Dan

Welcome to Sound Business Insights. I’m Dan Watkins. This episode is about business formation. This podcast is not intended to provide big liquid,

Neil

Dan, as we open our conversation on business formation, forming a business is a lot more than just picking an entity, downloading some forms from some site, filling out the Secretary of State’s forms. And wham, you’re in business. Why is that?

Dan

Well, this is the most important topic and so for some reason some companies have said, oh, it’s a simple thing. You shouldn’t spend any money on it. But think about this, our country’s GDP is like 140 trillion.

Neil

Yes.

Dan

And all 140 trillion comes from some form of business one way or the other. It passes through. It is affected by, and it is our economy that we live in. So it’s not simple and it’s very important how you start and what you do when you start your company. That’s why there’s so many business CPAs, business accountants, business attorneys, business consultants, MBAs, graduating from all these business schools and experts and this giant stock market and commodities market that we have.

Neil

Let’s just start with an overview of what you consider to be part of the business formation process. We have the entity selection.

Dan

Well, before we even select an entity, everyone thinking about going into business or in business, you should do what most successful business people do, and that is get a relationship with your lawyer. So you’re doing everything the best way, not just legally, but from a an experienced perspective.

Neil

Mm-hmm. <affirmative>,

Dan

I’ve had 10,000 clients like you and the successful ones did it this way. From your banker, making sure your access to funds is correct and accounted for and, and a good accountant or CPA, not just a tax person, an accountant or CPA that gives you business advice on making a profit. Those are the things you think about. And then you come to your lawyer who talks about the best way for you to go based on your profession and universal things you should have and special things just for you based on your own personal life and your own investment.

Neil

And part of that’s the corporate documents.

Dan

Well, the company documents, if you choose a corporation, not all corporations are the same. If you choose a limited liability company, if you choose a partnership, a limited liability partnership, there’s all types of different variations. And then you can get into the nitty gritty based on your profession and all the regs and all the uh, professional license requirements and all of the, depending on the kind of company, their resale license and permits. There’s all kinds of little things that your old business lawyer knows about <laugh> and can tell you about from the get go. As opposed to you finding out after you’ve made a few mistakes,

Neil

Then this process is a lot more than just picking an entity.

Dan

Correct. You’re giving birth to a living creature that’s been recognized by the United States Supreme Court. And so what it means is birth is what we call capitalizing. And so you have these corporate documents and you have to decide on how much ownership will be and who owns what. Then you decide about what potential ownership there are. Reserve shares, I mean other ways in which people can own it. And then you capitalize it. Either you capitalize it with cash or you capitalize it with goodwill or a combination or a property. But how you capitalize it can determine whether or not it’s a real company or you have all those protections of corporate veil and creditors and you’re personally shielded. So how you start it is very important. And thinking about it, we’ll send you on the right path to avoiding all kinds of pitfalls and trouble.

Neil

And let’s talk about the corporate veil for a minute. Because the whole reason to have an entity is to separate you the person from the legal person of the business.

Dan

Yeah, that’s a big one. I mean, especially if you’re going to be doing some big business, you’re going to have big liability or you could personally not have big liability. And also you can have an entity that can be sold. You can have an entity that can be sold in whole or bring in investors. If you do everything right, you get to do all these things. If you get a big opportunity and you didn’t set your company up correctly, then you can’t have your friend with an extra million dollars. So invest, come on over. You’ve got to rewrite everything and You’ve got to restructure everything and You’ve got to hope you didn’t make any mistakes. And all of a sudden that opportunity doesn’t look so like a good deal. And that person who’s got the investment money will say, well, this person’s not professional. This person’s not really serious about doing business. And you’ll miss it all because you didn’t pay attention in the beginning when you formed a company.

Neil

And the same thing for when a big company comes, knocks on the door and says, Hey, we really like what you’re doing. We might want to buy you. And then they look behind the curtain and they go, yeah, but I don’t want any on any part of this.

Dan

Well, every company gets a corporate book or a operating file of documents and they’re usually formed and signed in the beginning. And if they’re formed well and professionally, then you have got a more valuable company than if you didn’t.

Neil

Absolutely. Let’s talk about a few of the entities and then we’ll get into the guts of the company itself and what’s important to pay attention to. So what are some of the basic entities that are available in California?

