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References
Hisrich, R.D., Peters, M.P., & Shepherd, D.A. (2013). Entrepreneurship (Laureate Custom
Education). New York: McGraw-Hill Irwin.
Custom Create Edition LAUREATE EDUCATION INC'
264 I ,.,., .. h,, ~------------·-·--- ------ ----------·- -------------···----·--
THE ORGANIZATIONAL PLAN
1 To understand the importance of the management team in launching a new venture.
2 To understand the advantages and disadvantages of the alternative legal forms for
organizing a new venture.
3 To explain and compare the S corporation and limited liability company as alternative
forms of incorporation.
4 To learn the importance of both the formal and the informal organization.
5 To illustrate how the board of directors or board of advisors can be used to support the
management of a new venture.
I Entrepreneurship, Eighth Edition I 265
---------~-- ------T ---
OPENING PROFILE
JIM SINEGAL
Building a strong and lasting organization requires careful planning and strategy. No
one knows this better than Jim Sinegal, the founder and CEO of Costco Wholesale
Corporation, a successful warehouse chain store. Jim's philosophy is that a successful
organization depends heavily on its employees and that happy employees are loyal
•
and stable and can help generate successful sales and rev-
enue growth .
Jim Sinegal has had a long history with the warehouse
concept. It began appropriately when he was a student at
San Diego State University. In 1954, a classmate and good friend asked him if he would
be willing to help unload mattresses for the day at a newly opened discount store
called Fed-Mart. Jim didn't realize at that time how significant this would be as an
introduction to the more modern warehouse concept. He not only went to work for
Fed-Mart but he made it a career, rising eventually to executive vice president. More
importantly, as part of this career at Fed-Mart, Jim was able to learn a great deal about
this business from Fed-Mart's chairman, Sol Price, who is credited with being the inven-
tor of the concept of high-volume warehouse stores.
After many successful years working at Fed-Mart, Jim left the company in 1975 when
Sol Price was fired, having sold Fed-Mart to a German retailer. Both he and Sol then
teamed up to start a new warehouse company, Price Club. The success of Price Club
attracted competition from Wal-Mart, which launched Sam's Club, and Zayre's, which
started BJ's Wholesale Club. Noting the potential for these warehouse stores, Jim left
Price Club and, with the help of a Seattle entrepreneur, launched Costco. Sol Price and
Jim Sinegal became partners again in 1993 when Costco and Price Club merged to form
the largest membership cha in in the United States.
In 1995, Sol Price and Jim Sinegal again parted ways, mainly because they could
not agree on a strategy for building the business. Sol maintained some of the real
estate and concentrated his efforts on licensing PriceSmart warehouse stores in for-
eign markets. Jim retained control of all the warehouse stores in the United States
and has since built the business to be the number one warehouse club operator in
the country.
255
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256 PART 3 FROM THE OPPORTUNITY TO THE BUSINESS PLAN
Jim Sinegal would emphatically summarize the successful strategy of Costco in two
simple statements. First, build a strong organization with loyal, hardworking employees
by paying them above-average salaries (the average salary is $17/hour), providing
excellent benefits (90 percent of health insurance costs for both full-timers and part-
timers are paid by the company), and giving them the feeling that you care about
their welfare. Second, maintain the business model of a warehouse store by limiting
the product offerings, allowing fledgling companies to supply inventory, and main-
taining low prices.
In addition to the high wages and health insurance coverage, the company also
contributes between 3 and 9 percent of each employee's pay to a 401 (k). With this
policy Jim brags about the astoundingly low first-year employee turnover rate of
5.5 percent.
Wall Street, however, has been very critical of Costco's industry-high labor cost of
70 percent of total cost of operations. Analysts argue that Costco treats its employees
and cardholders better than its stockholders. Sinegal's response is clear and undaunted.
He argues that one of the most important aspects of a successful organization is its
people. It's important to hire the best people you can and then keep them long term so
they in turn will have some job security. He states, "It's not altruism. In the final analy-
sis, it's good business."
Even with its high labor costs and low revenue-to-sales ratio (in 2008 this figure
was 1.8 cents for every sales dollar, compared to almost twice that amount for Wai-
Mart), Costco established itself as the number-one-ranked warehouse club in the
United States. From 2006 to 2008 Costco's sales revenue increased from $60.2 billion
to $72.5 billion. In 2008 Costco's profits rose about 15 percent to $1.28 billion.
Although economic conditions have been poor, Costco did manage to achieve a
sales increase of 4 percent in the first quarter of fiscal 2009 compared to the same
period in 2008. Beginning with the single store in 1983, Costco now has more than
530 stores mostly in the United States, but with some in Canada, the U.K., South
Korea, Taiwan, Mexico, and Japan. The company has plans to open its first store in
Australia in 2009.
It's impossible to argue with the huge success that Jim Sinegal has achieved. His
combination of a quality, loyal labor force and his relentless attention to maintain-
ing the warehouse store concept by offering a bare-bones, cement-floor retail space,
charging a membership fee for the right to shop, and maintaining a limited product
offering at low prices with high inventory turnover has proven to be a successful
business model.
Jim Sinegal takes only a modest salary, spends a lot of time traveling to many stores,
and works with a lot of fledgling supplier enterprises, giving them an opportunity that
would not be likely with other giant retailers. He also continues to maintain his policy
of marking up retail prices no more than 14 percent. The success of the firm has recently
continued, albeit at a slower pace, because of the economic conditions affecting retail
sales. However, Sinegal expects that the bargain pricing position of Costco will be an
advantage in a weakened economy. 1
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AS SEEN IN ENTREPRENEUR MAGAZINE
PROVIDE ADVICE TO AN ENTREPRENEUR ABOUT SOME LEGAL ASPECTS OF STARTING A BUSINESS
You just started your business-who has time to t hink about an exit strategy? If you're putting off making such plans, you've committed a very com- mon legal mistake, says Alan S. Kopit, partner at Hahn Loeser & Parks LLP in Cleveland and advisor t o Lawyers.com. "Now is the time to decide those issues-not after a problem develops," he says. Here, Kopit runs down a few more common legal bl unders to avoid:
•. Failing to get good advice. Don't ever go it alone. Instead, Kopit suggests entrepreneurs enlist the services and counsel of a good lawyer, an accountant, and an insurance agent at the very beginning of their start-up ventures. "Younger [entrepreneurs] particularly need people to bounce their ideas off of," he says.
