seven stupid things entrepreneurs do · stupid thing #1: plan to fail or was that fail to plan? i...

SEVEN STUPID THINGS ENTREPRENEURS DO

TO RUIN A PERFECTLY GOOD BUSINESS

by Derek G. Rowley

5190 Neil Road, Suite 430, Reno NV 89502

(800) 638-2320

www.corporateservicecenter.com

101 Convention Center Drive, Seventh Floor

Las Vegas NV 89109, (800) 624-2677

www.nchinc.com

AAbboouutt tthhee AAuutthhoorr Derek Rowley is the founder of Corporate Service Center, Inc., the premier business formation and small-business consulting firm in Nevada, which offers business formation services in all 50 states. He is currently president of Superior Capital Corporation, a holding company that owns and controls Nevada Corporate Headquarters, Inc., Corporate Service Center, Inc., Integrated Tax Solutions, Inc., and other businesses. Mr. Rowley has worked to promote the benefits of Nevada business and incorporation laws since 1987, longer than any

other individual involved in the industry. He is also a leading business author. His best-selling book the Nevada Corporation Handbook, which he first published in 1994, has sold over 25,000 copies in 8 printings and is considered the primary authority on Nevada entities. Since 2002, Mr. Rowley has served as the president of the Nevada Registered Agent Association (NRAA), Nevada’s largest business organization representing more than 40,000 Nevada companies. In his capacity with NRAA, Mr. Rowley is active in the Nevada political process and has written and lobbied bills that now contain much of Nevada’s laws regarding corporations, limited liability companies and limited partnerships. His background also includes three years as Associate Director of the Northern Nevada Development Authority, a business development organization specializing in the recruitment and relocation of manufacturing, warehousing and distribution companies to Northern Nevada. He has also been the Nevada state legislative correspondent for Commerce Clearinghouse and for Offshore Finance U.S.A. magazine.

© Derek G. Rowley, 2008. Used by permission.

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IInnttrroodduuccttiioonn Having spent the better part of 20 years assisting tens of thousands of companies through the process of organization and startup, I have had the unique opportunity of participating in, managing and observing a unique laboratory of entrepreneurism in action. Some of these companies have gone on to attain significant success and profitability. They would be recognizable names to many readers. Others, however, never survived managing the first real crisis that crossed their path. It seemed as though they were engineered for failure. While those that have succeeded have followed dramatically divergent paths to profits (indeed, that mentality of “thinking outside of the box” to define and create a successful business model is almost a universal constant among the successful), alternatively, those failed companies have all followed a fairly narrowly defined set of principles that caused their ultimate collapse. The principles of entrepreneurial business failure are the topic of this book. Any library or bookstore can offer a seemingly limitless number of titles on how to succeed in business, written by captains of industry, specialists, gurus, consultants, CEOs of the Fortune 500 and scholars from the best business schools. This book, however, clearly outlines a few simple, basic things that any small business owner or entrepreneur can do to make such a perfect mess of their business that they will virtually guarantee its ultimate failure. I use the word “guarantee” carefully here. No, I am not offering to refund the price of this book to anyone who follows these principles and whose business succeeds anyway. There are two reasons for this:

1) Even the blind squirrel finds an acorn once in a while, as the saying goes, and;

2) Sometimes it takes a while for a ticking time bomb to go off. Sure, you could get lucky. I have read about many people who have won the lottery, but I haven't actually met any of them. I have also heard stories of people who have followed some of the principles outlined in this book but whose business succeeded anyway, and were able to eventually retire comfortably and/or cash out their business - but I haven't met any of them either. In fact, it is possible to have implemented these strategies so completely that a business that appears to be financially successful – even for many years - is nevertheless ensured of complete eventual destruction. The bad news is that too few entrepreneurs really know how to identify these land mines to business failure, and are left to stumble upon them unknowingly. Never fear, trusting reader, for this book will educate and empower you to call upon these principles whenever you choose, thus providing you with means to avoid the odds of wrecking your business accidentally and instead allowing you to do it on purpose. Or, I suppose, you could also use this book to help you avoid them entirely, which could make your business more likely to succeed. That is, if you are into that sort of thing. Good luck! Derek Rowley

Seven Stupid Things that Entrepreneurs Do to Ruin a Perfectly Good Business

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SSTTUUPPIIDD TTHHIINNGG ##11:: PPLLAANN TTOO FFAAIILL Or was that fail to plan? I can never keep those straight. It doesn't really matter because the two concepts are so interchangeable. And, their results are almost exactly the same. However the phrase “plan to fail” is the more assertive and intentional of the two, so that is what I will use. I have always been amazed and amused at how many people start a business with an “idea” but with no vision. Often, they can't even see that they are two completely separate concepts. But they are very different, indeed. The “idea” stage of business involves the conceptual, creative, inventive, gestation and birthing process of a new product or service. It can include significant analysis and give birth to other equally exciting ideas. It is an exhilarating time filled with great energy and anticipation. However, the idea will always be a failure by itself. It takes a very real sense of vision to turn the idea into something worthwhile. To have the vision of your company, you don't need to fill yourself with ideas, concepts, or presentations. No, that is not what company vision is about. Vision is all about results. It is about execution. It is about seeing precisely how the company is going to get from here to there; how to transform an idea into bottom-line profit; seeing what it is going to take in terms of time, finances, systems and human and other resources to pull it off. All of this presupposes that somebody knows exactly where the company's “there” is. You might be surprised at how many entrepreneurs don't know where their “there” is. And when that is the case, they are not unlike Alice in Wonderland asking the Cheshire cat for directions: “Would you tell me, please, which way I ought to go from here?” “That depends a good deal on where you want to get to,” said the Cat. “I don't much care where --” said Alice. “Then it doesn't matter which way you go,” said the Cat“...so long as I get SOMEWHERE,” Alice added as an explanation. “Oh, you're sure to do that,” said the Cat, “if only you walk long enough.” I have seen this approach taken by many bright business people. As long as they get somewhere with their idea, the details – it seems - can work itself out later. I recall several years ago meeting with an inventor who had discovered a “new technology” that made air-conditioning much more energy efficient. Now I'm no engineer, but he had a very convincing presentation. It seemed like a great idea – and he was very much a self-described “idea man” (more about that later). But he had no concept about what he wanted to do with it, or how he would take his idea to market. He didn't know if he wanted to manufacture himself – which itself had a set of planning challenges – or license his ideas to others.



He hadn't thought about either protecting his idea from others, or of protecting himself from his idea (which we'll get to later). He had no clue as to where or when his profits might appear; he had no map whatsoever for his idea. He formed his company in 1993 and dissolved it by the end of 1994. He was truly living in an entrepreneurial wonderland that would have made Alice proud. His “somewhere” ended up being nowhere at all. Another business owner I know operates in a very competitive market. He is extremely intelligent and technically capable. In fact, he may be too technically capable. He has invested a tremendous amount of time and resources developing a number of “cool” high-tech services – I call them “toys” - that none of his clients are asking for. But, he seems to impress himself with his technical prowess. He has built a sizable market share in his industry by essentially giving away his services. As a result, he values his company based on the exclusive nature of the “toys” he has developed, and the number of clients he has, and not on company profits – because there aren't any. The Internet bubble-burst of the late 1990s was a testament to the failure of this business model. That period was the outcome of people having plenty of ideas and no ultimate vision. The ability to start and manage an ongoing business with the end results in mind is the essence of good business vision. However, this ability does not simply allow the company to focus on distant results while ignoring all the interim necessities. Instead, this vision provides the company with a moment-by-moment road map of what is needed right now in order for the company to produce the eventual results it seeks. It allows the company to prioritize the things that really matter now. And it always focuses as much on today's results as it does on next year’s. This idea was expressed by Jeffrey P. Sudikoff, founder of IDB Communications Group, who spoke on how effective company vision must deal with the present priorities, and not get too caught up in irrelevancy when he said: “An entrepreneur knows that a start-up needs to focus on little things. Not the global strategy. Not the Big Plan. A start-up needs cash flow, not a corporate infrastructure. A start-up needs sales staff, not fancy office space and computer systems.” A business leader with this vision understands the truth of Sudikoff's remarks. I wish I had a nickel for every start-up company I have seen that focused attention on office furniture, computers, and nice pictures on the walls instead of on where their next sale was coming from. It is just as bad for a business leader to not be able to “see the trees for the forest” as it is to not be able to “see the forest for the trees.” Having a true vision of where you are, where you are going, and exactly how you are going to get there from here avoids both of these problems. All great leaders have this type of vision, whether they are leaders of business and industry, institutions, or of nations. It is a trait shared by successful businesses as well as the effective PTA president. Moreover, these leaders have the ability to communicate that vision to others, who then not only share in it, but then take ownership in it. Without this type of vision, the entrepreneur truly – although



inadvertently – plans to fail. And this failing reaches out and touches every aspect of a new business, and contributes to every component of business failure - which is why I am leading off with this principle. Lack of vision is the over-arching problem that results in all the rest of the issues covered here. Overcoming this major problem frequently solves many minor ones also.

THE BUSINESS PLAN

The business plan is the documented detail that outlines the vision of your company. Without it, you might be hard pressed to convince anyone that any company vision exists at all. Developing an effective business plan is as much an art as it is a science, which means that any guidelines you might follow for developing your business plan are just that – guidelines. While there will be a few standard requirements for any business plan, your approach to writing your business plan has to be modified to fit not only your business model, but to also fit you. Most businesses operate with a very informal business plan that may only be written inside the head of the owner. Naturally, this makes the plan difficult to communicate to others, not to mention the fact that it makes it virtually impossible to effectively keep all of our goals, analysis, deadlines and systems in our head without eventually overlooking or forgetting some critical elements of our business. Your business plan allows you to not only document, but also to communicate your vision, goals and objectives to others. It also represents a significant commitment to and focus on achieving results. An entrepreneur needs that kind of focus (since most of us intrinsically suffer from some degree of ADHD, or we wouldn’t be entrepreneurs in the first place). Perhaps more importantly, you need to provide focus for other employees who do not necessarily share the same degree of emotional attachment to your business. Employees also need to know where the company is going and how it is going to get there if they are going to be expected to produce the needed results. To that end, your business plan is really your best management tool: It helps you define your market, keep costs down, provide a timetable for operations, and be a vehicle for tracking your progress. It also provides a starting point for future planning. Just as important, when your company gets to the point where you need to start talking to investors, bankers, or potential partners, they will need a legitimate business plan to justify putting their faith – much less their money – into your project. Perhaps the most valuable aspect of spending the time to draft a business plan is that it will show whether the business is really viable or not. Frankly, not every business is viable.



If it is not viable– regardless of your emotional attachment to the “idea” – it doesn’t really make any sense to commit a significant portion of you life and you family’s lives to an enterprise that is destined for failure, does it? It would be hard to consider a few weeks of research and analysis up front in order to save a possible future bankruptcy a failure, wouldn’t it? It could be the best investment of time you ever make. Here are a few keys to putting together an effective business plan:

Keep it simple

A simple business plan is usually more tightly focused. Years ago, the trend was toward more complex and lengthy business plans, but in today’s fast-paced world we don’t have time to wade through all that paperwork – and neither will your banker or your employees. By keeping your plan simple, you force yourself to communicate your ideas with clarity. And, when it comes to business plans, clarity is precisely the point. So, keep your sentences short, straightforward and easy to read. Steer clear of industry jargon. Too often, we fall into the habit of using internal terminology to communicate to the outside world – this is especially true in technology-oriented companies. Don’t make your business plan read like a foreign language to an outsider. If your business plan requires translation, the probability of success is limited.

Focus on fundamentals

The most fundamental aspect of a successful business is the bottom-line. The company must be able to perform financially, or nothing else really matters. Hopefully, your company will also provide emotional and social fulfillment for the employees, charitable benefits to your community, or environmental benefits to the world. Regardless, however, the business plan can’t focus on those intangibles unless you actually intend to run a charity. You might be surprised how many for-profit companies actually do run like a charity when they lose sight of their financial goals! Focus on profits first, and you will eventually be able to accomplish all of your other objectives.

Keep it short, but not too short

If you can’t write at least 10 pages of detail about your business, you clearly haven’t put enough thought into it. That fact will be obvious to everyone who reads it. On the other hand, if you can’t convey your business plan in 25 to 30 pages (not counting appendices for financial projections, etc.), you may need to re-focus yourself on the fundamentals, or try to do a better job summarizing the minutia. Bullet lists help readers digest information easily, and make it easier to find. They are effective tools to condense data into understandable bites. Business charts and graphs can also make your important numbers more



accessible and easier to understand, and provide a visual context for the company performance. Never use a chart without explaining it in the text. And, make sure that the source numbers for a chart are in a nearby summary table, so the reader can see that they weren’t just pulled out of the air.

Polish it up

Simplify the language. Use a basic, sans-serif font for headings and a standard text font for the body. Use a page break to separate different sections, or to separate charts from text. This helps provide good use of white space that makes it easier to read. Then, spell-check and proofread like crazy. Your business plan represents you, and a potential lender or critical partner could easily determine that a sloppy plan is a reflection of sloppy thinking and amateurish execution. Mistakes, typos, and spelling errors in your business plan can be fatal.

Business Plan Mistakes

While we are at it, there are a number of other stupid things that people do to mess up a perfectly good business plan. Here are a few:

Procrastination

Perhaps you have a perfectly good idea of a basic business plan in your head, but are just too busy to spend some time really thinking it through and writing it down. The next thing you know, you need to get financing to open or expand the business. Or perhaps you simply grow to the point where the old, informal plan is hopelessly outdated. Maybe you decide to introduce a new product or enter a new market. Worse, someone wants to buy the business outright, and suddenly you realize that they need a written plan to be able to show the maximum value of the company. Procrastinating the development of your business plan can jeopardize or kill your future growth. It can eliminate your ability to take advantage of opportunities when they present themselves. And that would be more than unfortunate. It would be stupid.