Dan

Well, there’s so many, but let’s go basic. You’ve got your sole proprietorship where you’re just buy a business, get a business license from the county or the city, and you go into business that’s 36 bucks. Yep. And you’re just, there’s no documents and there’s no separation between you and the business. It’s just you. It’s you incorporated and you’re liable for everything.

Neil

Yep.

Dan

Then you have your corporations. Now corporations are all formed as C Corporations, but you can elect to make it an S corporation, which means that you don’t have to pay double taxation on your money. You can pay yourself a shareholder distribution that is not subject to your payroll tax and all those other, you know, withholdings you have to do if you’re not a corporation. And you can pay yourself a small salary and you can save yourself money that way and still be benefited to the corporate veil protection.

Neil

And the C corporation allows you a little more flexibility on international business, interstate business,, who can invest, those kind of things.

Dan

A C Corp is where you’re probably going to want to sell shares in the company or you’re going to bring in another investor(s), or you’re going to do some more complex transaction. And it’s not going to be a situation where one person or two people are going to siphon money out of the company.

Neil

Right.

Dan

It’s going to stay in the company and we’re going to distribute dividends to shareholders. We’re building an organization, ultimately there might be multiple companies. And so you’re building a company for investors mostly.

Neil

And then California has this beautiful thing called a professional corporation. Who is that for?

Dan

For people who have licenses like me? Like doctors, like architects, like all types of, professional individuals where their license requires that they have a professional corporation.

Neil

What’s unique about a professional corporation?

Dan

Us professionals are subject to license and license revocation. Meaning that we don’t get as much protection from the general public as a regular S-Corp or regular C-Corp.

Neil

Right.

Dan

We have special rules that say, yeah, you’re protected for this, this, and this, but you’re still going to be liable Dr. So-and-so if you cut the wrong foot off.

Neil

But doesn’t the PC also protect if you have six shareholders of the professional corporation and one commits malpractice, the others have a level of protection?

Dan

Well, it sounds like, yeah, there’s no protection, but there is a lot of protection. Professionals have professional liability insurance.

Neil

Yes.

Dan

That’s what we have. But we don’t have insurance from when your three partners take everything and you’re left as the only guarantor on the lease.

Neil

Right.

Dan

And it’s $50,000 a month and you’re the guarantor on it, right?

Neil

Yeah.

Dan

If you don’t sign the guarantor and you’re just a member of the C corporation, then you’re not liable because of the corporate veil. But they are. I mean, so if you’re the guarantor, remember those other people can leave and you’re stuck with the lease and you can’t pierce the corporate veil on them.

Neil

Talk to your attorney <laugh>. Dan, what’s the difference in a professional corporation between the relationship of a shareholder?

Dan

So in a general, in a S-Corp or C Corp, one shareholder does something, it can affect all of the shareholders. How is that different in a PC? Shareholders don’t act, but officers and employees of a company do make actions on behalf of the company, which can make the company itself liable.

Neil

Yes. But the other shareholders are not liable.

Dan

They’re not liable at all because they have a corporate veil. They’re liable in it. The assets of the company, which they are shareholders of may be subject to Levy, but everyone else can’t be liable as a shareholder. You’re going to only be liable for your own actions and your investment in the company.

Neil

Then we kind of skipped over one of the more common forms of entity is the limited liability corporation. How is that different?

Dan

Limited liability companies came along in the nineties, mid nineties, I think 94, maybe 89. But anyways, we were one of the, the first states to have it. It’s like a corporation or it’s like a partnership and you get to elect which way you want to be. It’s very versatile and it comes with what we call an operating agreement. You don’t have to have it, but it’s a great document that acts sort of like a shareholder agreement.

Dan
So five buddies want to get together and buy a bar. They can have an agreement that they all sign that has a lot of, what if this happens, what if that happens and who gets what money? Because sometimes you have sweat equity, you got one guy working the bar all the time and the other guy’s just drinking. So you can have it written in into your operating agreement that the guy who works harder, even though we didn’t invest, we all invested the same, can get more money. More distributions with corporations. You can’t do that unless you have a separate shareholder agreement that lays that out and you’re in compliance with all the tighter regulations for corporate laws.

Neil

So the type of people who would select an LLC as an entity, are these usually smaller companies, fewer people? Or is there any recipe to that?

Dan

Mostly it’s going to be a closely held company. For the most part. Those are more popular with, because you get the S corporation, you get all the benefits of an S corporation and you get more flexibility and you can bring in partners and you can remove partners and things like that.

