Should I Form a New Entity for My Idea?
You have a new idea and you’ve got a guy who has connections or resources or ways to help get that idea off the ground. It’s clear you want to work together. The assumption is, often, that you’ll “simply” form a new entity, like an LLC, to make this idea happen. Holdupwaitaminute.
Now that my cringe has worn off, let’s discuss the pros and cons of forming an entity to explore the viability of an idea.
Just forming an entity triggers lots of legal requirements that you might not want to get into just yet. In Nevada, you’ll pay for a state business license, and will need to follow through with registering with the Nevada Department of Taxation and obtaining your local business licenses. You’ll also be on the radar with the IRS, which means you’ll have to file tax returns. You’ll also want to be careful about how you establish the entity, because forming an entity with someone else (or multiple someone elses) is like getting married and splitting up is much like a divorce.
“Okay, Gina. So we won’t form an entity. We’ll just work together.” Hang on. If you just work together, you’ll form what’s called a general partnership where each partner is liable for the other’s decisions and neither partner has insulation from liability for things that go on in the business. That’s one of the reasons you form an entity – for the limited liability one would afford you in business. However, you’ll want to carefully weigh the pros and cons of forming an entity with someone else just to explore a new idea, especially if you don’t know the other person or entity very well.
The happy medium here is what’s called a joint venture, which is more like dating than getting married. You have two parties (ideally entities) coming together to explore an idea. If it doesn’t work out, you take what you brought to the party and go your separate ways. There’s nothing to cancel, no taxes to file. If you already have an entity, you’ll more than likely want to use that in your joint venture, to keep a corporate veil in place. Additionally, you’ll want a Joint Venture Agreement to address each party’s responsibilities, what each party is bringing to the table, how profits and expenses will be handled, and, most importantly, what happens if the venture doesn’t work out. As with any contract, you want the exit to be clearly marked. If the venture goes south, when and how can one person call it dead and how do the parties separate?
I also encourage joint venturers to specify a date, time, and place for a face-to-face meeting, maybe six months into the venture, during which the parties can speak candidly about what’s working and what isn’t. I often act as a mediator at these meetings to help the parties work through any issues. At this point, they’ll usually decide whether the venture can be tweaked and continued, or whether it needs to end and how they separate. Ideally, the separation language is already outlined in the Joint Venture Agreement, which minimizes disputes. If the venture can be tweaked, the agreement can be amended, or it might make sense for the parties to form an entity at that point, after the viability of the idea has been tested and the parties know they can work together.