Confusing Cash-Flow with Profits

This is very easy to do when all the numbers are just theoretical assumptions. But, there is a huge difference between the two. You can’t pay the bills with anticipated year-end profits. You have to have cash flow today, this week, this month, and this quarter to actually stay in business. Accountants understand a principle that many first-time (and a few second-time) entrepreneurs don’t: profits are an accounting concept, NOT money in the bank. You can spend your money in ways that don’t impact your profits – such as purchasing your inventory – that can absolutely kill your cash flow. You might have a “profitable” business model all right - if only you can get the customer to pay you!



As important as profits are, don’t neglect your cash flow, or you will be left scratching your head, wondering how in the world your business failed with such good profits.

Over-valuing the “Idea”

This was the bane of the Internet bubble of the late 1990s. Everyone rushed to place enormous values on the “idea” of an internet economy without stopping to realize that they have to actually have a business built to support it: they needed to have employees who show up every day, phones that ring, orders placed and fulfilled, customers served and paying their bills. Back then, investors unbelievably focused only on how long their investment capital would last – their “burn-rate” – while forgetting the basic fundamentals of viability and profitability altogether. Fortunes were lost as a result. In retrospect, it seems incredible. Remember, ideas really are a dime a dozen. An idea man is of little value unless he can also execute. It is the man who can execute an idea that is truly valuable – a fact not lost on lenders. That is because successful execution of a viable, profitable business plan is rare. And, as Adam Smith, the great economist taught, “that which is rare in a free market is of far greater value.” It is called the law of supply and demand.

Losing Focus

Too often, a business plan outlines so many priorities that none of them really carry any weight. If everything is a priority, then someone has forgotten what a priority actually is. When a business plan has more than three or four main points, it is unfocused and diluted. The more unfocused the business plan is, the more likely that the people are either distracted, or are going to be. The human intellect is really only capable of processing a single thought at a time. Though we may take a certain amount of pride in our ability to “multi-task,” the truth is that we never actually entertain two different thoughts simultaneously. We actually have to switch rapidly between the different thoughts or concepts that are presented to us. So, the unfocused or cluttered business plan presents a far greater opportunity for failure because we are not engineered for success in that environment.

Thinking the Plan is Finished Once it is Printed

A business plan is not worth the paper it is printed on unless it is implemented and produces results. Inevitably, as a plan is implemented we learn that it needs to be tweaked and modified along the way. Sometimes we have to recognize that our written dreams need to be modified as the result of our experience. No matter how well thought through the plan is, portions of it will almost immediately be replaced as soon as implementation begins. This is why a business plan is never really finished as long as the business still operates. It is a living, developing, changing document that reflects



the business realities of today. When the assumptions of today’s realities are no longer accurate – which can happen in a matter of minutes, it seems – then the business plan has to adapt to the new realities. Otherwise we may find ourselves, like the buggy-whip manufacturers of the past, playing by an entirely wrong set of rules.

Focusing Too Long-Term

Sure, every entrepreneur wants to build a successful, long-term business. But the fact is that none of us really know what is going to happen in three or four years, much less in 10 to 20 years. Yet, frequently business plans contain that kind of long-term forecasting. In reality long-term details in a business plan are not very helpful. It is only guess work at best. On the other hand, the details over the next 3, 6 and 12 months are vital. Who is doing what, and when? Things just don’t happen by themselves, so who is going to make them happen? How is the company going to generate a positive cash flow for each month of this coming year? Those are the important questions that can’t be glossed over.

Financing Factors

When you expect your business plan to help you get financing, there are a few special considerations that need to be made. Bankers and investors are a different breed, and are virtually guaranteed not to see you business the same way you do. They are completely objective and detached from your passion. In fact, many of them may not even get past the financials to read the actual text – which is a frustrating reality to the entrepreneur who has slaved over every word. Today’s typical local banker, frankly, is not the sophisticated financier of the past. With the large, national and regional banks, seldom will you have the ability to speak directly with the person making the ultimate decision on your loan request. Truthfully, the local branch manager is frequently little more than a glorified clerk these days. Generally, your loan package – which includes your business plan – will be submitted far over the branch manager’s head to a distant committee for initial review, and then on to a remote executive for final approval. Because these people specialize in reviewing funding requests, they have honed their approval standards down to a fine science. For them, the textual fluff of a business plan is just that – fluff. There are notable exceptions to this broad brush with which I have just painted all bankers. There are some very good bankers out there who do “get it”. It is very worthwhile to spend time finding the right banker who will actually read your plan, make suggestions and add value to your efforts. When you have found that type of banker, you have found somebody you will be able to work with and build a relationship.

Here is What the Banker Wants to See in the Business Plan:

Collateral. If you don’t have it, don’t expect anything but a polite form letter from him. A Balance Sheet, which records your assets, liabilities and working capital.



The Profit and Loss Statement, which shows historical balances and future cash flow requirements. Details on the management team, including their background and past successes. Last, if they like what they have seen so far, they will actually look at the business model: the products, services and strategies of the business plan. Investors can be even more fickle, because their investment decisions are potentially driven by even more criteria than that of the banks. With banks, you will find that there is some general similarity in the approach they take. However, every potential investor is unique; from non-demanding friends and family to very demanding high-end venture capitalists that only look for projects in particular industries with specified capital needs.

Venture Capitalists Look for:

A proven management team. They aren’t looking for ideas without a management team who can make it work. If your team doesn’t have enough experience, it is a deal killer. A competitive advantage. This is where the “idea” has value. The advantage could be in exclusive features, unique delivery systems, or patented technologies, but it must be something that can’t be easily duplicated or reverse-engineered. A reasonable valuation. In other words, they don’t want to deal with the entrepreneur who has his or her head in the clouds over the value of their “idea.” If you are offering half of your company for $10 million, then you have established a company valuation of $20 million. If that isn’t realistically supported by the pro forma, the venture capitalist may decide that they aren’t dealing with rational people and move on to the next proposal. The venture capitalist will want to see that they have the potential of increasing the value of the company from today’s value to about 100 times that in three to five years. So, the higher your valuation today, the more difficult it becomes for them to be able to forecast that type of growth. A minimum investment of $3 to $5 million. They want to see that the business plan clearly demonstrates that the money is really needed, and is carefully planned for. It takes the venture capitalist as much time to process a $250,000 investment as it does for a $5 million investment. If you were them, which would you rather do? A clear, legal statement of the investment offering. This includes detail about how to handle any future dilution of ownership in future rounds of investment. A clear exit strategy. Venture capitalists like to see how and when they are going to be able to get their money back.



This discussion of financing and venture capitalism sounds – and is – scary and exciting stuff. Most businesses eventually get to the point where they need some kind of financial support, whether it is to finance new equipment or inventory, or just to cover cash flow in down cycles. But the business without a plan of some kind quickly finds itself out of the league of bankers and investors. Many businesses fail as the result of not being able to obtain necessary capital at critical times. The business that can’t get financing or capital, because it hasn’t put together a viable and effective business plan and fails as a result, dies of self-inflicted wounds: the result of a stupid thing done to ruin what might have been a perfectly good business.



STUPID THING NUMBER 2: TO BE BLISSFULLY UNAWARE OF RISKS This is a big one. First-time entrepreneurs are very prone to this mistake; however, they are not alone. Even experienced businessmen and women can forget: The world of business is an extremely dangerous place where there are real live monsters around every corner. And the monsters will eat you if they get a chance. The purpose of this chapter is to help you see where the monsters might be hiding.

CULTURE OF LAWSUITS

An international law firm discovered an interesting fact in a study they conducted in 2006: the average company in the United States juggles 37 lawsuits at any point in time. Thirty-seven lawsuits! At once!! Not all of those lawsuits find the company on the defensive end of the legal world. The study showed that half of all companies had also filed a lawsuit against someone during the previous year. What’s worse, the scary part of that picture isn’t fully realized until you understand that – according to the study – in almost half of the cases, the corporate counsel could not predict, control or budget for the cost of litigation. A company in that position can easily bleed to death from multiple wounds disguised as legal fees. Even today, after tremendous efforts have been made in the area of tort reform in our country to control rampant litigation and out-of-control jury awards, we find that litigation is so ingrained in our culture that it is difficult to imagine the day that our current litigation culture ceases to exist. In fact, as technology increases and the development of our society actually speeds up, the smart money is on the premise that litigation will actually increase in coming years. It will probably get even worse. Consider the fact that the typical personal injury claim in the United States averages almost a full year. Or, think about the way you rely on technology to communicate with others in your personal and business life, and then stop to recognize that “electronic discovery” is the top new litigation burden in our culture. How comfortable would you be to disclose under court order all of the email you have sent or received over the past couple of years? In the U.S. there are over 1.1 million licensed, practicing attorneys – that is one for every 300 men, woman, and children in the country. How do they



pay their bills? Often, the answer to that question is that they have to create their own demand by generating lawsuits. Watch daytime television for an hour, and you are almost guaranteed to see ads run by attorneys to recruit people to file lawsuits. Class-action lawsuits have developed into its own cottage industry within the legal community, where the only winners are the attorneys. Recently, I was sent a letter from a law firm that had filed a class-action lawsuit against the insurance company that carries my homeowners’ policy. Evidently, I was part of the “class” of people that had been damaged by the insurance company, and the letter was sent to notify me of the settlement of the lawsuit. What did I get? A coupon! What did the lawyers get who handled the lawsuit? Over a half million dollars in legal fees! Who does that system really protect? As an entrepreneur, you need to understand the magnitude of the culture of litigation that is working against you. When you understand that, you can begin to prepare yourself to do business in that environment in a manner that protects you and your family.

CONTRACT LIABILITY

In business, you simply cannot operate without making a number of agreements with others. These agreements may involve business partners, investors, employees, agents, independent contractors, vendors, competitors, customers, or clients. They can include; both formal, written contracts open to interpretation of facts and language, or informal and unwritten agreements open to interpretation of the very presence of the agreement. Sometimes, these agreements are notarized and documented, and other times it is consummated on a handshake and a pat on the shoulder. In either case, welcome to the complex world of contract litigation – the #1 lawsuit risk for business in America. I don’t know anyone who has not had the experience of dealing with somebody who failed to hold up his or her end of an agreement. It happens all the time. In business, however, that experience can be very costly. Frequently, the only recourse for damages is in the courts.

PRODUCT LIABILITY

If your business includes the manufacture, shipment, handling, processing, or sales of tangible products, you need to be aware of the risks associated with product liability. Generally, product liability can exist as the result of three separate kinds of failure: 1. Manufacturing Defects. Traditionally, manufacturing defects have been the result of shoddy workmanship, worn tooling, or inadequate or improper components. As I write this, current events are filled with news of outsourced manufacturing of toys taking place in China where lead-based materials have been used in the manufacturing process. As our manufacturing economy continues to transition overseas – where the regulatory environment is not as stringent, we will see more American



companies brought into product liability lawsuits resulting from the actions of their suppliers. 2. Design Defects. Liability results from products that have inherent design flaws. When a product’s design causes injury or damage, the liability can be enormous. The poster child for design defects has to be the infamous Ford Pinto. To fight competition from Volkswagen and Toyota, Ford rushed the Pinto into production in 25 months, when their standard production schedule required 43 months. The design specifications for the Pinto required that the car weigh less than 2,000 pounds and cost under $2,000. Before production began, engineers discovered a major flaw in the design; the gas tank ruptured in rear end collisions. Because the assembly line was already tooled for production, Ford decided to manufacture the car anyway, even though the fix was proven later to only add $5.08 to the cost of the car. Over two million Ford Pintos were sold. As a result, over 500 people burned to death in auto accidents, according to a 1977 expose written by Mother Jones Magazine. 3. Failure to Warn. Even if a product is properly designed and manufactured, lawsuits can still result if the public is not properly warned about risks associated with using the product. Sometimes the warnings make sense, such as: “WARNING: This product is processed using machinery that also processes peanuts.” If I am allergic to peanuts, I am grateful for that warning. However, the risk for failure to warn is so great that our culture has created a lot of warning labels that are purely ridiculous:

“For External Use Only!” – on a curling iron.

“Do not use in shower.” – on a hair dryer.

“Recycled flush water unsafe for drinking.” – on a toilet at a

public sports facility in Ann Arbor, Michigan.

“This product is not intended for use as a dental drill.” – on an

electric rotary tool.

“Not intended for highway use.” – on a 13 inch wheel of a

wheelbarrow

“Not dishwasher safe” – on a remote control for a TV

“Do not put any person in this washer” – on a washing machine in

a Laundromat

“Never use a lit match or open flame to check fuel level” – on a

personal watercraft

“This textbook asserts that gravity exists. Gravity is a theory,

not a fact, regarding a force that cannot be directly seen. This

material should be approached with an open mind, studied

carefully, and critically considered” – on a textbook at

Swarthmore College. Seriously.

As silly as those warnings sound, they serve to illustrate the degree to which businesses are reacting to the risk of being held liable for failure to warn. You just have to know that every one of those warning labels would never exist unless, somewhere in the process, an attorney was involved.



If a judgment results from a product liability lawsuit, it can get very expensive, really quick. Juries can award compensatory damages, loss of consortium damages (damages to a spouse, even if not directly injured), and punitive damages.