Neil

In the medical field, we were talking about professionals in the California Professional Corporation, but in the medical field there’s an entity that’s really interesting, the management service organization. Can you talk to me a little bit about that entity and how that’s come charging onto the field lately?

Dan

Well, it’s been charging on meaning it’s popular. It’s been around for a long time. And there’s been changes in the law on what you can and can’t do with them. But what it is, you are a doctor, you’re in a medical practice, you are great at what you do.

Dan
(That) doesn’t mean you’re going to be great at staffing, at equipment, at rent, at all those things. Running a business and at valuing that, you can establish one of those, an MSO and it can help with all those things. And you can bring in third parties who are professional at it and you can cut a deal with those third parties to save costs, make you more money, and come up with a different revenue stream. That would be different than if you just bunched it all together with your medical practice and try to manage the whole thing and account for it. So they do what you’re not good at, take it off your plate so you can focus on practicing medicine, for example. The patient’s satisfaction goes up, the quality of healthcare goes up, the profitability goes up. This sounds like a pretty great deal. And scalability.

Neil

So Dan, how are management service organizations scalable?

Dan

Well, that’s it. You’re a doctor, you do good work. You have an office that’s set up to do great work. You get the patients in and out, you’re efficient. And now you don’t have to waste a bunch of time on all of the other administrative things. You can have help with that and it doesn’t violate your license. And so you can potentially blueprint, print and reprint and open up another office, open up another location, take on more doctors, take on more equipment, and also have different levels of protection based on different entities. So scalability all, all of a sudden becomes a possibility.

Neil

Yes.

Dan

And by, by the way, the person or the entity, you’re going into business to help you with this also. They may have access to cash equity investment to help with all the administrative costs to make it more feasible for you to go open up more locations. So it’s a way to tap into available investment capital without violating California’s strict corporate practice of medicine. Correct.

Neil

So Dan, joint ventures are fascinating to me. This is a great opportunity for people to take and expand their business opportunities in a new vertical markets or new geographical markets, places they can’t go or tap other resources. How does a joint venture work and what’s the difference between that and just forming another entity?

Dan

Well, a joint venture is the wild west <laugh>. Joint venture covers everything. You form a corporation, you have to comply with the corporation’s code, you form a LLC, you’ve got to comply with the Limited Liability Act. You have a joint venture. It’s between you, your lawyer, and the other party and their lawyers to draft it up any way you want and be as creative as you want. And sometimes that’s the only way people want to get their feet wet on a real estate venture, a restaurant, all kinds of things. You can write it up as a simple joint venture with an eye toward profitability and risk, almost a way of trying it before you make it a more formal relationship.

Dan

Or sometimes you have such good friends or such good trust, all you need is a joint venture and all the other stuff would just get in the way.

Neil

Interesting.

Dan

You can have a joint venture with a handshake, you can have a joint venture written up with a joint venture agreement. You don’t have to go down the road of a 30 page agreement to do business. You can still do it the old fashioned way. You can still shake hands with somebody and look them in the eye and move forward with a nice joint venture.

Neil

Then once we’ve selected the entity, and that’s going to be based on the nature of what we’re doing and how many people and all of those things we just discussed. You’ve often told me the biggest mistake that people make, especially at the outset, is they don’t pay attention to the corporate documents.

Dan

They don’t pay attention to the LLCs operating agreement. They don’t pay attention to the shareholders’ agreement.

Neil

And they take some boilerplate default and then down the road they get into the sauce and they get into, they’re making some money and there’s real issues that would’ve been easy to address back at the beginning. So can you tell me about why it’s important for a business owner?

Let’s take the operating agreement. What does that do for an LLC and why should they pay attention to it at the outset?

Dan

Well, when we bring in an LLC, we’ll charge $1,500. You can get it done online for $500, maybe less. All you’re getting is access to someone’s form file. But what we do is we create that relationship with you and we go through and tell you why we’re doing this and how it could impact you and why we’re filling this form out and what your options are and all those things that don’t take very much time, but it puts your mind in the right frame to know why I have this company and what each document does and also what selections I’ve known people that have formed companies and forgotten to do the S form selection four months later with the I R S and then they go on and they’re paying more taxes and they don’t understand because they didn’t pay attention to their corporate formation in the beginning.

