BUSINESS FORMATION 2
Starting a business with friends or family presents those close with an exciting and
challenging opportunity to venture into together. The scenario presented in this business
formation analysis highlights how quickly things can go wrong without proper planning and
agreements in place. To prevent such issues, it is essential to take several key steps before
starting a business, choose the right business structure, properly value contributions, and
establish clear agreements. Here is some advice based on the details provided.
Steps to Take Before Money Changes Hands
Before fiscal transactions are to occur, Adam, Betty, Camala, and Duane would be
greatly served with the Book of Proverbs. As Proverbs guides us in many areas of preparation
and when it boils down to starting a business, preparation is a vital step before proceeding in
investing. As a consultant for these friends, it would be beneficial in discussing Proverbs 24:27,
“Put your outdoor work in order and get your fields ready; after that, build your house” (NIV).
This verse guides all on the planning phase of beginning a new venture.
Prior to the proceeding in the funding of a new business, the friends would benefit from
having a discussion with a focus on aligning each of the investing party’s goals. With this being
the first step, the friends can have a foundation of understanding among all potential partners
about their goals, expectations, and visions for the business. In successfully having said
discussions, each of the potential business members should be on the same page regarding
multiple organizational aspects of the business and its organizational direction, including, but not
limited to the business's mission, objectives, long-term plans, and roles and responsibilities. By
thoroughly defining each friend’s role and responsibilities in the business, they can lower the
chances of future misunderstandings and conflicts later on. In this particular situation, it would
BUSINESS FORMATION 3
have been clear from the beginning that Adam and Betty would be more involved in the day-to-
day operations than Camala and Duane.
The planning stage of the business venture can be further enhanced by discussion and
alignment on how financial contributions and non-cash contributions (e.g. time and labor) will be
valued. This can prevent disputes over ownership shares and profit distribution. Each friend
contributed $2,000, but the time and effort they could contribute varied significantly. Prior to the
forming of their business, the friends would be best served in engaging a Law firm that that can
fully engage them on their legal formation option and make a potential recommendation to a
Certified Public Accounting firm to discuss the fiscal pros and cons of the various legal
formations, or vice versa. In returning back to Proverbs, the wise can appreciate the message in
Proverbs 15:22, “Plans fail for lack of counsel, but with many advisers they succeed” (NIV).
These lawyers and CPAs, as advisors, can provide valuable advice on the best business structure,
tax implications, and drafting necessary agreements.
Choosing the Right Business Structure
Choosing an LLC as the legal form of the business is not a bad option for the friends, but
prior to a commitment to this legal form, there should have been a discussion on whether
choosing a limited partnership could be the more viable option for the business. Since the early
1990s, there has been a substantial rise in the number of limited liability companies (LLCs) and
limited partnerships (LPs) in the United States. These flexible legal-organizational forms
combine the benefits of traditional corporations but with less public accountability and lower
taxation rates (Soener & Nau, 2019). While an LLC (Limited Liability Company) offers
flexibility and protection against personal liability, it may not always be the best option.
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An LLC can provide liability protection and flexible management structures, making it a
good choice for many businesses. However, forming a partnership, such as a General Partnership
(GP) or Limited Partnership (LP), could be more appropriate for friends or family businesses
where roles and contributions are well defined from the start. Given the dynamics of the
involvement of the friends in the business, the choice of a LLC might be appropriate as long as
this choice is inclusive of a comprehensive operating agreement to outline the roles,
responsibilities, and profit-sharing arrangements. The hindsight bias available presents the
preference of the LLC. While a LP would have allowed Camala and Duane to be classified as
Limited Partners, while selecting an LLC would present the two with managerial responsibilities
when feasible or open the discussion on transference of ownership interest.