EMPLOYEE LIABILITY

The transition from becoming a one-man show to having employees is fraught with challenges and danger. The employer has to follow complex rules and maintain all kinds of documentation covering everything from how long job application resumes can be kept; detailed files on employee performance – particularly when correction occurs; payroll records; hiring records, etc. Employers may find themselves exposed to legal actions brought by the Equal Employment Opportunity Commission (EEOC) if accusations are made that the employer has violated anti-discrimination laws. These actions may be legitimate or they may be fabricated. My company recently received a job application from a man who would have been considered among a discriminated class. His resume was glowing. He appeared to be an all-star in his field. When we checked on his education, work history and references, the problem was that it was completely bogus! So, naturally, we didn’t bring him in for an interview. A few weeks later, we were served with an EEOC discrimination lawsuit for not hiring him! It was a complete setup! Naturally, we prevailed – all it took was a little time that we will never get back and money that we can’t spend on something productive. Employees expose the employer to other liabilities as well. The employer might be responsible for harm caused by employees to others. Legal theories have allowed courts to hold employers liable for injuries their employees inflicted on co-workers, customers, and total strangers. For example:

Dominos Pizza pulled its “30 minutes or it’s free” delivery

promise after a 1993 case that led to an award of $750,000 in

actual damages and $78 million in punitive damages against the

pizza company after a delivery driver ran a red light and struck

a vehicle.

A company that issues cell phones to its employees so they can

check in at the office while on the road was found to be liable

when the employee hit a pedestrian while talking on the cell

phone.

A car rental company hired a man who later raped a co-worker. If

the company had verified his resume, they would have discovered

that he had actually been in prison for robbery during the years

he claimed to be in school. The company was found liable to the

co-worker.

INTELLECTUAL PROPERTY CLAIMS

Entrepreneurs generally don’t recognize the enormous liability that can come from intellectual property claims. Of all business risk, this is the



category that is most likely to result in a judgment in excess of $500,000. Intellectual property rights cover a lot of ground, including patents, trademarks, trade names, branding, copyrights, trade secrets, web domain names, industrial design rights, etc. Intellectual property can be an absolutely vital part of a company’s business model. In fact, the existence of defensible intellectual property is often the basis for investors and venture capitalists to make an investment into a company to take it to the next level. The typical entrepreneur moves rapidly when he/she has an idea they want to get to market. Usually, there is little time or attention given to researching trademarks, patents and web domains. As a result, it is not unusual for a company to find itself on either end of an intellectual property lawsuit. An eager entrepreneur can easily and innocently violate the intellectual property rights of someone else in their rush to get their business going. Conversely, an entrepreneur that depends on protecting their intellectual property rights as their market differentiator may be forced to defend their rights if a competitor starts to infringe them. Between 1996 and 1999, the number of patent applications at the U.S. Patent and Trademark Office grew over 30% per year. The number of patents granted has grown to the point that the number of patents issued has exceeded 6.2 million, with over 1 million active and enforceable patents in force today. Each one of these patents represents a “paper landmine” in today’s business world. Not surprisingly, in the decade since 1996, patent infringement lawsuits have increased 100%. Statistically, each one of those patents has a 1% chance of being litigated, although patents in the area of technology or pharmaceuticals can exceed a 25% chance of litigation. According to the Wall Street Journal, an intellectual property dispute can put an entrepreneur in a difficult predicament. For example, patent-infringement cases that are considered to be relatively “small” (involving damages between $1 million and $10 million – “small” is relative, I suppose), average $748,000 in litigation costs. Trademark and copyright litigation is not quite as expensive, but still averages around $249,000 and $180,000 respectively. With litigation costs so high, even the “winners” in the litigation are usually left with settlements that barely cover their expenses. The issues related to intellectual property claims are so complex that even the largest companies in the world, with seemingly unlimited legal resources at their disposal, find themselves caught in the muck of a legal lawsuit. Here are some recent examples:

Procter and Gamble filed a lawsuit against Kraft Foods over the

shape and design of its updated coffee cans.

Microsoft and Lucent Technologies have been locked in a lawsuit

since 2002 over alleged infringements of a Lucent patent.

Microsoft’s counterclaim alleges that Lucent also infringes on

several Microsoft patents.

Technology company Soloman Technologies has sued Toyota over

patent infringement in its use of proprietary technology used in

Toyota’s hybrid vehicles, which, if successful could prohibit

Toyota from importing the popular and timely vehicles in to the

U.S.



SCO Group (formerly known as Caldera Systems) has a $5 billion

lawsuit against IBM, accusing the giant company of “devaluing”

its version of the UNIX operating system by contributing SCO’s

intellectual property to the code base of the open source

operating system known as Linux.

Amazon.com has filed suit against a number of online retailers

for infringing on their patent of a “one-click” check out system.

Amazon was, in turn, sued by IBM, which claimed that the patents

that Amazon was defending actually belonged to IBM.

As expensive as these lawsuits are to fight, imagine how much it costs if you lose one of these! In today’s world, it is just crazy to go into business without knowing that these landmines exist – and without planning to protect yourself from the potential damage up front! For innovative entrepreneurs, every new idea is fraught with the potential of being a multi-million dollar risk. One of the sad realities of doing business in this culture is the fact that lawsuits and litigation are probably in your future. It isn’t a matter of “if,” it is simply a matter of “when.” And, when your “when” rolls around, won’t you feel a whole lot better knowing you structured, planned and attended to the details of your business in a way that gives you the best personal protection available? Of course you will. You can thank me later.



STUPID THING NUMBER 3: NOT USING A BUSINESS ENTITY It is a little hard to believe, but perhaps the most common stupid thing that entrepreneurs do to ruin a perfectly good business is that they go into business without a business entity. That is a lot like going to war without any armor. Why would anyone do this? I have never fully understood it. Without a business entity in place, business activity occurs as either a sole proprietor or a general partnership. Both of these are bad for you. In fact, too much exposure to these things may be fatal to your business and to your financial future.

SOLE PROPRIETORSHIP

A sole proprietorship is the most common form for conducting business activity. This is a disturbing fact, because it is almost universally a poor choice. A wise man once told me “we gravitate to the level of our own laziness.” I have taken that to heart. It has had application in many aspects of my life, including in business. When making either an active decision about using a specific business entity for a specific reason, or making a passive decision not to choose any business entity at all, we see this concept in action. Sometimes our “laziness” rules, and we get stuck with the consequences of not having taken any effort to organize things properly. Use of a proprietorship is a huge problem. According to the U.S. Government Printing Office, there were 17.5 million non-farm sole proprietor tax returns filed in 2000, and the number is growing every year. By my estimate, that number represents at least 17 million stupid decisions. Because the proprietorship is the default business entity for the individual who makes no effort to formally organize or plan his or her affairs, I believe that the large number of sole proprietorships functioning in the business world is testament to the accuracy of the statement at the top of this page. People really do gravitate to the level of their own laziness. I spoke with a young man recently who excitedly told me about a new business he was starting. It was the culmination of a dream he had since he was a boy. While he had some previous experience in this specific field, he had absolutely no experience in business. So, over lunch he sought the advice of a buddy who had previously started his own janitorial service about how to



get started. The advice he received was worth every penny that he paid for it: absolutely nothing. His buddy advised him that the “easiest way to get started” is to form a proprietorship. This “advisor” told him how simple it was to just file for a business name at the county clerk’s office and told him that he would save hundreds of dollars in state fees that incorporation requires. The business? He was starting a whitewater rafting tour company! Yet he had not considered for a moment the potential liability exposure he faces as the result of the inevitable injuries and possible death of his customer. The river he wants to run only took the lives of nine people in the prior year. For the cost of a corporate filing, he was risking every asset he – or his family - would ever possess! The lack of foresight in his decision reminded me of the famous quote, sometimes attributed to Benjamin Franklin: For the want of a nail, the shoe was lost; For the want of a shoe, the horse was lost; For the want of a horse, the rider was lost; For the want of a rider, the battle was lost; For the want of the battle, the kingdom was lost. And all for the want of a horseshoe nail. The sole proprietorship is, by definition, the business of a single individual. It is the least expensive form of business to establish, in terms of the cost of legal, accounting and other startup fees. It represents the shoe thrown by the horse, which may ultimately result in the loss of the kingdom. Huge risk factors make the sole proprietorship the most expensive entity of all to use over the long run. As a sole proprietor, there is absolutely no distinction between you, the person, and your business. Business liabilities and obligations are your personal liabilities and obligations. Its bills are your bills. If it is sued successfully, you may receive a judgment against your personal assets. And, the proprietorship cannot survive you. Your ownership interest ends when you die. The business assets will generally be subject to probate, which will effectively tie the hands of a potential successor until the probate is finished, which usually takes months for simple probate and years if it is complicated. On the other hand, since the proprietor is the boss, he or she gets to do as they please with the business. For some people, that is the great attraction to the proprietorship. I suppose there can be great value in not having to answer to anyone. In the proprietorship, there are no formalities to maintain, no meetings to hold, and no organizational documents to draft and file. Although there are no legal hoops to jump through to setup the proprietorship, its business activity must still fall within federal, state, and local guidelines. As a sole proprietor, the individual is the business, and it is easy to take profits out of the sole proprietorship. There are no difficult accounting procedures to maintain. And, there are no double-taxation problems that can



be associated with the regular corporation distributing profits. In a proprietorship, you simply write yourself a check. In fact, since there is no difference between you and the business, you don’t even need to maintain separate bank accounts for the proprietorship. For tax purposes, you do not even have to file a separate business tax return. Instead, simply attach a Schedule C to your IRS 1040 where you report your business income. When you add it all up, you pay taxes at whatever personal income tax applies to you. Any gain or loss from the business is simply combined with your other taxable items. Taxpayers who file Schedule C have traditionally been thought to be a much higher audit risks, with one writer describing a Schedule C return as “attracting auditors like bees to honey”. Because of the great disparity in the current personal income tax rates based on income levels, this can result in wide variations between what different individuals will pay in taxes on the same amount of income. The proprietor is not required to withhold federal income tax on his or her own business income (as opposed to salary income). But, if the proprietorship has any employees, there is a responsibility for withholding taxes from their paychecks. The individual proprietor will likely be required to make quarterly estimated tax payments and will definitely be subject to a 15.3% “self-employment tax” on business income, to offset what the government views as the proprietor’s ability to save in social security and Medicare taxes. Each asset in the sole proprietorship is treated separately for tax purposes, rather than part of one complete ownership interest. For example, a sole proprietor selling an entire business as a going concern calculates gain or loss separately on each asset, not on the value of the entire business as a whole. That can be a significant factor in trying to get the maximum value from the sale of a business. Since there is no difference between business and personal assets, the sole proprietor risks everything he or she has on every business day. If a judgment is placed against the business, every personal asset of the owner can be used to satisfy that judgment. This can include homes, property, automobiles, furniture, checking and savings accounts, investments and personal effects. Additionally, a proprietorship can find it difficult to raise capital resources, since it can only be accomplished if the individual can qualify for a personal loan. The business of a proprietorship does not maintain a separate credit record or profile from that of the individual. In most communities, the sole proprietor does business using a fictitious business name, or “DBA”. Do not mistake the existence of a fictitious firm name as if it represents any sort of legal separation between the individual and the business. The fictitious firm name does not provide any liability protection for the individual. The IRS has a tendency to disallow some expenses if there can be any question whether a certain expenditure was for business or personal use. Because there is no legal separation between the person and the business, this line gets a



little vague at times, which can favor the IRS position for denying the deduction. Obviously, the sole proprietor has several basic planning challenges to overcome that are particular to proprietorship status. And, from a practical perspective, there is no one else to rely on in case of disability or financial hardship. Considering all these factors, a proprietorship is certainly not a long-term business solution. It would be difficult to imagine a situation in which a proprietorship is an appropriate entity for serious business use. Perhaps the only worse choice would be to go into a business as a General Partnership – which is essentially a group of sole proprietors who do business together, making each of the owners completely liable for the business decisions and liabilities created by the other owners. Brilliant! We will discuss that next.

Summary

It is my opinion that business activity should not be conducted as a sole proprietorship. In fact, it is clearly at the top of the list of Stupid Things that entrepreneurs do to ruin a perfectly good business. Virtually every type of business has associated risk and liability exposure. Proprietors usually don’t recognize this (if they did, they wouldn’t be using a proprietorship), and as a result, face potential loss that they cannot possibly comprehend. The existence of a sole proprietorship is often the result of a general lack of planning and foresight. If you are currently a proprietor, you are not only gambling that you will not incur business liability, but you are also throwing away a whole host of potential tax benefits that you cannot get by yourself.

Advantages of Sole Proprietorship

The simplest form of doing business – only because you don’t

actually have to do anything to form it.

Requires less formality and fewer legal restrictions.

Needs no governmental approval.

Usually less expensive than a partnership or corporation to form.

(I say “usually” because I am not factoring in the potential

indirect costs of using a proprietorship, which is everything you

own, plus interest.)

Sole ownership of profits.

Simple to take profits out.

Requires no effort or expense to form or maintain.

Pay taxes at only one level -- your individual rate.

Control and management is vested in one owner.



Disadvantages

Proprietor has complete and unlimited liability for all business

activities. This may include debts that exceed the proprietor’s

total investment.

Potential liability extends to all of the proprietor’s personal

assets. That is not a good thing.

Unstable business life, due to risks associated with death or

disability of the owner, which could force the business to close.

For this reason, proprietorships almost never survive passing

from one generation to the next.

No differentiation between business and personal assets.

Business income is taxed at personal tax rates, which is often

much higher than corporate tax rates at certain income levels.

Additional self-employment taxes.