2 Neglecting important employment considerations. Hiring issues are a major legal consideration for start-ups. Consider whether you need a written non-compete contract with employees, whether you'll use independent contractors, and so on.
Selecting the wrong business structure. Should you classify your business as a sole proprietorship, an LLC, an LLP, or a corporation? "There are tax
implications that go along with [each choice]," cautions Kopit. Be sure to weigh each option with the help of your advisors to determine which form will best serve your business plan.
ADVICE TO AN ENTREPRENEUR An entrepreneur who is looking to create a new busi- ness has read the above article and comes to you for advice:
1. It is not surprising that a lawyer should say that an entrepreneur needs a lawyer to start a business. I certainly do not have money to burn on unnecessary legal fees. Which things do I need a lawyer for now, which things need a lawyer but can be delayed, and finally which things can I do myself?
2. Other than the costs, are there any disadvantages to "bouncing ideas" off a lawyer?
3. I certainly don't want to pay more taxes than I must. What are the tax implications of the differ- ent legal structures for the business?
Source: Reprinted with permission of Entrepreneur Media, Inc., "Laying Down the Law. Don' t Be Legally Blind-Watch for These Common Start-Up Blunders," by Nichole L. Torres, March 2003, Entrepreneur magazine: www.entrepreneur.com.
DEVELOPING THE MANAGEMENT TEAM We can see from the Costco example the importance of employees and their loyalty and commitment to the organization. Also significant to potential investors is the management team and its ability and commitment to the new venture.
Investors will usually demand that the management team not attempt to operate the busi- ness as a sideline or part-time venture while employed full time elsewhere. It is assumed that the management team is prepared to operate the business full time and at a modest salary. It is unacceptable for the entrepreneurs to try to draw a large salary out of the new venture, and investors may perceive any attempt to do so as a lack of psychological commitment to the business. Later in this chapter, the roles of various team members are discussed, particularly as the firm evolves into a legitimate ongoing concern. In addition, the entrepreneur should consider the role of the board of directors and/or a board of advisors in supporting the management of the new venture. At this point, however, the entrepreneur needs to consider the alternatives regarding the legal form of the organization. Each of these forms has important implications for taxes, liability, continuity, and financing the new venture.
257
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258 PART 3 FROM THE OPPORTUNITY TO THE BUSINESS PLAN
C corporation Most
common form of
corporation, regulated by
statute and treated as a
separate legal entity for
liability and tax purposes
proprietorship Form of
business with single
owner who has unlimited
liability, controls all decisions, and receives all
profits
partnership Two or
more individuals having
unlimited liability who
have pooled resources to
own a business
corporation Separate
legal entity that is run by
stockholders having
limited liability
LEGAL FORMS OF BUSINESS There are three basic legal forms of business formation with some variations available depending on the entrepreneurs' needs. The three basic legal forms are (1) proprietorship, (2) partnership, and (3) corporation, with variations particularly in partnerships and corpo- rations. The newest form of business formation is the limited liability company (LLC), which is now possible in all 50 states and the District of Columbia. The typical corporation form is known as a C corporation. Table 9.1 describes the legal factors involved in each of these forms with the differences in the limited liability partnership (LLP) and S corporation noted where appropriate. These three basic legal forms are compared with regard to own- ership, liability, start-up costs, continuity, transferability of interest, capital requirements, management control, distribution of profits, and attractiveness for raising capital. Later in the chapter, the S corporation and the LLC are compared and discussed as alternative forms of business, especially for the new venture.
It is very important that the entrepreneur carefully evaluate the pros and cons of the var- ious legal forms of organizing the new venture. This decision must be made before the submission of a business plan and request for venture capital.
The evaluation process requires the entrepreneur to determine the priority of each of the factors mentioned in Table 9.1, as well as tax factors discussed later in this chapter. These factors will vary in importance, depending on the type of new business.
The variations of organizational structure as well as the advantages and disadvantages are numerous and can be quite confusing to the entrepreneur. In the next section of this chapter, some of these differences are clarified to assist the entrepreneur in making the best decision regarding organizational structure.
Ownership
In the proprietorship, the owner is the individual who starts the business. He or she has full responsibility for the operations. In a partnership, there may be some general partnership owners and some limited partnership owners. There are also limited liability partnerships (LLPs) in which the partnership is treated as a legal entity. In the corporation, ownership is reflected by ownership of shares of stock. Unlike the S corporation, where the maximum number of shareholders is 100, there is no limit as to the number of shareholders who may own stock in a corporation.
Liability of Owners
Liability is one of the most critical reasons for establishing a corporation rather than any other form of business. The proprietor and general partners are liable for all aspects of the business. Since the corporation is an entity or legal "person," which is taxable and ab- sorbs liability, the owners are liable only for the amount of their investment unless there is negligence or fraud involved. In the case of a proprietorship or regular partnership, no dis- tinction is made between the business entity and the owner(s). Then, to satisfy any out- standing debts of the business, creditors may seize any assets the owners have outside the business.
In a partnership, the general partners usually share the amount of personal liability equally, regardless of their capital contributions, unless there is a specific agreement to the contrary. The only protection for the partners is insurance against liability suits and each partner putting his or her assets in someone else's name. The government may disallow the latter action if it feels this was done to defraud creditors.
