We met recently with a potential client who is starting up a new business with several partners. They are excited about the business and eager to get started. So eager that they have begun operating without really getting the business foundation established.
Just as a building needs a strong foundation, a business does also. A business foundation consists of three cornerstones: The business plan, the operating agreement and the working capital. The business plan will detail what the mission of the business is, what the structure will be (legal entity), who the management will be and how the business will market itself. The operating agreement will detail how much each owner put into the business, how much of the business each person owns, how decisions will be made, how each owner will be compensated, how profits or losses will be allocated. The final cornerstone is the working capital which means how much money is needed to get the business up and running until it is operating at a profit and where is the money coming from?
The partners in this potential business don't have the legal entity established. They need to decide if they should they be a multi-member LLC operating as a partnership for the IRS or a multi-member LLC operating as an S Corp for the IRS or an actual S Corp or a C Corp? The correct entity will be clear once they decide exactly how the business is going to handle expenses and how to best compensate the partners/owners.
They also haven't put together a business plan which will lay out how they will manage the business and how they will be compensated. How they will make decisions, who is responsible for what? What happens when there is a disagreement? What happens if they need to put more money into the venture? How does one member leave the business if they decide to? Lots of decisions to be made and it is really important to do this upfront. A good operating agreement will detail exactly how all these things will be handled so that when the situation arises, the procedure is already established.
Finally, they have not determined what the start up budget is and how it will be funded. Many a great idea has failed to succeed because there wasn't enough money to keep the business running until it was profitable. Part of a typical business plan is the pro-forma financial statements which forecast what the profit and loss, balance sheet and cash flow will look like for the business for the first three years of operation. The creation of these statements determines how much money the business will need to start up and continue operating until it can support itself with its own revenue and cash flow.
We have seen businesses start without an operating agreement and it never ends well. Problems will arise and if you haven't established how the problems will be dealt with, the partnership is apt to fail. We have also seen businesses fail because they hadn't put together a business plan which showed how the business needed to start and how it needed to be run. Seeing a great product or service fail because the business ran out of working capital before it could support itself is very sad.
It is understandable that people get excited about starting a business and putting together the business plan and operating agreement are not glamorous or fun. They are critical to the success of the business and the partnership so don't rush your start up and do the ground work first.