Certain business expenses are only partially tax deductible.

Limitations on available benefits.

Difficult to raise additional capital, depending upon credit

worthiness of the individual.

As a sole proprietor, all your knowledgeable friends, vendors, or

competitors will assume you are an idiot, and may try to take

advantage of you. This is not a minor point.

GENERAL PARTNERSHIPS

A general partnership is just as easy to form as a sole proprietorship. The difference, of course, is that a partnership must have at least two involved parties or partners. If two people agree to start some new enterprise, but make no effort to set up a specific business entity, by default they are general partners. The general partners are co-owners of the business and its assets. They are basically proprietors operating in partnership, with the added risk that any one of the general partners has the ability to expose the other partners to unlimited liability. And, that is just as bad as it sounds. Even though their ownership interests may not be identical, each general partner usually has the same legal powers in relation to the business. In other words, a general partner with a minority ownership has the same authority to bind the partnership as if he were a majority partner. Once you form a general partnership, it has its own identity for most purposes and can



own property, make contracts, and conduct business in the name the partners have adopted for the general partnership (its fictitious firm name). Although a general partnership is often formed by default, not all joint business activities are automatically classified as a general partnership. For instance, if two business people agree to share such business expenses as a reception area or a photocopier, this does not necessarily create a general partnership. But, if they then charge customers or clients to use the copy machine, the general partnership does exist. The Internal Revenue Service considers a partnership to be “any ordinary partnership, syndicate, group, pool, joint venture, or other unincorporated organization that is carrying on a business and that may not be classified as a trust or estate”. A partnership is not a taxable entity, per se. However it must figure out its profit and loss and file an informational tax return (Form 1065) within 3½ months of its year-end. This informational return essentially reports to the IRS the income tax obligation of each partner, in addition to disclosing the ownership interest of each partner. A general partnership is different from a limited partnership (which is discussed below) in the following ways:

1) Each general partner can legally bind the partnership by his

or her actions.

2) Each general partner is fully liable for all the business

activities of the partnership.

3) Each general partner must have the unanimous consent of all

other partners before being admitted into the partnership.

4) If any general partner dies or withdraws from the partnership,

the partnership is dissolved (unless a prior written agreement

provides otherwise).

Most states have adopted a version of the Uniform Partnership Act, a statute that provides some basic rules for deciding the rights of general partners and persons who have transactions with a general partnership. While this law provides general rules for determining the rights, powers and responsibilities of each individual partner in relation to the partnership and/or its other partners, the internal rules that govern the partnership specifically can be changed by a formal, written partnership agreement. Although most general partnerships probably exist without a formal agreement, it is advised that the partners get together and draft a written partnership agreement to govern and control the partnership relationship. I would take the time here to cover the essential points of a partnership agreement, but the reader might presume that such a discussion somehow legitimizes the general partnership as an appropriate choice for a business entity. General partnerships are subject to the same limitations as sole proprietors concerning their ability to participate in certain pension plans and medical reimbursement plans. Certain business expenses are not always fully deductible, and partners are subject to the 15.3% self-employment tax (12.4% Social Security, plus 2.9% Medicare).



In some ways, the partners in a general partnership have responsibilities to each other that can be compared to those found in civil marriage. Though the partners may have assigned themselves to specific roles and responsibilities in their relationship, perhaps even by written agreement, they are nevertheless jointly and severally liable to the rest of the world for the activities of the business as a whole. The actions of one partner in the name of the business are binding upon all of the partners. The effect of this reality cannot be understated. A general partner must realize that every personal asset may be attached to fulfill a legal obligation created by another general partner. In other words, all of the assets of all of the partners are in constant jeopardy. It would be possible for one general partner, without the knowledge of the others, to get a multimillion-dollar business loan in the name of the partnership, and then fly to some remote Caribbean island with the funds to live a life of luxury. That would leave the other partners fully liable for the debt, possibly forcing the sale of the remaining partner’s personal assets to repay the loan to the bank. Each of the individual partners includes the income or loss from a general partnership on their own tax return. In that way, the general partnership passes its income or loss directly to the individual partners. This avoids the problem with “double taxation” issues associated with drawing profit out of other forms of business. The way the IRS looks at it, it’s your money to do with as you please, as long as you report it and pay taxes on it on time. General partnerships are usually not filed with the Secretary of State because there are no uniform standards for limiting the liability of any of the partners involved. It is not unheard of for general partnerships to be formed as oral agreements. As with a sole proprietorship, a general partnership must file a fictitious firm name with the city or county clerk to conduct business by any name other than the given names of the individual partners.

Summary

A general partnership relies heavily on elements of trust between partners. I have learned that when it comes to business, trust alone is ultimately not sufficient. History is full of examples of partners whose talents allowed them to get a successful business off the ground, but whose talents were not sufficient to manage the enterprise over the long term. The changes that must be made in these situations are painful under the best of conditions. The general partnership provides a recipe for the worst of conditions. In addition to all of the problems that were previously associated with the sole proprietorship, evolutionary changes in the management of a general partnership commonly result in the forced dissolution of the enterprise when the partners do not agree. The only possible way that a general partnership can be properly used is if the partnership consists of separate business entities in a relationship where all the other disadvantages of using the form of business are appropriately managed.



Advantages of General Partnerships

Simplest form of conducting business activity for more than one

person.

Does not necessarily require any effort or expense to form or

maintain.

Only one rate of taxation -- partners pay on their individual

returns. No “double taxation” when taking profits out of the

business.

Partners are motivated by direct rewards resulting from their

efforts.

Disadvantages of General Partnerships

Partners are fully liable for debts or judgments against the

business, regardless of “who did what.”

The acts of one partner can be binding on all other partners.

Difficulty in disposing of partnership interest. Intelligent

investors have no interest in purchasing an interest in a general

partnership. They usually run.

No differentiation between business and personal assets. If you

don’t understand how important that is, refer back to the first

bullet point of this section.

Additional self-employment taxes.

Certain business expenses are only partially deductible.

Limitations on available owner/employee benefits.

Difficult to raise capital, depending on credit worthiness of

partners.

Generally speaking only idiots use general partnerships.



STUPID THING NUMBER 4: USING THE WRONG BUSINESS ENTITY My partner and I started an accounting firm a few years ago to provide tax preparation and bookkeeping for many of the businesses that have been formed through our incorporation companies. Recently, a new client came to our tax firm with an interesting problem: Five individuals had gone into business together to purchase a large parcel of land for $3 million that they intended to develop and sell. They formed a regular C-corporation, and had placed the property into the corporation a couple of years prior to hiring our tax firm. Now, they received a written offer from another group of investors who wanted to buy the property for $20 million. Our clients wanted some tax advice on how to structure the deal. Normally, we might think of this as a “good” problem; the type of problem that led old Tevya in Fiddler on the Roof to exclaim, “May I be smitten! And may I never recover!” Unfortunately, the relationship of these five individuals has soured considerably since the property was originally purchased. Now, they don’t really talk to each other, and they just want to sell the property and cash out. They were anxious to walk away from their bitter business relationship with the others. Hey, it happens. Our accountants had bad news for them, though. If the corporation sells the property, it will be subject to a 35% federal corporate tax, plus an 8% state corporate tax. Then the corporation would be holding the cash and would need to liquidate and distribute the proceeds to the individuals, which would trigger an additional federal personal income tax of 15%, plus state personal taxes! The bottom line was that the total tax bill on the sale was going to run at least 70% of the profit on the deal, or almost $12 million! We tried to help them work out an alternative, but there weren’t a lot of choices. They could sell the stock in the corporation instead of the property, which would limit the federal tax to the 15% capital gains limitation. But, since the buyers intended to subdivide and sell the property, they would have ended up paying $20 million for a corporation that owned land with only a $3 million tax basis. That wasn’t appealing to them, because they would have to deal with the huge tax bill when they ultimately sell the parcels. The last I heard, they were still negotiating with each other as well as with the potential buyer. Bummer, as they say. That is a perfect example of a beautiful business deal ruined by a stupid decision made early on. Too often, in the excitement of starting a business, entrepreneurs don’t think through all of the impacts of choosing the type of entity they are going to use for their business. Even more disturbing, many



entrepreneurs never make any clear decision on using a business entity, and end up as a sole proprietor or general partnership by default. To avoid these and other traps, business owners need to spend some time thinking through their business objectives and goals to determine what type of formal business organization best meets their needs. There is no single “right” answer that fits every circumstance.

12 Questions to Help You Decide

Here are a dozen questions that will help you through the process of choosing the right business entity for your business: 1. Where will the business be conducted? Where you conduct business, own property and have employees determines which state has the right to tax and regulate your business. The tax rules and level of personal liability protection offered by each state varies wildly. So, when you analyze where your business is actually to be conducted, you should find out about the tax and liability implications associated with those jurisdictions. If you don’t like what you learn about those implications, then you may need to spend some time with experienced planning professionals to find out what can be done to manage them and reduce their impact as much as possible. 2. Who will own the business? Individuals? Corporations? Limited liability companies? Limited partnerships? Trusts? U.S. residents? Foreign citizens? If you intend to have another business entity, nonresident aliens or certain types of trusts own the business, then an S-corporation isn’t an option. 3. How many owners will there be? An S-corporation is allowed to have up to 100 shareholders, but if there is more than that, a different entity must be used. The 1997 “check-the-box” procedures adopted by the IRS allows an LLC - which typically has more than one owner – to choose to be disregarded for tax purposes and be considered a sole proprietorship. 4. Where will you get the capital? If you expect to borrow money to get started, a corporation may not be the best choice. Shareholders of a corporation usually can’t include the debt of the company in the basis of their stock, so a flow through entity such as an LLC, or limited partnership, may be preferred. 5. Will the business need to retain significant earnings for future capital needs? If so, the regular C-corporation may be preferable to the LLC or S-corporation. A flow-through entity like the LLC or S-corporation that tries to accumulate earnings will end up generating a huge tax bill for the owners, since the owners have to pay tax on the company’s earnings regardless of whether they actually receive any money from the company. However, a C-corporation can accumulate up to $250,000 in earnings without creating any tax to the shareholders – and can accumulate more if it has a sound business reason for doing so. 6. Do the owners want pass-through taxation? Pass-through taxation (also called “flow-through” taxation) means that the business itself is not considered to be a taxpayer. Instead, all of the income or loss flows through to the individual owners and is reported on their individual tax returns,



whether or not distributions are made. Pass-through entities include S-corporations, all forms of partnership, and limited liability companies (LLCs). LLCs are usually considered a pass-through entity, but the “check-the-box” regulations allow an LLC to choose to be taxed as a C-corporation if desired. 7. Will the first few years of business generate net losses? Many businesses do just that as the result of start up costs, inventory acquisition, overhead costs in excess of revenues and front-loaded tax depreciation. A C-corporation cannot pass these losses through to the shareholders because it is not a pass-through entity. An LLC or S-corporation may give the owners a chance to deduct the pass-through losses against other (passive) income, subject to some limitations. However, an LLC may be the best option in these circumstances because of #4, above. Since the S-corporation cannot include debt in the basis of its stock, and an LLC can include debt in determining its basis, LLC owners may have more tax basis (if the business has debt), which can be used to reduce future gains and cut their taxes. 8. Do the owners want to create different classes of ownership to provide for different ownership rights, or to create various allocations of business income/losses or other tax attributes for different owners? C-corporations can have any number of classes of stock, as long as the Articles of Incorporation provide for them. An S-corporation may have only one class of stock, by rule. Limited partnerships and LLCs may have multiple classes of ownership, and can allocate income, gains, losses, deductions, credits, etc. among the owners by almost any method, as long as the allocations have a “substantial economic effect.” 9. Are the owners concerned about protecting themselves from the liability of the business? They certainly should be in today’s suit-happy world. This is especially true if the business has any contact or contract with any third party, or has any employees. While most of the common business entity structures – such as corporations, LLCs, and the relatively new Limited Liability Limited Partnership, (or LLLP) provide personal protection from business risks, that protection can vary somewhat. For example, a Delaware corporation doesn’t provide the same level of personal protection as a Nevada corporation does, and a California corporation can be “pierced” – which means the personal protection is set aside – much easier than in many other states. The General Partner of a limited partnership, on the other hand, has unlimited liability as it relates to his/her role managing the business. 10. Are the owners concerned about protecting the business from the liabilities associated with the other owners? Corporate stock is generally considered to be an attachable asset in the event that an adverse party or creditor obtains a judgment against any stockholder. This means that the other stockholders in the corporation can be economically damaged as the result of having a new, substitute stockholder as the result of foreclosure upon the stock. Limited partnerships and LLCs are subject to some protection from this risk through what is called a “charging order” limitation on partnership and LLC interests. This means that a creditor or adverse party cannot generally foreclose on the interest of a limited partnership or LLC, thus protecting the other owners from economic damage. These protections are strongest in Nevada, where the state statute clearly makes this charging order protection the “sole remedy” of a judgment creditor. 11. Do the owners of the business intend to offer employee benefits; health insurance, pension, profit sharing or cafeteria plans to owners? A C-



corporation has a significant advantage in providing benefits to shareholder-employees, as compared to LLC member-employees or S-corporation shareholder-employees who own more than two percent of the stock. 12. Is the business regulated or subject to special licensing requirements? Many regulated or licensed businesses, such as banks, physicians, financial institutions, real estate brokers, law firms, etc. will find that there are regulatory prohibitions against using certain forms of business entities. For example, many states prohibit LLCs from engaging in licensed professional activities. These regulations vary depending upon the state where the business operates. Now that we have established that there are a number of factors that can have an impact on the choice of proper business entity, let’s define more clearly what each of these entities are:

CORPORATIONS

The corporation is a business entity that has been used historically to provide a legal separation between a business and the individuals associated with it. It has legal rights and responsibilities separate from any person. The rights include the following:

1) The corporation has access to the court system and all

associated legal remedies. The right to sue and be sued is in

its own standing.