Dan

And the same is true for your tax ID number or your, if you’re a doctor, a tax ID number is, is your same number you use to go contract with providers insurance to get you paid and all these other little things. You’ve got a relationship with a lawyer who’s probably represented exact same companies like yours. And you can ask basic questions about vendors, about contracting, about how I sign my documents, how I sign my name, my articles, my bylaws, all those things that are in place real simply for us. We give you a menu, take this, I wouldn’t do that for your kind of company. We go through them all, tell you what they mean and then three years later you got somebody investing with you and they say, oh, I’m going to, I’m going to do that. And you go, no, no, no, I already have that written down and I already talked about it.

You’ll remember that they can’t do that to you because you spent a little time with your lawyer forming your company.

Neil

So let’s talk about the relationships between people. If you have a company, and let’s say there’s three or five people that are members in this LLC, life happens, unfortunately, people die, they become incapacitated, they get divorced, they file personal bankruptcy. So why is it important to address what happens in those events upfront in an operating agreement in this case?

Dan

Because it doesn’t cost that much money and we already have them on file. And not only do we automatically do it for you, we go through it and we go through it with the areas that are important for you to think about and to know and make choices on and an explanation. And so when this happens, which you never think it could happen, you’ll remember that, oh yeah, we do have a clause for what happens to Uncle Joe can’t participate anymore.

Dan

And it’s in there and it’s a long document, but it’s in there, it’s there for you. It’s a framework and it gives you guidance on what are the steps you should take? How are we going to value that person’s interest? How are we going to, who gets the first shot at buying them out? A lot of what ifs. And you can’t account for every possible what if on the planet, but there are 95%, 99% of the what ifs you may come across in your life that can be covered by your standard operating agreement.

Neil

And if I don’t cover them up front, and now I’m three years down the road and I’m making money and we’ve got five of us and we’re rocking at it and boom, something happens. What’s the cost? What’s the disruption from your experience, Dan, after 40 years? What happens when the wheels come off if you don’t address it up front?

Dan

You’re right. If there’s a lot of money, there’s a lot of fights. And what do they say in the military? … failure to plan is a plan to fail. This is automatic. We make you go through these things. We improve your knowledge of how this, and so when you’re having everyday discussions with people you do it with less stress and you’re prepared for a lot more than you would be had you just tried to form it yourself,

Neil

And when businesses are starting up, there’s an energy to that, right? There’s an excitement. We’re all pulling the same direction. Those conversations are a lot easier at that point than they are three or five years down the road, aren’t they?

Dan

Yes. It’s really, it makes you feel good when you know you planned for a lot of things. Now you can focus on making money and it makes your company worth more money and as you go down the road.

Neil

Yeah. So Dan, let’s talk about the corporate documents in a corporation. And the first one that comes to mind is the bylaws. Tell me a little bit about why you need an attorney when you’re looking at the bylaws.

Dan

Well, like I said, you go to the forms file fine, but your standard corporation has your articles. Very important because if they’re filed correctly and accepted by the Secretary of State, then that’s one check mark you have to make to get protection (of the corporate veil). Then you have your bylaws, which say what other officers and people in your company can and can’t do. And you’ve got your minutes, which say I’m spending my company money on company things and my company actions are formal and I’m acting like a corporation.

Dan

That’s your basic, that’s where you need advice. You do that right, you’re protected. Now what happens if you have more than one shareholder?

Neil

Yeah.

Dan

And you make money. Right?

Neil

Right.

Dan

You know where I’m going, right?

Neil

I do.

Dan

You’re going to fight. You’re going to fight because everybody’s got a great imagination. And they can imagine a scenario which they’re entitled to more money.

Neil

And you’ve always said you’ve known a lot of people who are just seemingly solid people. And then when there’s money on the table, people do crazy things.

Dan

That’s the problem with a corporation and an LLC. Corporations don’t automatically come with a shareholder’s agreement. And if you have partners, you should have a shareholder’s agreement so that if your partner’s wife gets sick and can’t work there’s something in there for that.

Neil

Or you make so much money and your partner is driving a brand new Mercedes and you are not.

Dan
There’s something in there for that. And you’re not just relying on the corporations code, which is a bunch of lawyers fighting over what it really means. You have it in black and white, it doesn’t cost that much money. And you have spent an hour of your day learning about all the what ifs that could happen in the future, just like the limited liability company. And you’re protected.

Neil

So which documents literally establish the protection of the corporate veil?