Entrepreneurship, Eighth Edition 269
CHAPTER 9 THE ORGANIZATIONAL PLAN 259
TABLE 9.1 Factors in Three Forms of Business Formation
Factors
Ownership
Liability of owners
Costs of starting business
Continuity of business
Transferability of interest
Capital requirements
Management control
Distribution of profits and losses
Attractiveness for raising capital
Proprietorship
Individual.
Individual liable for business liabilities.
None, other than filing fees for trade name.
Death dissolves the business.
Complete freedom to sell or transfer any part of business.
Capital raised only by loan or increased contribution by proprietor.
Propr ietor makes all decisions and can act immediately.
Proprietor responsible and receives all profits and losses.
Depends on capability of proprietor and success of business.
Partnership
No limitation on number of partners.
In general partnership, all individuals liable for business liabilities. Limited partners are liable for amount of capital contribution. In limited liability partnership (LLP), there is no liability except when negligence exists.
Partnership agreement, legal costs, and minor filing fees for trade name.
Death or withdrawal of one partner terminates partnership unless partnership agreement stipulates otherwise. Death or withdrawal of one of limited partners has no effect on continuity.
General partner can transfer his/her interest only with consent of all other general partners. Limited partner can sell interest without consent of general partners. No transfer of interest in an LLP.
Loans or new contributions by partners require a change in partnership agreement. In LLP partnership, entity raises money.
All general partners have equal control, and majority rules. Limited partners have limited control. Can vary in an LLP.
Depends on partnership agreement and investment by partners.
Depends on capability of partners and success of business.
Corporation
No limitation on number of stockholders.
Amount of capital contribution is limit of shareholder liability.
Created only by statute. Articles of incorporation, filing fees, taxes, and fees for states in which corporation registers to do business.
Greatest form of continuity. Death or withdrawal of owner(s) will not affect legal existence of business.
Most flexible. Stockholders can sell or buy stock at will. Some stock transfers may be restricted by agreement. In S corporation, stock may be transferred only to an individual.
New capital raised by sale of stock or bonds or by borrowing (debt) in name of corporation. In S corporation, only one class of stock and limited to 100 shareholders.
Majority stockholder(s) have most control from legal point of view. Day-to-day control in hands of management, who may or may not be major stockholders.
Shareholders can share in profits by receipt of dividends.
With limited liability for owners, more attractive as an investment opportunity.
In a general partnership there also may be limited partners. These limited partners are liable for only what they contribute to the partnership. This amount, by law, must be regis- tered at a local courthouse, thus making this information public. The LLP has become very popular among larger law firms and accounting CPA firms. It is actually a form of limited
210 I '"'~'~"'"""'' "~ -~ --+-- --------~------~---- - ··-------· ··-- ··-·-······ ---··- ·--·-- ····--·---- ---- ----- --- ----·----· --······- ··----·- -- -- --------- -----·- --
260 PART 3 FROM THE OPPORTUNITY TO THE BUSINESS PLAN
liability company (LLC), where the firm elects this status when filing its entity classifica- tion with the IRS on Form 8832. Thus the advantages of the LLP are the same as the LLC, allowing the partners to protect their personal assets from liability risk. The LLP will be distinguished from the general partnership as appropriate in our comparison of the various forms of organization that follows. 2
Costs of Starting a Business The more complex the organization, the more expensive it is to start. The least expensive is the proprietorship, where the only costs incurred may be for filing for a business or trade name. In a partnership, in addition to filing a trade name, a partnership agreement is needed. This agreement requires legal advice and should explicitly convey all the respon- sibilities, rights, and duties of the parties involved. A limited partnership may be somewhat more complex than a general partnership because it must comply strictly with statutory requirements.
The corporation can be created only by statute. This generally means that before the corporation may be legally formed, the owners are required to (1) register the name and articles of incorporation and (2) meet the state statutory requirements (some states are more lenient than others). In complying with these requirements, the corporation will likely incur filing fees, an organization tax, and fees for doing business in each state. Legal advice is necessary to meet all the statutory requirements .
Continuity of Business
One of the main concerns of a new venture is what happens if one of the entrepreneurs (or the only entrepreneur) dies or withdraws from the business. Continuity differs significantly for each of the forms of business. In a sole proprietorship, the death of the owner results in the termination of the business. Sole proprietorships are thus not perpetual, and there is no time limit on how long they may exist.
The partnership varies, depending on whether it is a general partnership or a limited liability partnership (LLP) . In a general partnership, the death or withdrawal of one of the partners results in termination of the partnership unless the partnership agreement stipulates otherwise. Thus, the partnership agreement may contain stipulations that allow for a buy- out of the deceased or withdrawn partner's share, based on some mechanism or predeter- mined value. It also may be possible to have a member of the deceased partner's family take over as a partner and share in the profits accordingly. Life insurance owned by the partnership can be valuable protection for the partnership, often providing the funds neces- sary to buy out the deceased partner's share.
If there are limited liability partners in a general partnership, their death or withdrawal has no effect on the continuity of the business. A limited partner also may be replaced depending on the partnership agreement.
In a limited liability partnership (LLP), the death or withdrawal of a partner has no effect on the partnership. The deceased or withdrawn partner may be replaced much like any employee of a corporation.
The corporation has the most continuity of all the forms of business. Death or with- drawal has no impact on the continuation of the business. Only in a closely held corpo- ration, where a few people hold all the shares, may there be some problems trying to find a market for the shares. Usually, the corporate charter requires that the corporation or the remaining shareholders purchase the shares. In a public corporation this, of course, would not be an issue.
271
CHAPTER 9 THE ORGANIZATIONAL PLAN 261
Transferability of Interest There can be mixed feelings as to whether the transfer of interest in a business is desirable. In some cases the entrepreneur(s) may prefer to evaluate and assess any new owners before giving them a share of the business. On the other hand, it is also desirable to be able to sell one's interest whenever one wishes. This may be of particular significance when there is the need to consider a succession plan or strategy. This is discussed in more detail in Chapter 15 . Each form of business offers different advantages as to the transferability of interest.