2) The right to hold assets separate from the assets of its

members. Assets owned by the corporation do not rightfully

belong to the owners. Neither do the assets belonging to the

owners attach to the corporation.

3) The right to hire agents and employees. Because the

corporation is a legal person instead of a natural person, it

requires the assistance of individuals to represent the

company and to take actions on its behalf;

4) The right to change ownership without affecting the existence

of the company.

5) The right to exist in perpetuity. The assets and structure of

the corporation exist beyond the lifetime of any of its owners

or agents.

6) The right to limit the liability of its ownership and

management. The economic loss of its members cannot exceed

the amount they contributed to the corporation as capital.

7) The right to sign contracts and enter into agreements.

8) The right to govern its own internal affairs.



These rights vary somewhat or may be added upon, depending on the jurisdiction. As a result, a corporation formed in one jurisdiction may have slightly different rights than one formed elsewhere. As a result, experienced business planners have developed a tendency to rely on certain jurisdictions where the corporation has rights to the greatest level of flexibility and benefits. One or more individuals who share in the ownership of the company own the corporation. Thus, corporate owners are sometimes referred to as shareholders, although the more technically correct term is stockholder; one who holds shares of stock in the company. The company is internally governed by a board of directors, who appoint or hire corporate officers (such as president, secretary, treasurer, CEO, etc.) to manage the daily affairs of the company. The corporation does not technically exist until such time as it is properly registered with a jurisdiction that has authority to create a legal entity. In the US, each state maintains that power. The forms, requirements, maintenance, reporting and fees vary in each state. These differences also have an impact on which jurisdiction an experienced organizer might use to form an entity. The corporation, as a legal citizen of the state and country in which it is formed, has responsibilities to follow regulations, obey laws, and pay taxes imposed by those jurisdictions. Generally, a corporation formed in one state is not subject to taxation or regulation of other states unless it establishes a legal connection – or nexus – with another state. This can happen in many ways, but the most common elements that create tax nexus are:

Qualifying the corporation to conduct business in another state.

Having an office, warehouse or other business location in another

state.

Maintaining a telephone answering service in the state.

The corporation owns or leases real property in the state.

The corporation sells tangible goods from within the state.

The corporation has employees within the state.

There are a number of other elements that states will also look at when determining if a corporation has established tax nexus within the state. It is foolish to use a corporation in a multi-state environment without knowing all the details of the corporation’s nexus activities and potential tax and regulatory obligations. There are other issues related to incorporation that also require advanced consideration. Frequently these matters are overlooked until afterwards, which can cause problems down the road. These items include: Financing. Where does the money or assets of the corporation come from, and what considerations do the members receive in return? Share Structure. How many shares will be authorized, and will there be a need for different classes of shares with different rights?



Securities Regulation. Will the corporation need to comply with state and federal securities regulation in order to raise the necessary capital? Tax Election. Will the corporation function as a regular corporation for tax purposes, or will it elect S-corporation treatment? Will the owners take advantage of Internal Revenue Code 1244 stock treatment or Section 351 treatment for non-cash assets? Are there any potential tax problems such as personal holding company status, personal service corporation status, or imputed interest problems? Management and Control. What rules are needed to govern the stockholders meetings and the voting rights? How much latitude and control is to be given to the board of directors? Agreements. What kinds of agreements, such as stock restrictions, stock subscriptions, buy/sell agreements, employment agreements or independent contractor agreements are needed? Benefits and Pension Plans. What do the stockholder/employees expect in terms of benefits and insurance, and what is the best way to provide it? Estate Planning and Liquidity. If stockholders are investing significantly in the corporation, how are they assured of liquidity at death? How will their ownership interests transfer to their heirs?

Summary

The corporation generally provides tremendous advantages and flexibility in key areas by providing flexibility in the financial, tax, management and benefits arenas. The corporation remains the most important form of business entity in use today. That is a strong reason for considering the corporation as your business entity of choice. As an owner or manager of a corporation, the power and influence of the nation’s entire business community, including high-powered lobbyists at every level of government, are on your side of important issues.

Advantages

Shareholders have liability limited to their investment in the

corporation.

Lower federal income tax rates in many instances.

Centralized management, ease of doing business.

More tax deductions available to the corporation than to other

forms of business entities.

Full fringe benefits available.

Stability and permanence of business.

Easy transfer of assets and ownership.

Established case law.

Flexibility in raising capital.



Distinctly separate legal existence.

Disadvantages

Can be complicated to form properly.

Can be expensive to form and maintain.

Possibility for double-taxation.

Requires maintenance of certain corporate records and

formalities.

Activities limited by the corporate charter and various laws.

May be subject to extensive governmental regulations and required

local, state, and federal reports.

LIMITED LIABILITY COMPANIES

An LLC is an effective hybrid between the single level of taxation provided by a partnership and the liability protection offered by a corporation. The limited liability company (LLC) is a relatively new development in business law. Developed in the 1970s, the LLC has become the most popular type of entity for new businesses since 2004. This is the result of the tremendous flexibility and protection that the LLC provides in business use. Based on European tradition, the LLC creates a business entity that provides liability protection to its owners and managers, while preserving flexibility regarding the pass-through tax status associated with a partnership or S-corporation. The partnership classification can be either good or bad, depending upon the circumstances. While it may avoid double taxation, but you might still find yourself paying tax on company income at a ridiculously high personal income tax rate, instead of at a lower corporate rate. An LLC is an entity that is legally separate and distinct from its owners, just as a corporation is its own legal person. For tax purposes, the LLC is usually treated as a partnership, (although it can choose to be taxed as a corporation if that is preferable). When taxed as a partnership, the LLC merely files an informational tax return that details the gain and loss of the individual members. The tax liability flows through to the owners. Partnership tax treatment avoids double taxation problems that exist when profits are distributed to corporate shareholders. When this happens, the dollar is taxed at both the corporate and individual tax rates. The LLC provides charging order protection, which is designed to protect innocent LLC members from being forced into a partnership-type arrangement with potentially hostile members they did not choose. Nevada provides LLCs with greatest level of charging order protection because under the law, no other remedy – such as foreclosure – is allowed by statute. One key advantage to the LLC is in the lack of restrictions regarding the type and number of stockholders. This is an important distinction between the LLC and the S-corporation, which is the other entity that provides corporate



liability protection and flow-through tax status. Unlike the S-corporation, which has severe limitations on the number and type of qualified shareholders, the LLC has no such limitations. (For example; most trusts, estates, corporations, partnerships and other LLCs are prohibited from owning stock in an S-corporation.) The owners of an LLC are called “members” of the company, and are indemnified by statute for any judgment, debt or obligation of the company, including decrees of the court. The members may exercise direct control over the company, according to their individual percentage of ownership, or may appoint one or more managers. If managers are used, they perform functions commonly associated with corporate officers and directors. For years, I have written that one of the potential drawbacks to the LLC is in the lack of financial privacy it provides for its members. It has been my opinion that since the members are disclosed on federal tax returns and are frequently listed in the articles of organization, which are filed as part of the public record with the Secretary of State, the LLC is a relatively transparent business entity. However, others do not share this opinion, and have targeted the LLC for specific criticism as an entity that can provide an “unreasonable” level of privacy. Statutes have been enacted in several states that target LLCs for specific ownership disclosure when doing business with state or federal agencies, or when making campaign contributions, for example. Moreover, in late 2006 several reports were published that also targeted LLCs as entities of choice by criminals and money launderers because of their lax disclosure requirements. I suppose that beauty is sometimes in the eye of the beholder. Certain types of business are a natural fit for the LLC, including research and development, oil and gas exploration, and real estate development. The reason this type of activity is such a good fit for the LLC is because of the inherent limited lifespan of the business. For example, in the oil business, you locate the well, drill it, pump it, and hope to walk away. The LLC allows that to happen. The chief financial officer of a large manufacturing company in Nevada shared his thoughts with me about the LLC. He said that the real excitement in industrial circles about the LLC has to do with speculative development and research. In his words, “it’s the closest thing there is to a collapsible company.” The LLC is already replacing the S-corporation as a flow-through tax entity, in many situations. It may also replace the limited partnership in some instances. The LLC will not completely replace the corporation or limited partnership, but it is definitely making a big dent in new business filings.

Summary

The LLC quite simply provides the best combination of flexibility and protection, although it is not recommended for all situations... As the legal systems of the individual states establish the appropriate case law to lay a solid foundation for the LLC concept, it has become a business standard.



Advantages

Good liability protection for members, management and employees.

No limitation on number or type of owners.

No limitation on classes of membership interests.

No limitation on ownership of other corporations.

No citizenship requirements for members or managers.

Simple to take profits out.

Personal creditors treated like assignees, and cannot force the

sale or dissolution of the company.

Disadvantages

There is still a question about the flow-through tax status of a

“one-man” LLC in those states that provide for such an entity.

One-man LLCs may not provide adequate asset protection in certain

circumstances.

LIMITED PARTNERSHIPS

Limited partnerships have the same basic features as a general partnership, with one important exception: Limited partnerships have limited partners, who generally have neither liability for business activities nor management responsibilities; in addition to general partners who have the same rights, responsibilities and status as a partner in a general partnership. The limited partnership is based on a principle that attempts to preserve the interests of the public good by requiring the existence of at least one general partner. That way, someone has responsibility and liability for the activities of the partnership. However, the liability of the limited partner is limited to the amount they have invested in the partnership. Because their role in the partnership is viewed as passive, they are not held accountable for partnership activity. All they can do is lose their partnership investment. Filing a Certificate of Limited Partnership with the appropriate state and establishing a formalized partnership agreement following state law will create a limited partnership. So, a limited partnership is not a “default” entity that can exist without taking some kind of formal action. The only way to establish and preserve the limited liability of the limited partners is to officially organize the entity with the state, which then grants the limited liability features. The limited partnership agreement is a legal document that specifically details the powers and responsibilities of the partners, and other factors that will decide how the partnership will function and react in specific



situations. Because of the complexity of the partnership agreement, it is important to recognize that all limited partnerships are not created equal. The effectiveness that a limited partnership will have in accomplishing your specific goals depends a great deal on the skill and knowledge of the person drafting the agreement. The wording of the agreement can greatly affect all aspects of the partnership, including the tax consequences of different partnership activities. For example, a common use of a limited partnership is to protect assets from judgments or creditors. But the value of the partnership in accomplishing that goal is dependent upon the partnership agreement addressing any possible eventuality that a judgment creditor can create. The agreement should cover at least the following points:

The name of the partnership;

The state of the partnership domicile;

The amount of cash or property to be contributed to the general

partnership by each partner, along with a schedule for making the

contributions;

The duties of each partner in conducting the business, and the

scope of authority of each partner to make decisions and incur

obligations for the partnership, (which may be useful in settling

legal disputes between the partners, but will not necessarily

protect any one of the partners from liability exposure to others

because of partnership activity);

Internal procedures for handling separate debts, including tax

obligations;

Methods for changing the partnership agreement;

Operating procedures, such as maintenance of books and

accounting, employee management, etc.;

The percentages by which the profits and losses of the general

partnership will be shared among the partners; and

The events that would cause the partnership to be dissolved,

including procedures for winding-down the business, discharging

all debts, and distributing the available assets among the

partners.

The most common and basic problem that I have seen with limited partnerships used for asset protection purposes is using an individual as the general partner. I wish I had a nickel for every time I saw a qualified attorney, purportedly an expert in the field of asset protection, set up a limited partnership that resulted in exposing the very client he is supposedly protecting to the unlimited liability associated with being the general



partner. I can only conclude that there are fools in every occupation, and that the legal field is not exempt. Unfortunately, not all partnership agreements are written with asset protection as a primary goal, and partnership agreements that do focus on asset protection are frequently drafted by attorneys whose background, experience, and skills vary widely. The result is that there are bad partnership agreements out there, and the average person, including many lawyers, couldn’t tell the difference until it is too late. Unless a partnership agreement exists, the only governing document the entity has is state law – and which of us is comfortable allowing politicians to set our partnership policy for us? Every state has adopted a version of either the Uniform Limited Partnership Act (ULPA) or the Revised Limited Partnership Act (RLPA). It is not necessary to detail the distinctions between these two acts here, especially since individual states have adopted different forms of these acts. But, the person drafting the agreement should be familiar with the version of the law being used. As you can see, it is far more complicated and expensive to form an effective limited partnership than it is to form a general partnership due to the wide range of attorneys’ fees and state filing fees that will apply. And, as with other business entities, there are annual maintenance requirements that add to the cost. Besides their limited liability, the limited partners have the advantage of dealing with a single level of taxation. Income into the partnership flows directly to the partners according to their individual interest, and is included on their personal tax returns. There is no double taxation to worry about when taking profits, but the general partners are subject to the 15.3% self-employment tax on their income from the partnership. Although the partnership itself is not taxable, it must still file an annual federal tax return on Form 1065 and provide K-1 schedules to each partner. The K-1 lists each partner’s ownership interest, share of income, deductions and credits. Some states also require state income tax filings. A limited partnership can hold virtually any asset, except some retirement plans, stock in professional corporations and shares of S-corporations. Retirement plan contributions for limited partnership are limited to “net employment income,” (which is: gross income minus deductions, including the deduction for retirement plan contributions). Under this formula, you can contribute and deduct as much as 20% of the partnership’s profits per year to an approved pension plan. The proper uses of a limited partnership are commonly found in three major situations:

1) As an asset protection tool against lawsuits or other

judgments,

2) As a tool to spread income among the family and achieve a

lower overall family income tax rate, and

3) As a tool in estate planning to lower estate taxes.