Valuing Non-Cash Contributions
In reviewing the issues that have risen in this business amongst friends, the valuation of
non-cash contributions, such as time and labor, appears to be a more material aspect for the
group and how the shares of profit need to be distributed were not properly address before
disagreement occurred. The friends may solve any distribution of ownership interest or profits
based on a formula inclusive of the time and labor invested alongside the financial invested. The
first option in presenting a formula is a time-based valuation that allocates a fiscal amount (e.g.,
fair market value) to time invested, thus recognizing the time each friend contributes to the
success/failure of the organization. For example, as Adam and Betty elected to work full-time,
their contribution should be valued accordingly, and this should be reflected in his ownership
share. Owner-managers have considerable discretion over their compensation, and can choose to
pay themselves with either salary or dividends, thus giving rise to a compensation-shifting
opportunity (Christoffersen et al. 2023).
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Necessity of an Operating or Partnership Agreement
An operating or partnership agreement is crucial, even if not legally required of the
business, it will provide guidance on how to solve business agreements and disagreements,
including the status of the business members. A member of an LLC has the right to request that a
judge or court dissolve the LLC if it is not reasonably practical to carry on the LLC; the LLC is
not following its operating agreement; a member or manager is acting in a manner that is illegal,
oppressive or fraudulent; or the LLC’s assets are being misapplied or wasted (Overland Park,
2019) Operating Agreement officially documents the internal organization of the company-trie
roles and duties of its members and managers. Although not all states require LLCs to have an
Operating Agreement, it's recommended to have one because it outlines the LLC's financial and
practical decisions (Akalp, 2021). For this group of friends, the operating agreement should
include each of the following:
Criteria over ownership percentages and initial capital contributions of each member,
Clear definitions of the role, responsibilities, and expected time commitment of each
investing member
Profit/Loss Distribution framework inclusive and considerate of both financial
contributions, time and labor investment.
Decision-Making Process: Establish the process for making major decisions, including
voting rights and quorum requirements.
Transferability of ownership interest/Buyout Provisions inclusive of scenarios that may
arise (e.g., buyout of members who wish to leave, become inactive, or fail to fulfill
commitments).
Requirement to seek mediation or arbitration in dispute resolution matters.
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Access and termination of access to information (e.g., access to financial records,
business documents, and bank accounts).
Conclusion
Starting a business, in general, can be a daunting task for anyone, and deciding to do so
with friends or family can ease the progression. As we know from Ecclesiastes 4:9, “Two are
better than one, because they have a good return for their labor:” (NIV). However, success
requires thorough planning with clear agreements in place to prevent conflicts and ensure the
success of the venture. In one last return to Proverbs, the friends can learn from the message that
“The simple believe anything, but the prudent give thought to their steps” (Proverbs 14:15, NIV).
Before any money changes hands, it is essential to align goals, define roles, and consult legal and
financial experts. Choosing the right business structure and valuing non-cash contributions fairly
are critical steps. Lastly, and most importantly, drafting a comprehensive operating or
partnership agreement will provide a sound foundation for the business and help resolve future
disputes.
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References
Akalp, N. (2021/07//). Everything You Need to Know About LLCs to Help Your Clients.CPA
Practice Advisor,31(6), 22-23. https://go.openathens.net/redirector/liberty.edu?
url=https://www.proquest.com/trade-journals/everything-you-need-know-about-llcs-help-
your/docview/2549730920/se-2
Christoffersen, J., Plenborg, T., & Seitz, M. (2023). Compensation Shifting from Salary to
Dividends.NEuropean Accounting Review, 1–30.
https://doi.org/10.1080/09638180.2023.2226724
Overland Park. (2019).NGetting out of an LLC or farm partnership. Corn and Soybean
Digest,https://go.openathens.net/redirector/liberty.edu?url=https://www.proquest.com/
trade-journals/getting-out-llc-farm-partnership/docview/2277886718/se-2
Soener, M., & Nau, M. (2019). Citadels of privilege: the rise of LLCs, LPs and the perpetuation
of elite power in America.NEconomy and Society,N48(3), 399–425.
https://doi.org/10.1080/03085147.2019.1626629
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