In the sole proprietorship, the entrepreneur has the right to sell or transfer any assets in the business. Limited partners, if existing in a general partnership organization, have more flexibility and may typically sell their interest at any time without consent of the general partners. The new limited partner's rights will remain the same as those of the prior part- ner. However, this may vary depending on the partnership agreement. General partners usu- ally cannot sell their interest without first refusal from the remaining general partners, even if the partnership agreement allows for the transfer of interest.
In an LLP, the transfer of interest of one limited partner is typically not allowable. As stated previously, the LLP has become popular among law and CPA firms. Limited partners also may vary in distinction (e.g., there may be associate partners or junior partners), in which case they also may not share the same profit percentages as full partners. Full part- ners in law or CPA firms may elect to sell the business, but such a decision usually requires the approval of all or a majority.
The corporation has the most freedom in terms of selling one's interest in the business. Shareholders may transfer their shares at any time without consent from the other share- holders. The disadvantage of the right is that it can affect the ownership control of a corpo- ration through election of a board of directors. Shareholders' agreements may provide some limitations on the ease of transferring interest, usually by giving the existing shareholders or corporation the option of purchasing the stock at a specific price or at the agreed-on price. Thus, they sometimes can have the right of first refusal. In the S corporation, the transfer of interest can occur only as long as the buyer is an individual.
Capital Requirements The need for capital during the early months of the new venture can become one of the most critical factors in keeping a new venture alive. The opportunities and ability of the new venture to raise capital will vary, depending on the form of business.
For a proprietorship, any new capital can come only from loans by any number of sources or by additional personal contributions by the entrepreneur. In borrowing money from a bank, the entrepreneur in this form of business may need collateral to support the loan. Often, an entrepreneur will take a second mortgage on his or her home as a source of capital. Any borrowing from an outside investor may require giving up some of the equity in the proprietorship. Whatever the source, the responsibility for pay- ment is in the hands of the entrepreneur, and failure to make payments can result in foreclosure and liquidation of the business. However, even with these risks the propri- etorship is not likely to need large sums of money, as might be the case for a partnership or corporation.
In the partnership, loans may be obtained from banks but will likely require a change in the partnership agreement. Additional funds contributed by each of the partners will also require a new partnership agreement. As in the proprietorship, the entrepreneurs are liable for payment of any new bank loans.
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262 PART 3 FROM THE OPPORTUNITY TO THE BUSINESS PLAN
In the corporation, new capital can be raised in a number of ways. The alternatives are greater than in any of the other legal forms of business. Stock may be sold as either voting or nonvoting. Nonvoting stock will of course protect the power of the existing major stock- holders. Bonds also may be sold by the corporation. This alternative would be more diffi- cult for the new venture since a high bond rating will likely occur only after the business has been successful over time. Money also may be borrowed in the name of the corpora- tion. As stated earlier, this protects the personal liability of the entrepreneur(s) .
Management Control
In any new venture, the entrepreneur(s) will want to retain as much control as possible over the business. Each of the forms of business offers different opportunities and problems as to control and responsibility for making business decisions.
In the proprietorship, the entrepreneur has the most control and flexibility in making business decisions. Since the entrepreneur is the single owner of the venture, he or she will be responsible for and have sole authority over all business decisions.
The partnership can present problems over control of business decisions if the partner- ship agreement is not concise regarding this issue. Usually, in a partnership the majority rules unless the partnership agreement states otherwise. It is quite important that the part- ners be friendly toward one another and that delicate or sensitive decision areas of the busi- ness be spelled out in the partnership agreement.
The existence of limited partners in a general partnership offers a compromise be- tween the partnership and the corporation. In this type of organization, we can see some of the separation of ownership and control. The limited partners in the venture have no control over business decisions. As soon as the limited partner is given some control over business decisions, he or she then assumes personal liability and can no longer be con- sidered a limited partner. In the LLP, the rights of all partners are clearly defined in the partnership agreement. As mentioned earlier, these types of organizations use titles such as junior partner, associate partner, and so on as a means of designating management responsibilities .
Control of day-to-day business in a corporation is in the hands of management, who may or may not be major stockholders. Control over major long-term decisions, however, may require a vote of the major stockholders. Thus, control is separated based on the types of busi- ness decisions. In a new venture, there is a strong likelihood that the entrepreneurs who are major stockholders will be managing the day-to-day activities of the business. As the corpo- ration increases in size, the separation of management and control becomes more probable.
Stockholders in the corporation can indirectly affect the operation of the business by electing someone to the board of directors who reflects their personal business philosophies. These board members, through appointment of top management, then affect the operation and control of the day-to-day management of the business.
Distribution of Profits and Losses
Proprietors receive all distributions of profits from the business. As discussed earlier, they are also personally responsible for all losses. Some of the profits may be used to pay back the entrepreneur for any personal capital contributions that are made to keep the business operating.
In the partnership, the distribution of profits and losses depends on the partnership agreement. It is likely that the sharing of profits and losses will be a function of the partners'
Entrepreneurship, Eighth Ed it ion 273
CHAPTER 9 THE ORGANIZATIONAL PLAN 263
investments. However, this can vary depending on the agreement. As in the proprietorship, the partners may assume liability. Limited partners in a general partnership, or the forma- tion of an LLP, are alternatives that protect those limited partners against personal liability but that may also reduce their share in any profits.
Corporations distribute profits through dividends to stockholders . These distributions are not likely to absorb all the profits that may be retained by the corporation for future in- vestment or capital needs of the business. Losses by the corporation will often result in no dividends. These losses will then be covered by retained earnings or through other finan- cial means discussed earlier.