There has been a lot of discussion in recent years about an entity called the Family Limited Partnership, which is touted as a suitable device for dealing with a variety of family and estate matters. For the most part, the Family Limited Partnership performs as advertised. But the entity is still a limited partnership, and subject to limited partnership law.

Asset Protection Use

Regarding the asset protection use, a limited partnership provides the following generally accepted advantages, provided the document is drafted properly:

1. A creditor that has a personal judgment against you merely gets a

charging order against your limited partnership interest, so

generally cannot seize any partnership asset unless he or she is

a creditor to the partnership itself. The charging order only

gives the creditor a right to the income portion of a limited

partner’s interest in the partnership, and is usually the only

means by which a creditor can reach a limited partner’s interest.

2. Charging orders give a creditor no voting rights, no annual

income distribution rights (if the provision is included as part

of the partnership agreement) and can be the most worthless asset

a creditor could ever hold.

3. Creditors cannot remove the general partner of a limited

partnership, so you can continue to control all partnership

activities and assets by controlling the general partner.

4. Since the personal creditor has no vote, or accounting or

inspection rights in the partnership, he or she is treated as an

assignee instead of a substituted limited partner and is very

much at the mercy of the other partners.

5. The creditor cannot force the sale of partnership assets to

satisfy personal judgments.

However, a limited partnership is not an absolute barrier against creditor judgments and claims. The First District Court of Appeals for the State of California held in 1989 that a limited partnership interest may be sold on foreclosure of a charging order lien at the request of a judgment creditor. The court determined that the state law gave them implied power of equitable distribution to order the foreclosure sale of a partnership interest to satisfy a judgment creditor’s judgment. This case set a disturbing precedent, which makes limited partnerships vulnerable except in a state such as Nevada, where the statutes restrict the remedy of a creditor to the charging order – and only the charging order. Almost all other states have statutes that give the court access to other creditor remedies, including foreclosure.



Recently the National Conference of Commissioners on Uniform State Laws released a draft of the latest revision to the Revised Uniform Partnership Act that provides for this power of foreclosure. It provides that “the court may order a foreclosure of the charging order at any time and under such conditions as it considers appropriate.” So, to protect a limited partnership from this type of attack, it should be filed in the State of Nevada. Since 2003, Nevada law has prevented the foreclosure of the charging order, and offering the highest level of protection for the partners (or LLC members, for that matter). In 2007 Nevada provided this protection to closely held corporations as well – the only state to do so. There can be several drawbacks to using limited partnerships. For instance, a limited partner must be careful not to take an active role in management or exercise too much control over his or her investment, or the partner’s legal status can be elevated to that of general partner. The undesired result would be that the limited partners suddenly find themselves exposed to all the personal risk that has been described earlier. Also, if the partnership has not been filed appropriately, the limited status of the partnership may be jeopardized, possibly resulting in full liability exposure to all of the partners.

Summary

The limited partnership is a terrific tool when in the right hands. Used improperly, it is as dangerous as dynamite. It is dangerous, because many people who think their partnership protects them from liability will be sadly disappointed when they find out that their partnership documents are full of holes or that their state does not guarantee them charging order protection. The attorney who specializes in asset preservation concerns, monitors developments in case law and constantly revises his documents to reflect what he has learned is a good bet to establish a limited partnership properly. I wouldn’t let the average attorney draft a limited partnership for me any more than I would let my family doctor perform brain surgery.

Advantages

Limited partners have limited liability.

Partnership has one level of taxation.

Effective tool for estate planning, asset protection, and tax

planning under certain circumstances.

Limited partnership interests are generally not attachable by a

creditor.

Mechanism for adjusting the tax basis of real property.

Personal creditors are precluded from seizing or forcing sale of

partnership assets.

No double taxation for partners when taking profits.



Disadvantages

Complicated and expensive to form and maintain, not for the do-

it-yourself crowd.

Effectiveness of the partnership depends upon the provisions

included in the partnership agreement.

General partners have unlimited liability for partnership

activities.

Limitations on available fringe benefits.

General partner may be subject to self-employment tax.

Possibility of limited partners losing liability limitations in

certain circumstances.

Not an absolute guarantee against claims, depending largely upon

the jurisdictional statutes regarding charging order limitation.

LIMITED LIABILITY LIMITED PARTNERSHIPS

The Limited Liability Limited Partnership (LLLP) is a new twist on the limited partnership described above that is beginning to emerge in law. As the LLLP becomes more broadly understood, it has the potential to virtually replace limited partnerships in the future. The LLLP is a traditional limited partnership that has elected to provide limited liability to the general partner, thus removing several of the negative implications of using the standard limited partnership. As stated earlier, the general partner (GP) of a traditional limited partnership is exposed to potentially unlimited liability, regardless of whether the GP owns 1% or 99% of the partnership interest. In a state such as Nevada where LLLP filings are allowed, this provides a higher level of asset protection. New or existing limited partnerships simply file a form signifying the election of the LLLP status and pay the required fee to give the GP of that partnership a level of indemnification that approaches that available to corporate officers and directors. As the author of Nevada’s LLLP statutes, I am justifiably pleased with this new element of business entity law. More recently, as LLLP status has been included in the latest recommendations for the Uniform Limited Partnership Act, we will soon see LLLP status adopted by many other states.

Advantages

Limited partners have limited liability.

Partnership has one level of taxation.



Effective tool for estate planning, asset protection, and tax

planning under certain circumstances.

Limited partnership interests are generally not attachable by a

creditor.

Mechanism for adjusting the tax basis of real property.

Personal creditors are precluded from seizing or forcing sale of

partnership assets.

No double taxation for partners when taking profits.

General partners are indemnified by statute and subject to

charging order protection against personal claims.

Disadvantages

Complicated and expensive to form and maintain, not for the do-

it-yourself crowd.

Effectiveness of the partnership depends upon the provisions

included in the partnership agreement.

Limitations on available fringe benefits.

General partner may be subject to self-employment tax.

Not an absolute guarantee against claims, depending largely upon

the jurisdictional statutes regarding charging order limitation.

Your attorney probably won’t have a clue what it is for several

more years.



STUPID THING NUMBER 5: NO CONTINUITY PLANNING Failure to plan properly impacts a business in many ways. In the previous chapter, we discussed how failing to plan for your organization and structure could ruin a perfectly good business. In this chapter, we will discuss how failing to plan on how to keep your business running in a worst-case scenario can ruin your perfectly good business. This is a very popular Stupid Thing: No business continuity planning. Business continuity planning has a couple of different aspects to it. One part of it involves estate planning, or making proper plans for the business to continue to operate after your death; and the other part involves making planning decisions that allow your business to continue in the event of a catastrophic event, such as a natural disaster or terrorist attack. Any company that doesn’t have a plan for both of these possibilities is not likely to survive either of them.

Estate Planning

I read an interesting article in a local newspaper recently about a small retailer that was trying to fend off an attempt by a large and powerful developer to move them out of their downtown business location where they have conducted business for 100 years. What caught my eye was the fact that this business has been family-owned and family-run for five generations. And the sixth generation was waiting in the wings for their turn! The reason that is an amazing story is because it is so rare. The director of the Institute for Family-Owned Businesses out of the University of Southern Maine, Tom Juenemann, says that the number of family-owned businesses that are run by the second generation drops to 30 percent, and plummets to 3 percent by the fourth generation. Estate taxes discourage successors because, unless there is enough cash to pay the taxes outright, it forces a distressed sale of the business just to pay the estate tax bill that comes due in full only nine months after the funeral. While there seems to be an inherent injustice in the outcome of a forced sale of a business just to satisfy the vultures, the reality is that the estate tax is truly one tax that is completely voluntary. With proper up-front planning and foresight, estate tax obligations can be simply avoided altogether. In planning your business, a simple thing such as how the company is owned from the beginning can make a huge difference. By keeping the value of a



growing business out of your estate, you eliminate any estate taxes on the future value of your company. Keeping your company ownership in your name puts the value of the business directly into your estate and subjects it to the time and money-consuming process of probate.

Probate

Probate is the legal process that involves the formal filing of a deceased person’s will with the local probate court, taking an inventory and appraisal of assets, paying all legal debts, and at the end of this time-consuming process, eventually distributing the remaining assets to heirs. It generally costs 5% of the gross value of the assets in probate – not just of the equity value, mind you. While in probate, the assets are essentially frozen. So, business owners who hold their company in their own name are usually doing something very stupid. Consider just the costs of probate for a moment. If you are a small business owner, it is probably safe to assume that you also own a home and other assets. Your home, business, vehicles, investments and miscellaneous assets could easily surpass $2 million – particularly if your home is located in California or other expensive areas of the country. With a total estate value of $2 million, the probate fees will cost your estate about $100,000. That’s not chump change! And remember that the probate value does not take into account how much actual equity exists. Your estate could theoretically face probate fees that exceed the available equity! If the business is organized as an LLC or partnership, the entity may be dissolved upon the death of one of the owners, depending upon the operating or partnership agreement. Then, the company assets are split up, and the portion that is assigned to the deceased is tied up in probate. So, the decision to own the LLC in your own name may have just cost your family a lot of money and a lot of time. As a result, it is less likely that the company will survive. Businesses organized as corporations are no better off. If the stock is in the name of the deceased, the stock becomes a probate-able asset. It can be seized by the probate court, and all the assets of the company can be frozen for months – or even years! How many businesses can survive that? Can yours? I’m thinking: probably not. There is simply no good excuse to have this happen to your family. Through the use of proper estate planning tools the financial impact on your family can be greatly diminished. This type of planning isn’t even considered to be pushing the envelope these days. It is just simple common sense. And, while it does require a certain level of professional expertise to put this type of planning arrangement into action, it isn’t exactly rocket science, either. Unfortunately, most small business owners stay so focused on the daily drama and challenges that continually cross their desk that they have precious little time to think about these things. Even then, they frequently don’t know what to do or who to turn to for help. While estate planning is much easier and has a greater likelihood of accomplishing its objectives if done in advance, it is never too late to make a significant impact on your estate. A successful estate-planning attorney once told me that he was able to completely eliminate estate taxes for his clients, regardless of their situation, if only they lived long enough.



So, to ensure the greatest chance that your business will not succeed you, follow this simple rule: Avoid estate planning at all costs. With proper estate planning, not only can you eliminate probate from touching your estate, but you may also be able to dramatically reduce or eliminate estate taxes. This is possible through the proper use of legal entities, known as trusts, in combination with proper life insurance measures.

Living Trusts

In a general sense, a “trust” is a legal arrangement where one person, called the “grantor,” gives control of his property to a trust, which is administered by a “trustee” for the benefit of the beneficiaries. The grantor, trustee, and beneficiary may be the same person, so he or she can control and benefit from the trust assets. The grantor usually names a successor trustee in the event of incapacitation or death, as well as successor beneficiaries. A “living trust” is created while you are alive and allows you to control the distribution of your estate. You serve as the grantor, trustee, and beneficiary while you are alive. Upon death, a successor trustee takes over and manages the trust to benefit successor beneficiaries – frequently children or other family. Because the trust owns the property instead of an individual, all the assets in the trust avoid probate. When drafting estate planning trusts, there are a number of available options: revocable or irrevocable trusts; A-B trusts; A-B-C trusts; insurance trusts; asset protection trusts, etc. It can be difficult to know which trust is appropriate for your circumstances, and it is even more difficult to find someone who is qualified to help you answer that question, and also to provide you with the best solution. But your investment in time finding the right advisor on these matters will pay off big. Of course, it is possible for you to go through the process of putting a living trust together and STILL do something really stupid. For example, too frequently people begin the process of establishing a living trust – they think through the details of their wishes, answer a lot of questions, review draft documents, and pay the attorney – but they never get to the point where they actually fund it. The trust isn’t complete – and isn’t useful or effective – until it is funded. That means that the assets that are supposed to be in the trust are actually placed into the trust. It doesn’t happen on its own. If stock certificates are issued to the trust, property is deeded to the trust, bank and investment accounts are in the name of the trust, vehicles are titled in the trust; then the trust can actually do what it was intended to do.

The Pour-Over Will

The living trust is a central component of a comprehensive estate plan, but it is usually used in combination with a few other legal documents, including a pour-over will, durable powers of attorney, and health care declarations. A pour-over will is designed to catch any assets that were inadvertently left out of the trust.



The pour-over will prevents the creation of an intestate estate (which means that the property was not in a legally valid will), and usually distributes any assets that it “catches” into the living trust. Without a will, your heirs are defined by state law rather than by your own choice. While the state laws vary somewhat in their approach to dealing with intestate estates, here is an example of how it could work in California:

1. If the deceased is married, the spouse gets 100% of the community

property, but only one-third or one-half of the separate

property; the separate property is also distributed among

children or parents.

2. If the deceased is not married, the property is distributed in

the following order:

a. All assets go to

i. children,

ii. grandchildren,

iii. great-grandchildren, if there are any.

b. If there are none, then all the assets go to the parents.

c. If there are no parents, then all the assets go to

i. other children or

ii. grandchildren of your parents.

d. If there are none, then –All the assets go to either

i. your grandparents, or

ii. any surviving descendants of your grandparents.

e. If there are none, then all the assets go to either:

i. The parents of a predeceased spouse (your in-laws), or

ii. to their descendants.

iii. If there are none, then all the assets go to the State

of California.

