belongs to the firm and any application for a business methods patent should be on behalf of the firm. All ideas, inventions, and other forms of intellectual property developed by the employee that are deemed within the scope of the venture’s activities should be assigned to the firm.

Chapter 3: Organizing and Financing A New Venture

44

Of course, an employee’s development of intellectual property not related to the venture’s scope of business belongs to the employee. 5.

[Income Taxes] The Capital-Ideas Company is in its development stage and is deciding how to formally organize its business venture. The founder, Rolf Lee, is considering organizing as either a proprietorship or as a corporation. He expects revenues to be $2 million next year with total expenses amounting to $1.625 million resulting in a taxable income of $375,000. Rolf is interested in estimating his federal income tax liability based on the schedules contained in Figure 3.6. A. Calculate the amount of federal income tax that Rolf would pay if Capital-Ideas is organized as a proprietorship. What would be the marginal tax rate on the last dollar of taxable income and what would be the average tax rate? Assume Rolf files as a single tax payer. Personal Taxable Income

Tax Rate = Tax Rate =

Over

Dollar

Marginal

But not over

Amount

Tax Rate

8,700 35,350 85,650 178,650 375,000

8,700 26,650 50,300 93,000 196,350

10.0% 15.0% 25.0% 28.0% 33.0%

8,700 35,350 85,650 178,650

Total Tax Liability

Amount

Marginal 33.0% 870.00 Average 3,997.50 12,575.00 26,040.00 64,795.50 of Taxes

$108,278.00

$108,278/$375,000 = 28.87% Table A presented above can be used to reduce the number of calculations. The cumulative taxes for $178,650 are $43,483. The additional taxes on $196,350 ($375,000 - $178,750) at 33% are $64,795.50. Total taxes would be $108,279 ($43,483 + $64,795.50) rounded. B. Calculate the amount of federal income tax that the Capital-Ideas Company would have to pay if the venture is organized as a regular corporation. What w...