Dan

The corporate veil documents would be the articles, bylaws and minutes. And the fights between shareholders would be the shareholder agreement and the reason to have a business. One of the primary reasons to establish the corporate veil. If you don’t get the bylaws right, you could be threatening the protections of the corporate veil. Bylaws and, and minutes.

Neil

Yes. Dan, let’s talk a little bit more about shareholders agreements.

Dan

If we’re making money, the odds of a dispute down the road exponentially increase in your mind. And from our experience, I’m here doing a podcast with you because people don’t have shareholder agreements and they fight. And we have to represent them.

Neil

You’ve shared a story in the past and you mentioned, you know, my other shareholder’s driving a Mercedes, tell us about the company. That was a surgical instrument, I believe, and the company went, it failed. And they say, yeah, this isn’t working. Let’s close up. And then six months later, some of the shareholders find out there may have been something else going on.

Dan

Yeah, that’s right. There was no shareholder agreement. Bunch of friendly people put in $25,000 each and in the company allegedly failed. And then they noticed that three of the 10 shareholders were like driving brand new cars with new houses. And they were still doing the same old day-to-day nine to five jobs. And so one of them, my client looked into it and found their company’s products in another country, <laugh> with a, with a similar name and these guys owning it, they just took everything and took a big investor from overseas and made millions.

Neil

You’ve told us the story about the doctors that closed the office, took the website, closed the office moved two door, two blocks down the street.

Dan

That’s right. They took, they’re a bunch of surgeons too. There are 10 surgeons and five of them decided that they’re going to take over the company. They changed the mailing address, they moved the phone number. <laugh>, they changed the locks on the door over the weekend. They changed everything. Bank accounts, everything on late Friday.

When the rest of the doctors came to work on Monday, it was locked, then something happens. And they were out of work at a job, and that’s what happens when the wheels come off if you don’t address it up front. That’s how they decide to fight. Never know what’s going to happen down the road.

Neil

From your mind as a business attorney with decades of experience, Dan, it’s worth it to take a few moments at the start and set the table.

Dan

That’s right. Shareholder agreement.

Neil

When we do a shareholder’s agreement, we don’t have to start from scratch.

Dan

Right. We have banks of these agreements and they’re updated through our professional libraries. And so, and we are also knowledgeable about how litigation happens and what the pitfalls are. And so our agreements are an attempt to provide you with the what ifs in there and be prepared for that.

And also remedies too. You know what to do and who pays what if they do this?

Neil

And so to sum all this up, when you’re forming a company, this isn’t just about creating a name and creating some entity and getting into business. If you’re serious, if you intend to make money, if there’s more than one of you, you really need to spend some time with the Dan Watkins and find out what, how to set the table so that as things go, you can escape all of this madness and, and achieve more success and avoid the battles down the road.

Dan

People don’t fight if there’s an agreement in place. It’s really true. The vast majority of cases we have where they fight and there’s always money, is when there was no agreement defining what happens with this and that because they’re not evil. They just, they just convince themselves they’re being ripped off or they convince themselves they have more rights because there’s no shareholder agreement. They can read.

Neil

I’m working a lot harder than Bob is.

Dan

Right. There’s no agreement in writing. It says definitively, if this happens, then these are the rules. If there’s no rules, then people get in their own heads and can decide that’s not right. I disagree. And they then they fight. And they don’t just fight in court. They take actions, they do things, they self-help. Most of the time when there’s a shareholder agreement, everyone just calms down and they go about things in an orderly fashion. If they want to move on, then they utilize the agreement and then they move on. But it’s not this chaos that funds all these law firms. Sad.

Neil

So on the other side equation, sad. If you’re an investor, if you’re going to become a shareholder and there’s a new company being formed and somebody else is doing the business formation, don’t you think you need to take those papers to another attorney and have them look over and make sure your interests are covered?

Dan

Yes. Yes. You know, there’s something called the business judgment rule. You’ve got no shareholder agreement and you got somebody who’s the president, owns the most chairs and he decides it’s really important for, for him to dress in really nice suits and take big vacations because it’s going to help promote the company. And you can’t do anything about it. It’s really hard. Had you had a shareholder agreement, then he wouldn’t do that.

You can put limits on, spending limits on everything. I mean, it’s a pretty long agreement, standard for me, but includes a lot of things for you so you can set expectations and keep the parties from fighting if you’re serious about business.

Neil

That’s right. Thank you Dan.

Dan

Thank you. You can learn more about the Watkins firm at http://watkinsfirm.com or call our office at (858) 535-1511.