If all that seems pretty confusing, just think how much more complicated it will get if there are half-siblings, children born out-of-wedlock, foster children or step-children involved in any of the definitions listed above. Then, you have to ask yourself, “Is this a smart way to pass on my company when I die?” I think it is obvious: No, this is a stupid way to deal with any business.

Durable Powers of Attorney

A Durable Power of Attorney allows someone to act on another person's behalf even while that person is still alive. People suffering from dementia or senility, who are no longer competent or perhaps temporarily unable to make their own decisions can specifically authorize others to take care of



business or make decisions for them. A Durable Power of Attorney allows them to do that. Setting up a Durable Power of Attorney is as easy as signing a single legal document, naming whomever you would like to appoint as your agent. It doesn’t require any legal hearings or court orders. A business owner who is seriously injured, incapacitated, or suffers from dementia places the entire business at risk if no one is properly authorized to take care of business for them. If they have not named an agent to act on their behalf, they may end up having a Conservator appointed over their assets and affairs. Conservatorship is a lengthy and expensive court procedure requiring someone to volunteer to become your Conservator. Finding a volunteer whom you trust with your affairs may be difficult. Of course, when this happens, the person for whom the conservator is appointed won’t know if the person appointed is someone they actually trust. The Conservator is paid for his/her time, which means that they don’t have any incentive to handle things efficiently. As a result, the entire process is a huge financial drain. Individuals granted Power of Attorney must, by law, act in good faith at all times on behalf of the grantor. Suppose an elderly man is declared incompetent, but had given his adult child a Durable Power of Attorney. The son cannot turn around and put his father's house in the child's name, or sell off assets for his own use. The law maintains agents have a fiduciary duty to the grantor, and cannot take advantage of his or her position.

Medical Durable Powers

Dealing with the health care needs of an incapacitated loved one can be extremely difficult in any circumstance. Traditionally, health care providers have turned to next-of-kin for decision making. However, the tragic case of Terri Schiavo showed how any disagreements or objections by next-of-kin can create a real disaster. Many states – but not all – have laws that specify who can make decisions for a patient that has not provided a Durable Power of Attorney for Health Care. In many of those states, the spouse is designated as the first priority, followed by adult children, parents, and siblings. But the laws vary, and create enormous potential for Schiavo-like disputes. Some states give spouse, parents, children or guardians all equal legal status in making decisions for incapacitated patients. Other states give the attending physician the right to choose the decision-maker based on who he/she believes is best suited for the responsibility. So, if the spouse does not agree with the desires of the doctor, the doctor can simply appoint someone who does agree. In Florida, the court does not give first priority to a spouse but to a court-appointed guardian. Because the requirements for a valid Durable Power of Attorney for Health Care differ from state to state, your document must comply with the law in your state. Some states require that the documents be witnessed. Others require that they be notarized, while yet others may permit either. Some states require that specific warnings or notices be included in any preprinted forms. Others do not. (If your Durable Power of Attorney for Health Care is valid when you sign it in your home state, it will be honored



in other states when you are traveling or if you have moved to another state.) Having a carefully drafted Durable Power of Attorney for Health Care is vital for every adult — young or old, healthy or sick, disabled or able-bodied. That is the only way to be assured that someone who has your best interests in mind will be making your medical decisions if you are ever unable to make those decisions for yourself. In today’s world, with the impacts of the Health Insurance Portability and Accountability Act (HIPAA), health care providers may not provide any information, or answer any questions about the status of a patient unless they are designated by an advanced directive such as a Durable Power of Attorney for Health Care. So, not having one is, frankly, stupid.

The Legacy of ACME Rockets

The next level of estate planning for business owners is illustrated when there are multiple owners or partners: we’ll call them John, Lisa, and Doug. Their company is ACME Corporation Incorporated. (Perhaps you’ve seen their products strategically placed in classic children’s cartoons involving a certain running bird and its “wily” predator.) John Tilley owns 50% of ACME and serves as company president. Lisa Johnson owns 40% and serves as treasurer; and Doug White, the company secretary, owns the remaining 10%. All three are also company directors. They have all had their personal estate plans prepared and have properly funded their living trusts to hold their stock for them. Then, John is unexpectedly killed in an unfortunate rocket testing accident. Everyone is shocked and saddened at the loss. Lisa, Doug, and John’s widow, Mary Tilley, all grieve together in support of one another. That is, for a few days. Then, they realize they have a problem. They need a new company president and director. Mary Tilley, as the trustee of John’s trust, now controls half of the company. She has never been involved in business operations. In fact, she really knows nothing about the rocket business at all. However, she has never liked Lisa, and she has never trusted Doug. So, she decides that she wants to turn the company reigns over to her oldest son, 23-year-old Rosencranz Tilley. The job would be perfect for Rosencranz, who needs a job anyway and, she decides, Rosencranz has a certain “birthright” to it. Naturally, Lisa and Doug disagree with this decision. Vigorously, in fact. The company bylaws require a simple majority vote of the board of directors to elect a new president, which is not unusual. So, for practical purposes,



Lisa and Doug have the authority to put a new president in place without Mary’s authority. The two of them hold a meeting and elect Lisa Johnson as the new president of ACME, and then notify Mary of their action by certified letter. This infuriates Mary, who immediately calls her attorney. The attorney reviews the articles of incorporation, bylaws and state statutes, and informs Mary that the bylaws only require 50% of the voting shareholders in order to elect new directors. So, not surprisingly, Mary immediately calls an emergency meeting of the stockholders. Doug and Lisa also show up at the meeting. Mary moves for a special election of the board of directors, and with her 50% of the stockholder vote, removes Doug and Lisa from the board. Now, Mary is the sole director. As the sole board member, she then promptly calls for a meeting of the board of directors, where she proceeds to fire Lisa and Doug as corporate officers. Next, she appoints Rosencranz as the new company president. Doug and Lisa file a lawsuit against Mary, Rosencranz and ACME Rockets Incorporated. The company is torn apart in the turmoil and litigation. Essential new rocket technology development stalls as the company loses sight of its very purpose for being. It soon loses its contract with Looney Tunes, and eventually files for bankruptcy – never to return. All of which reminds me of a story told by the satirist Ambrose Bierce: A man died leaving a large estate and many sorrowful relations who claimed it. After some years, when all but one had had judgment given against them, that one who was awarded the estate asked his attorney to have it appraised. “There is nothing to appraise,” said the attorney, pocketing his last fee. “Then what good has all this litigation done me?” said the successful claimant. “You have been a good client to me,” the attorney replied, gathering up his books and papers, “but I must say you betray a surprising ignorance of the purpose of litigation.” Could this be the fate of your company? The answer is: very possibly - unless you have planned for the succession of the business in the event of the death of one of the owners. This planning can be accomplished through a buy-sell agreement, insurance, or other means, if you have qualified, experienced professionals to guide you.

Emergency Preparedness Planning

No discussion of continuity planning would be complete in today’s world without mentioning the importance of emergency preparedness planning for your business. Few small businesses have made such plans. It could be a fatal mistake for many businesses: A Stupid Thing that could ruin a perfectly good business.



I know. I’ve made that mistake. I’ll never forget New Year’s Day, 1993. A warm winter storm generated torrential rains that fell on the mountains of the Sierra Nevada, melting the season’s snow pack and sending all the runoff down the mountain at once. Small, picturesque rivers and streams turned into raging white water. Dry creek beds transformed into deadly flumes. The experts called it a “500-year flood event.” I do not doubt that. At the time, I owned a small commercial printing operation in Reno, Nevada. It was located in a warehouse not far from the airport. The Truckee River, usually flowing well below its banks at not much more than a trickle during drought years, was over a half mile away. The business location was not, to my knowledge, in a flood plain. I had never remotely considered that our location would be in danger of floodwaters. We had a couple of expensive electronic presses, plate burners, light tables, tens of thousands of dollars of printed material ready for delivery, and many thousands of dollars in stock, chemicals and supplies. Plus, we had furniture, computers, telephones and other items typical of an office. That day, two feet of floodwater rushed through the plant, destroying everything as the river overflowed and flooded the airport. The power of the flow was incredible. We had no emergency preparedness plans, and perhaps it would not have mattered in that situation. But that episode shut down my printing business and it never reopened. We never contemplated the worst-case “what if” scenarios. If we had, then we surely would have instituted backup plans, and perhaps that business would have survived. Is it just me, or do these “500-year” events seem to be happening almost with regularity these days? We don’t have to rummage long in our memory to be reminded of earthquakes, floods, fires, winter storms, terrorist attacks, etc. that have caught us off guard. Along with immense personal loss, businesses are also severely impacted. It only amplifies the loss to the individual and the family when such a calamity occurs to have his/her means of earning a living affected as well. Here are some alarming statistics: 78% of businesses that suffer a catastrophe without a contingency plan are out of business in two years.1 Even more disturbing is the fact that nine out of 10 companies that are unable to resume operations within five days after a disaster are out of business within a year.2 While 100% of the Fortune 500 companies have a business continuity plan, less than 10% of all businesses in the U.S. with 10 or fewer employees have one. It seems that nobody is completely immune to potential catastrophe, unless you live in Blanding, Utah, which USA Today identified as a “relatively safe place.”3 (Although having driven through it, it isn’t necessarily someplace I would want to live.) Just think of the significant events of the past decade

1 State of Oregon Enterprise Business Continuity Planning Initiative, March 2005 2 Neal Rawls, security columnist and author writing about “Avoiding Disaster” by John Lay, 2002, quoted in report to Lloyd’s of London by Chairman

Lord Levine, 21 April 2004 3 “Catastrophic weather is hard to escape”, USA Today, November 7, 2006



that have littered the news. If you haven’t already noticed, the government has been using the term “pandemic” a lot lately as well. How will your business continue to operate – or survive – if one of these events happens to you? How will you handle communications, staffing, data access, and finances during such a crisis? And how long do you really think your business can survive in a crisis without knowing those answers? There is a library of information available to help businesses assess how their company functions and what needs to be considered to prepare businesses for both man-made and natural disasters at www.ready.gov. It is a huge mistake to not have an emergency plan for your business.



STUPID THING NUMBER 6: NO INDUSTRY UNDERSTANDING OR RESEARCH As Ray Kroc built the McDonald’s Empire in the 1950s and 1960s, his success was tied to the fact that he knew his market so well. He intrinsically knew that his primary market was, at least at that time, the families of America. An often-repeated story about that era tells of Kroc flying over the developing suburbs of our country in a Cessna looking for church steeples and spires. He knew that neighborhoods that could support several churches were prime territory for the McDonald’s core market. Then he started looking for property near schools – where kids were – to place his stores. Over time McDonald’s, under the continuing influence of Ray Kroc, developed its own precise science of site selection based on a number of specific criteria that was unmatched by any other fast-food business. They went from flying over neighborhoods in single-engine planes to helicopters to commercial satellite photography to ingenious computer software that overlays not only satellite photography, but also census figures and in-depth, block-by-block demographic studies of traffic counts, income levels and ethnic background. Their goal has been to always be slightly ahead of growth and sprawl. That way, they could always be where real estate was inexpensive. By the time growth arrived, the McDonald’s restaurant was up in a great location. Their competitors followed them, and once McDonald’s purchased property, other fast-food chains were not far behind. Many people don’t realize that the business model of McDonald’s is different than most of their fast-food competitors. Sure, they sell hamburgers and fries, but they are also in the real estate business; they typically own the real estate where their stores are located and collect rent from the franchisees. They are able to do that only because of time and effort they have spent paying attention to every detail of their business. In many respects, McDonald’s competitors, formidable as they are and with arguably better products, have been playing “catch-up” ever since. Every industry has its own, unique set of performance metrics, and unless you know the key metrics for your business model – like McDonald’s does - you literally have to be lucky to be successful. This is another hard-luck lesson of mine. One of the difficult lessons I have had to learn in the past few years is that I did not know the key indicators for running a tax and accounting firm. I was very familiar with what it takes to run a sales organization. I know the pricing and expense models; I know the margins; I know the management structure; I know the marketing strategies and costs; I know the break-even points and the daily-



required production levels. But I don’t know anything about accounting and tax preparation. When my partners and I started our tax and accounting firm, we mistakenly assumed that by hiring experienced tax and accounting professionals that somehow they would magically know what the key benchmarks were, and that profits would naturally flow. As we discovered, the tax professionals did not know the key metrics of their business – they only knew tax and accounting! And so, it has taken a great deal of effort and education for us to learn enough about running a tax and accounting business to even know what the right questions were to ask of our staff. I won’t bore you with the details, but the questions we needed answered were pretty specific and difficult. Some of the easier questions included:

1) How do our revenues compare with other tax firms? (Could we

get comparable numbers about our industry? Where?)

2) Is our expense ratio within industry standards? (What are the

industry standards?)

3) What percentage of our expenses should be payroll related in a

payroll-heavy business?

4) How many tax returns per day should we expect our preparers to

complete?

5) What is a reasonable range for billable hours per employee?

6) What are the national standards for renewal rates for

bookkeeping clients?

7) Can we institute “menu-pricing,” or do we need to bill clients

hourly?

8) Can we manage our workflow and meet client needs without

detailed time tracking?

9) Would the model support low-margin entry packages?

As we began to understand these issues, and many others, we started to grasp the realities of our business model. It should not have surprised us that the model was very different than our previous businesses. We learned that hiring a tax professional was not the same thing as hiring a business manager. We learned that we needed to make adjustments in our pricing and in our reporting. We learned that key systems had to be changed to accommodate our new model. We learned that our payroll was too high, and that we had too many bodies doing too little work. If we had not learned those things – and changed those things - our tax and accounting firm would have never survived. Without knowing something about the industry in which you compete, it is very difficult to judge your business performance. For example, if you want to compete with Reebok and Nike, you will need to gather data on the size of the athletic shoe market, identify all the key manufacturers with their respective market shares, and what the trends and projections are for that industry.



