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Key Considerations in Forming a New Business

Everyone would like to have a simple checklist to use when buying a business or forming a new business venture. However, the process is not a static one and every business has its particular needs and requirements.

If one just wants a checklist, there are numerous resources online. In effort to provide a bit of helpful insight that one won't get from a check list, though, consider the following:

Business Plan.

One should absolutely have a written business plan before launching a business endeavor. Again, there are many online resources where one could find a template. A major reason for going through the exercise, though, is that the would-be owners will benefit from going through an extended assessment of all the "what ifs" and trying to anticipate how to deal problems before they arise. Beyond organizational issues and finances, important questions would include:

  • Who is going to manage the business on a day-to-day basis?

  • How much time does each person plan on putting into the business?

  • How will imbalances in labor and other contributions to the business be taken into account?

  • Is anyone going to be paid for his or her time, and if so, under what circumstances?

  • Is anyone going to be obligated to put any additional capital into the company and, if so, under what circumstances?

  • Who is going to be responsible for keeping the books and records?

  • What is the initial annual budget going to be?

  • How much time is each principal required to contribute to the venture?

  • Will the owners be limited in any way in terms of other activities that can be pursued, even if they may be in competition with the business?

  • What are exit strategies going to be?

Organizational Structure.

Either a limited liability company or a corporation should be considered. There are pros and cons to each, but an LLC would probably give the most flexibility. Forming and perfecting the entity is a relatively easy process. Issues with regard to ownership, management and control can largely be addressed by referring to what is set forth in the business plan and in connection with answering questions like those suggested above. As a couple further thoughts:

  • An LLC has "members" and not "partners" or "shareholders." It can be a "member managed" entity or one that has a "member manager". In a closely held business, a member managed organization may make the most sense, where each owner would have the right to manage the affairs of the business, much like a general partnership. (Reference herein to "partners" is not in a technical sense, but in the context of how co-owners of a business often refer to themselves.)

  • Capital contributions should be clearly agreed upon in advance. If there is an existing business that is going to be contributed to the new venture, the agreed upon going concern value for this business is no doubt going to be one of the critical points to address before moving forward. The same thing would hold true with regard to any assets other than cash that are going to be contributed.

  • Control with an LLC can either be based on the relative values of assets contributed to the organization, or based on membership units issued to each member. It may not make any substantive difference so long as contributions are the same. In most instances, however, ownership and control be based on membership units may make more sense so that there is never any question.

  • The owners should try to address what happens in the event of a dispute. A buy sell agreement would be helpful in this regard.

The above considerations and others would be addressed in what is commonly called a limited liability company agreement or an operating agreement, that would serve much the same purpose as bylaws would be used with a corporation.

Licensing and Regulation.

The owners will have to jump through the hoops of filing a master business application and otherwise obtaining licenses necessary to operate the business. It is important to be sure that the business entity is properly formed and maintained it in compliance with local, state and federal laws. Even though this can be an expensive and burdensome process for any business, taking short cuts is never advisable.. If the business cannot sustain itself with the inevitable taxing and regulatory burdens, one should not go into the venture.

Taxes.

An LLC is a "pass through" entity meaning that it would not pay income tax on net revenues. The income (or losses) would, instead, flow through to the members and they would be responsible for tax consequences on this income. Each member should get a K-1 at the end of the year. The LLC could elect to be taxed as a partnership or as an S corporation, which is an issue that should be discussed in advance with the company's accountant. However, the LLC will still have to file a federal income tax return each year. The LLC will also be responsible for B&O taxes, property taxes, possibly sales taxes, as well as other taxes. An owner has to be extremely diligent to make sure that all these taxes are paid and that they are paid in a timely manner. Otherwise, there is a possibility of personal liability exposure for payment of the taxes, as well as fines, penalties and interest.

Insurance.

Do not overlook insurance requirements. Talk to an insurance broker up front to find out what the needs of the business will be. At a minimum, a business would need comprehensive general liability insurance. The principals may be able to piggyback on a business insurance policy that is already in place, but this is something that should be discussed in advance with the company's insurance agent.

Division of Labor.

Also keep the division of labor in mind. If, for example, one owner is spending many hours in developing a certain aspect of the business, this is something that needs to be taken into account. It may not be a good idea just contribute expertise or labor without compensation since it may sow seeds of resentment at a later point in time. If the owners cannot agree on things like this up front, it may be a harbinger of things to come. One alternative would be to contract out for expertise or labor if the owners cannot agree that some consideration should be paid or taken into account with regard to their respective efforts. This would also help to prioritize things since, if someone is not being paid for labor, it will sink to the bottom of the "to do" stack, which can be another source of irritation among the partners.

Time and Effort.

On the same train of thought, a common thread of many of the points mentioned above is that each owner needs to be very candid about how much time he or she plans to contribute to the new business. One of the biggest areas of disagreement that lead to a falling out among partners in new business ventures is that resentment can build if one person ends up putting in a lot more uncompensated time than the other one. Each owner needs to put a value on his or her time.Some provision should be made for additional or separate compensation with regard to specified duties that are in addition to regular duties as the owners may define them. For example, if one is given the specific responsibility of managing the day-to-day affairs of the business, he or she might allocate some compensation for those services (e.g. 5% of net revenues). If some else, for example, ends up doing marketing materials, there might be some agreement on compensation in advance (e.g. a flat fee).

Capital Contributions.

It is very important not to undercapitalize a business. It is not a bad idea to put in more money and assets up front than one thinks might be needed so as to have a buffer during the initial stages of operation. It may also be a good idea for everyone to put in some cash.

Finances.

Owners should agree in advance where they want to bank and they should establish a relationship with a banker. There should be discussions on how to manage finances and when distributions will be made from the business. It may be helpful in managing cash flow to talk with a banker about establishing a line of credit. It would be easier to get one up front when the business does not need it rather than trying to get one later on when the organization may be having temporary cash flow difficulties.

Reciprocal Buyout Rights.

An exit strategy is an essential part of any discussion going into the business. At some point, someone is going to want to move on to something else or one partner is going to want to buy out the other. One of the best ways to deal with the inevitable is to try to come up with some form of reciprocal buyout rights. Generally, if one person wanted out, the other person would have to offer up a proposed purchase price. The first party to can then elect either to accept the purchase price, or if he or she thought it was too low, to buy out the second party at the same price. If this does not work out within a set period of days, the parties would then agree to liquidate and dissolve the business.

Professional Advisors.

It is important to retain professional advisors. Consistent with the above discussion, these would include an attorney, an accountant, a banker and an insurance agent.

Additional resources provided by the author

Additional resources would include the following:

http://www.wsbdc.org/buying-a-business
http://wa.gov/business/start.aspx

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