Attractiveness for Raising Capital In both the proprietorship and the partnership, the ability of the entrepreneurs to raise cap- ital depends on the success of the business and the personal capability of the entrepreneur. These two forms are the least attractive for raising capital, primarily because of the prob- lem of personal liability. Any large amounts of capital needed in these forms of business should be given serious consideration.
The corporation, because of its advantages regarding personal liability, is the most attractive form of business for raising capital. Shares of stock, bonds, and/or debt are all opportunities for raising capital with limited liability. The more attractive the corporation, the easier it will be to raise capital.
TAX ATTRIBUTES OF FORMS OF BUSINESS The tax advantages and disadvantages of each of the forms of business differ significantly. Some of the major differences are discussed next. There are many minor differences that, in total, can be important to the entrepreneur. If the entrepreneur has any doubt about these advantages, he or she should get outside advice. Table 9.2 provides a summary of the major tax advantages of these forms of business.
Tax Issues for Proprietorship For the proprietorship, the IRS treats the business as the individual owner. All income appears on the owner's return as personal income. Thus, the proprietorship is not regarded by the IRS as a separate tax entity. As can be seen in Table 9 .2, this treatment of taxes affects the taxable year, distribution of profits to owners, organization costs, capital gains, capital losses, and medical benefits. Each of these is treated as if it were incurred by the individual owner and not the business.
The proprietorship has some tax advantages when compared with the corporation. First, there is no double tax when profits are distributed to the owner. Another advantage is that there is no capital stock tax or penalty for retained earnings in the business. Again, these advantages exist because the proprietorship is not recognized as a separate tax entity; all profits and losses are part of the entrepreneur's tax return.
Tax Issues for Partnership The partnership's tax advantages and disadvantages are similar to those of the proprietor- ship, especially regarding income distributions, dividends, and capital gains and losses.
27 4 l Entrepreneurship -----'--------t- -- - ------- .. -
264 PART 3 FROM THE OPPORTUNITY TO THE BUSINESS PLAN
TABLE 9.2 Tax Attributes of Various Legal Forms of Business
Attributes Proprietorship
Taxable year Usually a calendar year.
Distribution of All income appears on profits to owners owner's return .
Organization costs
Dividends received
Capital gains
Capita/losses
Initial organization
Limitations on losses deductible by owners
Medical benefits
Retirement benefits
Not amortizable.
$100 dividend exclusion for single return and $200 on joint return.
Taxed at individual level. A deduction is allowed for long-term capital gains.
Carried forward indefinitely.
Commencement of business results in no additional tax for individual.
Amount at risk may be deducted except for real estate activities.
Itemized deductions for medical expenses in excess of percentage of adjusted gross income on individual's return. No deduction for insurance premium.
Limitations and restrictions basically same as regular corporation.
Partnership
Usually calendar year, but other dates may be used.
Partnership agreement may have special allocation of income. Partners pay tax on their pro rata shares of income on individual return even if income not immediately distributed.
Amortizable over 60 months.
Dividend exclusion of partnership passes to partner (conduit).
Capital gain to partnership will be taxed as a capital gain to the partner (conduit).
Capital losses can be used to offset other income. Carried forward indefinitely (conduit).
Contributions of property to a partnership not taxed.
Partnership investment plus share of recourse liability if any. At-risk rules may apply except for real estate partnership.
Cost of partner's benefits not deductible to business as an expense. Possible deduction at partner level.
Same as for corporations.
Corporation
Any year-end can be used at beginning. Any changes require changes in incorporation.
No income is allocated to stockholders.
Amortizable over 60 months.
80% or more of dividend received may be deducted.
Taxed at corporate level.
Carry back three years and carry over five years as short-term capital loss offsetting only capital gains.
Acquisition of stock for cash entails no immediate taxes. Transfer of property in exchange for stock may be taxable if stock value greater than contributed property.
No losses allowed except on sale of stock or liquidation of corporation. In S corporation, shareholder's investment in corporation is deductible.
Cost of employee-shareholder coverage deductible as business expense if designed for benefit of employee.
Limitations on the benefits that can be derived and on the benefits that can be contributed to a defined contribution plan.
Limited partners in a traditional general partnership have the advantage of limited liability (they are liable only for the amount of their investment), but they can share in the profits at a percentage stipulated in the partnership agreement. The LLP is treated the same as the LLC for tax purposes, and all profits are distributed through the partners in some designated fashion as personal income.
ration Special
corporation where
- are distributed to
lders and taxed as
income
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CHAPTER 9 THE ORGANIZATIONAL PLAN 265
Both the partnership and proprietorship are organizational forms that serve as nontax- able conduits of income and deductions. These forms of business do have a legal identity distinct from the partners or owners, but this identity is only for accounting reporting.
It is especially important for partnerships to report income since this serves as the basis for determining the share of each partner. The income is distributed based on the partner- ship agreement. The owners then report their share as personal income and pay taxes based on this amount.
Tax Issues for Corporation Since the IRS recognizes the corporation as a separate tax entity, it has the advantage of being able to take many deductions and expenses that are not available to the proprietorship or partnership. The disadvantage is that the distribution of dividends is taxed twice, as in- come of the corporation and as income of the stockholder. This double taxation can be avoided if the income is distributed to the entrepreneur(s) in the form of salary. Bonuses, incentives, profit sharing, and so on, are thus allowable ways to distribute income of the corporation as long as the compensation is reasonable in amount and payment was for ser- vices rendered.
The corporate tax may be lower than the individual rate. The entrepreneur is best advised to consider the tax pros and cons and decide on that basis. Projected earnings may be used to calculate the actual taxes under each form of business to identify the one that provides the best tax advantage. Remember, tax advantages should be balanced by liability responsibility in the respective form of business.