Unfortunately, not all industries have equal amounts of data available. It can vary widely, depending upon the specific industry, size, age and rate of technological change that is occurring in the market. So, where do you begin? There are essentially four segments to industry research:

1) Industry structure. This is a good place to start in order to

gain a basic understanding of how things work. In this segment,

you are more interested in general background information, not

specific company names. Sources include:

Encyclopedia of American Industries, published by Gale

Research. This is a two volume set that covers a large number

of industries.

U.S. Industry & Trade Outlook, issued annually by the

Department of Commerce and McGraw-Hill.

Career Guide to Industries, published by the Department of

Labor, provides information on the working conditions,

earnings and benefits, training and advancement potential for

workers. This can be a goldmine of knowledge in understanding

what it takes to compete in terms of workforce and labor.

CRM Commodity Year Book, published by the Commodity Research

Bureau each year can be an important resource if your business

in is a commodity-oriented business.

2) Industry profiles. This is where you start to look at specific

companies competing in your industry, and will give you some idea

as to future trends and developments. Sources include:

Standard & Poor’s Industry Surveys, which are issued in three

volumes covering 52 general topics. Each topic includes

information on the current industry environment, trends and

profiles, how the industry works, composite data and analysis.

Moody’s Industry Review covers about 150 industry groups,

including over 4,000 companies ranked in each industry

according to 12 key financial, operating and investment

criteria.

Value Line Investment Survey identifies leading companies

within industries and provides analysis of their economic

outlook and performance.

Market Share Reporter describes market share data on companies

and their products and services taken from brokerage reports



and periodicals. The source notes are a particularly good

source of industry leads on trade association information.

D&B Business Rankings: Public and Private Businesses Ranked

Within Industry Category and State is an excellent resource

for comparing companies within industry segments.

Small Business Advancement National Center, which operates as

a partnership between the Small Business Administration and

the University of Central Arkansas, has a website with

terrific information profiling small business industry

segments. See www.sbaer.uca.edu/profiles/

The International Trade Administration maintains data on a

number of key industrial and service industry profiles. See

www.trade.gov

3) Current industry developments. Things to look out for in this

segment include industry problems and challenges, new

developments, mergers and acquisitions, bankruptcies, etc. Trade

journals or business periodicals are good sources. Sources

include:

Business Periodicals Index, which is a standard source for

locating trade journals and publications.

Industrylink.com is a handy online resource that serves as a

link directory to industry websites.

4) Industry statistics. This will give you industry ratios,

information published by trade associations, and government

statistics. Sources include:

Dun’s Census of American Business is an annual compilation of

the makeup of the American marketplace. It displays

statistics on national, state and county levels.

Standard & Poor’s Statistical Service is a loose-leaf

subscription service that would be available at larger

libraries. It provides current and historical statistics for

a number of key areas.

Statistical Abstract of the United States provides industry

trends dating back to 1878 in some industries.

Fedstats.gov provides online access to federal statistics

compiled from a number of federal agencies, without requiring

you to know which agency does the research.



With few hours spent researching these areas, soon you will begin to know that there were things you probably didn’t know that you didn’t know. That’s a good start.



STUPID THING NUMBER 7: IGNORE DETAILS If you remember a movie comedy in the early 1980s entitled “Night Shift,” starring Henry Winkler and Michael Keaton, you certainly remember Keaton’s character, “Billy Blaze.” Billy Blaze was a fast talking “idea man” who, in the movie, convinces Henry Winkler’s neurotic character, Chuck Lumley, to turn the night shift of the city morgue into a brothel. Bill is continually spouting ideas into a miniature tape recorder, hoping to catch that one big idea that will make his fortune: “Wanna know why I carry this tape recorder? To tape things. See, I’m an idea man, Chuck. I’ve got ideas coming at me all day… I couldn’t even fight ‘em off if I wanted. Wait a second… hold the phone! Hold the phone! OK, here’s an example. Watch out. Stand back. [Speaks into tape recorder] This is Bill. Idea to eliminate garbage: Edible paper. You see, you eat it, it’s gone. Eat it, it’s out of there!” Or, here is my favorite line from the movie: “What if you mix mayonnaise in the can WITH the tuna fish? Or…hold it! Chuck! I got it! Take LIVE tuna fish and FEED ‘em mayonnaise! Oh this is great! [Speaks into tape recorder] Call Starkist!” The really funny thing about the movie from my perspective is how Billy Blaze is such great caricature for so many other self-described “idea men” that have come into my office. Honestly, feeding mayonnaise to live tuna isn’t too far off the mark from some of the ideas I have heard over the years. Billy saw himself as a “big picture” kind of guy who took no time and had no interest in details – just like a lot of real entrepreneurs. Billy was always chasing the next big idea, because he never actually executed the last big idea. And the reason he never executed the last big idea is because there were just too many details. He didn’t want to drown in the details. Perhaps he felt that the details sapped his creative spirit and would take the fun out of business. Sound familiar? It is no coincidence that the one significant thing that Billy Blaze has with so many “idea men” is that they are all broke. That is because in business ignoring the details is a stupid thing. The details that you overlook can absolutely kill you.



ISSUE OWNERSHIP INTEREST

Entrepreneurs can be a funny lot. I am qualified to say that, because I am one. On the one hand, entrepreneurs are by definition people who organize a business venture and assume the risk for it. On the other hand, it is not at all uncommon for an entrepreneur to also attempt to manage that risk simply by relying on privacy. The thought is that by keeping information about what the individual owns private from the world, that somehow this privacy will protect him/her from losing those assets in a lawsuit. One method used – foolishly, in my reserved opinion – to accomplish this privacy is simply not to issue ownership interest in the business. That means that if the business is a corporation, no stock is issued; and if it is a limited liability company, no membership interest is issued. That way – the theory goes – if the individual is sued, they can’t lose what they don’t own, and nobody can prove that they own anything. There are a couple of serious problems with this approach. First, the IRS strongly disapproves. They generally adopt a philosophy that someone who is trying to hide like this must have something to hide. And, frequently they would be right. You see, there are a lot tax rules that the IRS has the responsibility to enforce – some “idea men” might consider these to be minor details, perhaps – but these rules are impacted by the ownership structure, ownership percentages and investment basis in a business entity. By not issuing ownership interest, the IRS is going to have an issue with the company. Second, a business entity such as a corporation or LLC is designed to create legal separation between the individual owner(s) and the business. However, in the event of litigation – when that legal separation is going to be desperately needed – a judge is likely to rule that a company with no owners isn’t really a company after all. If that happens, the legal separation disappears, the corporate veil is legally pierced, and the company becomes the “alter ego” of the person. And that is bad. Very bad. The entrepreneur who had the foresight to setup a business entity to provide some legal protection can unwittingly surrender that protection if, in the rush to the first million dollars of profits, he or she forgets to take care of a few minor formalities and details, such as issuing the ownership interest. I have seen this a hundred times:

1) Entrepreneur forms a corporation or LLC to start business;

2) Entrepreneur gets fancy company record book for his new

business entity, complete with special certificates and a shiny

name plate;

3) Entrepreneur immediately puts fancy record book on dusty shelf,

never to open it again;

4) Entrepreneur continues to conduct business under the company

name.

When it comes to details like these, the Rule of Thumb to consider is this: If you don’t treat your company like a separate person, don’t expect the



court to either. The application of the rule is this: A company without owners is not separate from the individuals. In a word, it is a sham.

PROPER MEETINGS AND PAPERWORK

The best way to develop a track record and paper trail to demonstrate that the company has been treated like a separate entity is to have the company hold all the required meetings and document the decisions and actions of the company in those meetings. It isn’t hard to do, but it does take a little time. When John, the president of John, Inc., negotiates the purchase of a $50,000 piece of equipment, how does he show that he is not acting in his own name, but in the name of the company? He should have company records, such as meeting minutes and resolutions to prove it. The documentation will show that the company discussed the transaction and authorized him to make the purchase. This shows that he was acting as an agent of the company and not in his own name during the transaction. Perhaps that sounds like splitting hairs, but that is precisely why these things are called details. Without taking care of these things, the obligations and liabilities associated with the equipment could become John’s personal problem if things ever came to legal blows. The entrepreneur who incorporates and permanently shelves the record book is not very likely to have ever held a company meeting or recorded a company resolution. What kind of paper trail does that leave? Perhaps now you can understand why the first thing that an opposing lawyer will demand in the discovery phase of litigation is a copy of the company record book. Instead of providing a wall of protection, the typical company record book of an entrepreneur is a gaping, empty hole that your legal combatants are only too happy to expose. It can provide a pathway to piercing the corporate veil and creating personal liability. The IRS has an interest in this also. In an audit, the deductibility of many expenses can either be validated or tossed aside, depending upon whether the company can demonstrate that the expenses were authorized and properly documented.

COMPANY OFFICERS AND DIRECTORS

Even though a corporation or limited liability company is a separate person that the law recognizes as having its own life, purpose, assets and liabilities, which are separate from any individual, it can’t do anything by itself. It needs other people to be its eyes, ears, mind, hands and feet to accomplish its business. This is the primary purpose of company officers and company directors. Without them, a company really isn’t a company at all.



Here’s the thing: Officers and directors need to act like officers and directors. They have certain basic responsibilities that they need to fulfill. The decision about who serves as the company president or company secretary is an important one and requires a little thought. This may seem difficult for any sane, reasonable person to believe, but I have seen people try to name complete strangers, children and even pets as corporate officers or directors. I don’t know what they were thinking. Maybe they were trying to be funny or think “outside the box.” However, by dealing with their company in such a cavalier manner, they not only destroyed the integrity of the corporate veil, but they also may have committed a criminal act – technically speaking, a Class D felony. When a company officer signs a contract for the company, or executes an agreement, purchase order or other company document, the officer needs to remember to write his or her title next to the signature. That simple detail changes everything. It turns a personal signature into a company signature. That title makes the difference in detailing who is actually responsible for fulfilling the agreement.

FORMALITIES CHECKLIST

DO'S

Hold regular, scheduled meetings. The date for your annual

shareholders' meeting should be in the bylaws. Bylaws typically

call for an annual board of directors meeting to be held

immediately after the annual shareholders' meeting.

Hold special meetings when necessary. This is important when

unusual, significant or isolated situations arise such as:

o Entering into a new lease;

o Entering into a substantial funding commitment;

o Opening a new bank account;

o Entering into any other significant contractual agreement;

o Changing an officer's salary;

o Filling a vacancy on the board or appointing a new officer;

o Entering into a significant new venture;

o Considering the sale, in whole or in part, of the assets or

the dissolution of the business.

Keep good records. Take minutes of meetings and maintain a

corporate record book.



Keep good financial records. Keep your business books separate

from your personal accounts.

Keep things close to the vest. Directors and officers owe a

fiduciary duty to the corporation, meaning that they must at all

times do what is in the best interest of the company and its

owners.

Keep corporate matters confidential to the extent possible.

Remember: Loose Lips Sink Ships. This is never truer than in

business.

Develop a planning routine.

o Review each year's activities during the final month of the

fiscal year.

o Budget ahead for the longest period reasonably possible and

review and analyze results at least semi-annually.

o Review operations with your attorney and CPA to ensure tax

planning and compliance are properly emphasized.

o Develop formal long-range planning capacities beyond the

budgeting process.

o Sign all contracts in the name of the corporation. Use

with a signature block in the following form:

[Name of Company]

By: ______________________ [Title of Individual]

Adopt corporate resolutions that authorize an officer to sign

contracts.

Make all corporate purchases in the name of the company.

Maintain corporate funds in a company account or accounts

separate and apart from any other account.

Carry reasonable insurance on the company, considering the risks

inherent in the company’s business.

Fund the company at the time of organization/incorporation with

enough money to keep it going during an initial phase of

operations.

Set up a review mechanism for decision-making, so that all

aspects of a proposed course of action will be considered.

Comply with Articles of Organization/Incorporation, the Bylaws,

and other organization documents or contractual restrictions.



Obtain a federal tax I.D. number, pay file all required tax

returns, and pay all required taxes.

DONT'S

Don't mix company and personal funds.

Don't do insider deals on loans, leases, etc., between the

corporation and a principal other than on an "arm's length" basis

(just as you would with someone not associated with the company).

Don't use company assets for personal use.



CONCLUSION The truth is, there are actually more than seven stupid things that entrepreneurs do to ruin a perfectly good business. A lot more. In fact, all the ways to ruin a perfectly good business probably haven’t been invented yet. (Who could have predicted Enron, for example?) But I wanted to keep this book short enough that someone might actually read it so it has a chance to do some good. So, as you leave the comforts of this book to take on the world, remember that it is a very dangerous world out there. You just can’t afford to do stupid things. You have to use your head. And if using your head is difficult, don’t be afraid to use somebody else’s head. There are some very good heads out there that won’t mind. Some of the most successful business people I know frankly aren’t that bright themselves. But, they surround themselves with people smarter than they are. It seems to work pretty well. Business is a blast. It is a thrill. It can be very rewarding. But it can also be very dangerous. Avoid the Seven Stupid Things, and your odds of success will improve considerably. So, I will end this Conclusion the same way I ended the Introduction: Good Luck

seven stupid things entrepreneurs do · stupid thing #1: plan to fail or was that fail to plan? i...

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