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What is the Proper Value of a Business Formation?

By Edited Nov 13, 2013 0 0
Albuquerque Business Law, P.C.

I was recently asked to donate an item of value to my daughter’s daycare as part of a silent action it was holding to raise money for the daycare. One of the things that was asked on the form was the value of the item that was being donated, something that I was tempted to flippantly value at “$1 million to $15 million depending on the success of your business idea.” If one takes the long view of how any business idea plays out, one can see the truth in such a statement. There is a process to the formation of any sound business idea. Having planned, launched, and worked through the start-up phase of several successful business and one or two quasi or downright unsuccessful business launches, I can tell you that the process and the key documents cannot be ignored. The chances of success in businesses with no real business planning and no governing documents becomes pretty remote, and even if such a business is successful in the short or even medium term, it’s an invitation for failure in the long term.

Every week I see something like 350 new business registrations in the Business Outlook, and I wonder how many of them will succeed. I don’t wonder what the common string will be amonth those that do succeed, however. It’s planning, proper documents, hard work, and of course, talent, luck, and a good product or service that scratches an itch that is either quantifiable or speculative. Some of those things you can’t control, but others you can, and it is so important down the road that those steps have been taken. If you expect your business to fail within the first six months, then you probably don’t need a business plan or the proper formation documents. If you expect it to go further, then keep reading!!

Chances are you are either a business person with an established business, or you are pondering some new and exciting business idea—or both. Either way, you probably already appreciate and understand that there are a variety of ways that any new business idea can pan out. Most new business ideas, if they have advanced to the point of drafting a business plan, creating pro-formas, and identifying potential partners or investors, are probably being considered seriously enough to justify an investment of time in planning the governing documents of a business. The business plan and pro-forma are vital to that process and we believe form the DNA that guides the business in the first several years. While the business planning documents are a vital first step in the business formation process, an equally important step before a single dollar of “company money” is put in by you, potential partners, or investors is the formation documents. Even after that point, there is a wide range of logical ends to the business idea. Some businesses do well enough to recoup the initial investment over a period of time, many businesses do well enough to provide small business owners with a decent living and job satisfaction for a long time, and still other business ideas that were nothing more than ideas in recent memory are now multi-billion-dollar companies, like Sun Edison, Google, Apple, or hundreds of other businesses you may never have even heard of.

Before you get to comfortable dreaming of leading your business idea from your garage to some sprawling campus and a big IPO, let me bring you down with a couple of horror stories. Have you ever had a nightmare that was so vivid that you woke up upset or frightened from the reality of the dream? Do you remember the sense of relief when you woke up to find that the horrible thing you dreamed about, in fact, had not happened? Did it ever give you an appreciation for something that perhaps you didn’t have before that nightmare? Did it make you want to hug your dog that, in fact, did not get run over as he did in your dream? Well, you can have that opportunity now by indulging with me in a few real-life horror stories, the kind that come into our offices week after week and pay large retainers for protracted, unpleasant, largely unnecessary and sometimes catastrophic litigation. Take the following as but just a sampling of typical cases. None of the details below are the actual details of real cases, but are fairly typical. Any resemblance to a real case is merely coincidental.

Scenario A—“Bob” is a tremendous salesperson. He recognizes businesses that have wonderful potential and brings to those businesses the ability to convey those products or services to customers. He is also amazing with driving the company to perform once the contracts have been landed. Bob encountered just such a company in 2006 and developed a business relationship with one of the two existing owners, let’s call him “Terry.” Those conversations blossomed into a discussion of Bob devoting his time and talents to the success of the company. The company’s annual sales in 2006 were just over $500,000, and the company struggled to meet its cash flow needs, make a payroll, and even provide any return for its owners after five years of business. The agreement was that if Bob were successful in what he intended to deliver to the company, he would become a 35% stockholder in the company (a New Mexico corporation). Bob, brimming with confidence and excitement, decided to move forward. He asked about reducing their agreement to writing, and was promised that this would be done, but he didn’t want to make waves with his new colleagues. The issue didn’t come up again for a while.