THE LIMITED LIABILITY COMPANY VERSUS THE S CORPORATION Although the perception among entrepreneurs is that the C corporation is the entity desired by investors, the actual entity desired by venture capitalists is the limited liability company (LLC), which is similar to the S corporation. The emergence of the LLC as a more popular alternative has resulted from the finalization of new regulation. This new regulation now allows an LLC to be automatically taxed as a partnership, unless the entrepreneur actively makes another choice (taxed as a corporation). This easing of election is one important fac- tor that has enhanced the LLC's popularity.
The S corporation (the S refers to Subchapter S of the Internal Revenue Code) had been the most popular choice of organization structure by new ventures and small businesses. However, the growth rate of the formation of S corporations has actually declined in the last few years primarily because of acceptance of the LLC in all states and amendments in sev- eral states making the LLC more attractive. 3
5 CORPORATION The S corporation combines the tax advantages of the partnership and the corporation. It is designed so that venture income is declared as personal income on a pro rata basis by the shareholders. In fact, the shareholders benefit from all the income and the deductions of the business. Before the passing of the Small Business Job Protection Act of 1996, the rules governing the S corporation were considered too rigid. The passage of the 1996 law loos- ened some of the restrictions that existed in regard to number of shareholders, ownership of stock of another corporation, role of trusts as stockholders, classes of stock, and a number of other changes. In 2004, Congress again responded to some of the criticisms of the re- stri.cti.ons on S corporations as compared to LLCs. As a result a number of changes were
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made, such as an increase in the number of shareholders to 100, allowing family members to be treated as one stockholder, allowing IRAs to own shares in banks that are declared S corporations, as well as some modifications regarding the transfer of stock in a divorce. The intent was to make the S corporation as advantageous as the LLC since it is difficult to change status once a firm has declared itself an S corporation. It is anticipated that Congress may revisit the S corporation again in the future .4
One of the issues with the S corporation is that its status must be carefully monitored and maintained. For example, its tax status as a pass-through entity (with its income taxed as personal income of shareholders) still requires an affirmative election of shareholders. If the S corporation status is ever lost, it usually cannot be reelected for five years and with some costs. As stated earlier, the differences between the S corporation and the LLC are generally minimal but should be evaluated on a case-by-case basis because of the existing company and shareholder circumstances .
Advantages of an S Corporation The S corporation offers the entrepreneur some distinct advantages over the typical corpo- ration, or C corporation. However, there are also disadvantages. In those instances when the disadvantages are great, the entrepreneur should elect the C corporation form . Some of the advantages of the S corporation are as follows:
• Capital gains or losses from the corporation are treated as personal income or losses by the shareholders on a pro rata basis (determined by number of shares of stock held). The corporation is thus not taxed.
• Shareholders retain the same limited liability protection as the C corporation.
• The S corporation is not subject to a minimum tax, as is the C corporation.
• Stock may be transferred to low-income-bracket family members (children must be 14 years or older).
• Stock may be voting or nonvoting.
• This form of business may use the cash method of accounting.
• Corporate long-term capital gains and losses are deductible directly by the shareholders to offset other personal capital gains or losses.
Disadvantages of an S Corporation Although the advantages appear to be favorable for the entrepreneur, this form of business is not appropriate for everyone. The disadvantages of the S corporation are as follows:
• Even with the regulations passed in 1996 and 2004, there are still some restrictions regarding qualification for this form of business.
• Depending on the actual amount of the net income, there may be a tax advantage to the C corporation. This will depend on the company payout ratio, the corporate tax rate, the capital gains tax rate for the investor, and the personal income tax rate of the investor. 5
• The S corporation may not deduct most fringe benefits for shareholders.
• The S corporation must adopt a calendar year for tax purposes.
• Only one class of stock (common stock) is permitted for this form of business.
• The net loss of the S corporation is limited to the shareholder's stock plus loans to the business.
• S corporations cannot have more than 100 shareholders.
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$ ETHICS
LAWYERS EXPLAIN THE STEPS TO TAKE IF YOUR BUSINESS PARTNER VIOLATES HIS OR HER OBLIGATIONS TO THE BUSINESS
My business partner and I have owned a technology company for six years. It's an S-Corporation and we are 50-50 share- holders, each with a board position. Our bylaws are boilerplate and our stockholder agreement is pretty weak, focusing on when we can or can't sell the business. Recently I found out that for the first four years, my partner was getting paid by one of the corporation's customers through a local university to work in the same technology we do in the company. Is this a conflict of interest on his part? What should I do?
C. G. (Rome, NY)
Yes, this is a conflict of interest. In legal terms it's call ed "a diversion of corporate opportunity." This
eans your partner took work for himself that the cor- poration could have done. This is most likely a breach of
ur partner's fiduciary obligations and his duty of loy- to the corporation, says Stuart Blake, co-founder
d chief executive officer of the General Counsel, a -aw firm based in Newport Beach, Calif. It's also a seri-
breach of trust between the two of you as partners. Relying on boilerplate documents and a weak reholder agreement may make this dilemma more
;.e ious. "This is the pitfall of not having an attorney elp draft your corporate documents when you set
_ your 5-corp. With a more detailed agreement, uding buy/sell provisions, noncompete clauses, and f lict-of-interest provisions, you could extricate your- from this situation much more easily," Blake says.
VT THE EVIDENCE IN BLACK DWHITE
at you should do depends largely on what you t from your partner and from the corporation,
says Rubin Ferziger, a business attorney based in New York. Do you want to continue with the corporation, but recover the lost profits and perhaps other dam- ages? Are you considering dissolving the corporation and going off on your own? Does your business de- pend on your partner or could you carry on alone?
"Take your shareholder agreement to an attorney and explain what has happened," Ferziger suggests. "You should also discuss the situation with your fam- ily and with an accountant who is not affiliated with your partner."