Immediately, Bob began delivering results. By the end of 2007, the company’s sales numbers were on a meteoric trajectory, and focus then became on keeping up with the growth in sales. Bob split his time between pitching and landing contracts and recruiting and training project managers to take on the new work, working ridiculous hours to both travel regionally to pitch leads he cultivated, and then come back and work the projects along side two new project managers, then three. He had them fully trained and functional by mid 2008. In 2008, the company had revenue of just over $3.5 million and the company had managed the growth surprisingly well and profitably. Bob raised the issue of reducing the earlier “handshake” agreement to writing, more forcefully this time. Not wanting to scare off the goose who was laying golden eggs, the owners and Bob wrote up a document that loosely contained the agreement, but was silent on many, many key issues. Bob never knew that a Corporation is governed by ByLaws, had never seen the Corporation’s Bylaws or any other documents, and didn’t have any specific agreement about stock ownership, transfer, nor any employment agreement with the Corporation. So you just know this story has a happy ending, right?

In 2009, revenue topped $6 million and the number of employees had grown from 7 to 13 with three full-time, over-capacity project managers. The company was on track to increase the 2009 numbers significantly in 2010 with many more contracts on the horizon, many if not all of which were the result of Bob’s skills. In this timeframe, however, and due to a wide variety of factors, most of which that had nothing at all to do with the company, the relationship between Bob and Terry soured. The third owner was largely an absentee investor who had a long-standing relationship with the other owner. Terry began working around Bob and dealing with the project managers directly, often giving them conflicting directives. Terry began circumventing Bob on key accounts and conducting sales presentations on other leads that Bob had cultivating. They had, in essence, stopped communicating, and their prior agreement to share all management decisions was simply not being honored. The sales continued to come, although not with the same level of growth. Bob was beside himself and had not idea what to do. So he confronted Terry about the apparent deterioration in their professional and personal relationship, but things did not get better. Bob ultimately begin to sabotage the Corporation, began to develop a plan to take many accounts with him as well as employees, which Terry discovered, and the situation blew up.

Both sides lawyered up and ensued what would be many months of intense litigation, litigation that would inevitably seriously impact the company’s performance. After spending more than $25,000 on legal fees, Bob eventually decided that his time and effort would be better spent simply starting over. Bob accepted far less than what he was entitled to in terms of the company’s value, the company sputtered without his sales abilities, and eventually failed to honor even his meager settlement agreement before ceasing operations and before filing for bankruptcy under Terry’s “leadership.”

What a spectacular waste of potential.

This is a very typical scenario that often walks into the offices of business litigation attorneys in New Mexico and throughout the country, day after day. You just woke up from this nightmare, and it is a nightmare. Your dog’s not dead!! You’re not Bob, so do this thing right BEFORE you go make somebody else a bunch of money that that dial you out of while your’re busy working your guts out. We don’t mean to focus on the negative here, because many businesses, some of which may not have followed the process correctly, are composed of upstanding, good-faith, intelligent principals who realize as Terry couldn’t that keeping Bob happy and productive was the smartest thing he could have done. But why take that gamble? There are hundreds of scenarios like this one, many not as dramatic, but most of which could have been prevented with an investment of less than $1,000 on a proper business formation process with proper business formation, legal documents. In our next blog entry, or maybe the next few if this is too much to cram into one blog, we will discuss in greater detail the following topics:

1. What are the components of a useful Business Plan?
2. Why is a Pro-forma useful?
3. Selecting an entity type.
4. Finding an attorney who can draft key documents and what questions to ask:
• Operating agreements for limited liability companies
• Bylaws for corporations
• Partnership agreements for partnerships
• Other key documents such as articles of formation/incorporation
5. The need for secondary documents and formation checklists:
• Leases for space
• Employment agreements for key personnel
• Policies and procedures that do not necessarily be kept in the formation documents
• Checklists related to business formations that cover everything from obtaining the proper professional casualty and insurance policies to obtaining proper business licenses, construction licenses, and much, much more


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