Make sure you have documentary evidence about the competing work your partner did, says Ray Gallo, a Los Angeles attorney with Gallo & Associates. "Hav- ing it in black and white minimizes the possibilities for arguments and litigation. Present the evidence to a lawyer you engage to act as counsel to the corpora- tion to make this determination," Gallo says.
If the lawyer concludes your partner has violated his duties, sit down with your partner promptly, Gallo says. If you want to continue working together, both of you should agree that he won't do this again and-ideally- that he'll put the money he made into the corporation . "Hopefully it'll go well," he says. "If not, you'll have to choose whether the money at issue is worth fighting over. Either way, you'll have to decide whether this is a guy you should continue in business with. If your gut reaction is that he cheated you, the answer is no."
Source: Reprinted from June 26, 2008 issue of Business Week by special permission, copyright© 2008 by The McGraw-Hill Companies, Inc., Karen E. Klein, "Resolving a Conflict of Interest," Business Week Online, p. 16.
THE LIMITED LIABILITY COMPANY As stated earlier, the new flexibility offered by LLC status has enhanced its choice by en- trepreneurs. The tax rules for an LLC fall under Subchapter K, and this business form is considered a partnership-corporation hybrid with the following characteristics:
• Whereas the corporation has shareholders and partnerships have partners, the LLC has members.
• No shares of stock are issued, and each member owns an interest in the business as designated by the articles of organization, which is similar to the articles of incorporation or certificates of partnership.
• Liability does not extend beyond the member's capital contribution to the business. Thus, there is no unlimited liability, which can be detrimental in a proprietorship or general partnership.
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• Members may transfer their interest only with the unanimous written consent of the remaining members.
• The Internal Revenue Service now automatically treats LLCs as partnerships for tax purposes, unless another option is elected. Thus, as mentioned earlier in this chapter, members may elect to designate the firm as a partnership or a corporation.
• The standard acceptable term of an LLC is 30 years. Dissolution is also likely when one of the members dies, the business goes bankrupt, or all members choose to dissolve the business. Some states allow continuity with majority or unanimous consent of the members. One of the important characteristics of the LLC is that the laws governing its formation differ from state to state. Thus, a firm that is operating in more than one state may be subject to different treatment. An analysis of these differences should be considered before choosing this form of organization.
Advantages of an LLC A number of advantages of an LLC over an S corporation are described here. 6
• In a highly leveraged enterprise, the LLC offers the partnership a distinct advantage over an S corporation in that the partners can add their proportionate shares of the LLC liabilities to their partnership interests.
• With the exception of Texas and Pennsylvania, states do not tax LLCs.
• One or more (without limit) individuals, corporations, partnerships, trusts, or other entities can join to organize or form an LLC. This is not feasible in an S corporation.
• Members are allowed to share income, profit, expense, deduction, loss and credit, and equity of the LLC among themselves. This is the only form of organization that offers all these features.
The one major concern with the LLC is in international business, where the context of unlimited liability is still unclear. Otherwise the LLC offers all the distinct advantages of a C corporation but with a pass-through tax to the members. Owners of an LLC can neither be paid as employees nor participate in certain employee benefits. Instead they are paid in the form of guaranteed payments with no federal or state withholding involved.
Thus, members are responsible for filing estimated taxes on a regular basis.? The LLC appears to be the favorite choice for venture capitalists since it offers more flexibility based on the advantages already discussed. However, entrepreneurs should compare all the alternative forms of organization before election. This should be done with the advice of a tax attorney, since once a decision is made, it may be difficult to change without some penalty.
DESIGNING THE ORGANIZATION Generaiiy, the design of the initial organization wiii be simple. fn fact, the entrepreneur may find that he or she performs all the functions of the organization alone. This is a com- mon problem and a significant reason for many failures. The entrepreneur sometimes thinks that he or she can do everything and is unwilling to give up responsibility to others or even include others in the management team. In most cases when this occurs, the entre- preneur will have difficulty making the transition from a start-up to a growing, well-managed business that maintains its success over a long period of time. Regardless of whether one or more individuals are involved in the start-up, as the workload increases, the organizational structure will need to expand to include additional employees with defined roles in the
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CHAPTER 9 THE ORGANIZATIONAL PLAN 269
organization. Effective interviewing and hiring procedures will need to be implemented to ensure that new employees will effectively grow and mature with the new venture. All the design decisions involving personnel and their roles and responsibilities reflect the formal structure of the organization. In addition to this formal structure there is an informal struc- ture or organization culture that evolves over time that also needs to be addressed by the en- trepreneur. Although we are speaking of an organization culture rather than an organization design, the entrepreneur can have some control over how it evolves. Since issues related to this culture can be just as critical as the formal design of the organization for ensuring a successful and profitable enterprise, they will be discussed in more detail in the next section of this chapter.
For many new ventures, predominantly part-time employees may be hired, raising im- portant issues of commitment and loyalty that Jim Sinegal was able to successfully over- come with some creativity in his organization. However, regardless of the number of actual personnel involved in running the venture, the organization must identify the major activi- ties required to operate it effectively.
The design of the organization will be the entrepreneur's formal and explicit indication to the members of the organization as to what is expected of them. Typically these expec- tations can be grouped into the following five areas: 8
• Organization structure. This defines members' jobs and the communication and relationship these jobs have with each other. These relationships are depicted in an organization chart.
• Planning, measurement, and evaluation schemes. All organization activities should reflect the goals and objectives that underlie the venture's existence. The entrepreneur must spell out how these goals will be achieved (plans), how they will be measured, and how they will be evaluated.
• Rewards . Members of an organization will require rewards in the form of promotions, bonuses, praise, and so on. The entrepreneur or other key managers will need to be responsible for these rewards.
• Selection criteria. The entrepreneur will need to determine a set of guidelines for selecting individuals for each position.
• Training. Training, on or off the job, must be specified. This training may be in the form of formal education or learning skills.
The organization's design can be very simple-that is, one in which the entrepreneur performs all the tasks (usually indicative of a start-up)-or more complex, in which other employees are hired to perform specific tasks. As the organization becomes larger and more complex, the preceding areas of expectation become more relevant and necessary.
Figure 9.1 illustrates two stages of development in an organization. In stage 1, the new venture is operated by basically one person, the entrepreneur. This organizational chart reflects the activities of the firm in production, marketing/sales, and administra- tion. Initially, the entrepreneur may manage all these functions. At this stage, there is no need for submanagers; the owner deals with everyone involved in the business and all aspects of the operation. In this example, the president manages production, which may be subcontracted; marketing and sales (possible use of agents or reps); and all adminis- trative tasks such as bookkeeping, purchasing, and shipping. Planning, measurement and evaluation, rewards selection criteria, and training would not yet be critical in the organization.
As the business expands, the organization may be more appropriately described by stage 2. Here, submanagers are hired to coordinate, organize, and control various aspects
280 _1 Entrepreneurship
270 PART 3 FROM THE OPPORTUNITY TO THE BUSINESS PLAN
FIGURE 9.1 Stages in Organizational Design
Stage 1
of the business. In the example in Figure 9.1, the production manager is responsible for quality control and assembly of the finished product by the subcontractor. The marketing manager develops promotion and advertising strategy and coordinates the efforts of the expanding rep organization. The administrative manager then assumes the responsibility for all administrative tasks in the business operation. Here the elements of measurement, evaluation, reward, selection, and training become apparent.
A third stage may exist when the firm achieves a much larger size (i.e., 1,000 employ- ees). The activities below each manager in stage 2 would then be represented by a third level of managers (i.e., quality control managers).
As the organization evolves, the manager or entrepreneur's decision roles also become critical for an effective organization. As an entrepreneur, the manager's primary concern is to adapt to changes in the environment and seek new ideas. When a new idea is found, the entrepreneur will need to initiate development either under his or her own supervision (stage 1 in Figure 9.1) or by delegating the responsibility to someone else in the organiza- tion (stage 2 in Figure 9.1). In addition to the role of adaptor, the manager will also need to respond to pressures such as an unsatisfied customer, a supplier reneging on a contract, or a key employee threatening to quit. Much of the entrepreneur's time in the start-up will be spent "putting out fires."
Another role for the entrepreneur is that of allocator of resources. The manager must de- cide who gets what. This involves the delegation of budgets and responsibilities. The allo- cation of resources can be a very complex and difficult process for the entrepreneur since one decision can significantly affect other decisions. The final decision role is that of nego- tiator. Negotiations of contracts, salaries, prices of raw materials, and so on, are an integral part of the manager's job, and since he or she can be the only person with the appropriate authority, it is a necessary area of decision making.
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BUILDING THE MANAGEMENT TEAM AND A SUCCESSFUL ORGANIZATION CULTURE In conjunction with the design of the organization the entrepreneur will need to assemble the right mix of people to assume the responsibilities outlined in the organization structure. Some of the issues identified in the organization design will be revisited here since they are not only critical to the building of the team but are just as important in establishing a posi- tive and successful organization culture. This strategy must be maintained through the stages of start-up and growth of the enterprise. There are some important issues to address before assembling and building the management team. In essence the team must be able to accomplish three functions:
• Execute the business plan.
• Identify fundamental changes in the business as they occur.
• Make adjustments to the plan based on changes in the environment and market that will maintain profitability.
Although these functions may seem simple and easy to achieve, the people engaged and the culture promoted by the entrepreneur are critical in accomplishing these func- tions. As we discussed in the organization design section previously, the entrepreneur will first need to assume the responsibility of determining what skills and abilities are needed to meet the goals in the business plan. Not only are the skills and abilities impor- tant, but the entrepreneur also will need to consider the personality and character of each individual to create a viable organization culture. The organization culture will be a blend of attitudes, behaviors, dress, and communication styles that make one business different from another. There is no specific technique for accomplishing this since every organiza- tion will be different. However, we will explore some of the important considerations and strategies in recruiting and assembling an effective team and hence in creating an effec- tive and positive organization culture.
First, the entrepreneur's desired culture must match the business strategy outlined in the business plan. For example, Fran Bigelow, founder of Fran's Chocolates in Seattle, has been able to get her team to consider themselves artisans, focus on detail, and strive for per- fection. Fran feels that this strategy is effective for her venture because of her premium product line but might result in disaster for someone marketing a high-volume, low-cost manufactured product. 9
Second, the leader of the organization must create a workplace where employees are motivated and rewarded for good work. There are many different ways to motivate and re- ward employees, as evidenced by Brad Nierenberg, cofounder of RedPeg Marketing, who turned to unusual perks as incentives for employees. Trophies are handed out for good per- formance, breakfast is provided at meetings, and the company even rents a house on the beach that employees can sign up for year round. Nierenberg one time gave 38 employees $1,000 each in cash because the company reached its planning goals. Besides the many other perks that are provided, Brad has also eliminated some of these incentives when things are not going well. However, Brad understands the difference between these perks and life-altering incentives such as insurance, day care, or flextime. He understands that taking away any of these significant incentives is what creates employee discontent and that the fun perks are what keep his employees happy. 10
Third, the entrepreneur should be flexible enough to try different things. This is not al- ways possible in a very small organization but has been the successful strategy in the growth of Google. The leadership of this company has an abundance of talent, and the attitude of management is that this talent needs to be given enough flexibility to make decisions, as
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AS SEEN IN BUSINESSWEEK
ELEVATOR PITCH FOR 20 x 200 WEB SITE
A friend of yours who loves to collect art has asked you to find new Web-based businesses that she can invest in that relate to the art industry. After reading the following pitch, you think that your friend may be interested in investing in this start-up. Would you consider introducing Jen to your friend? How can she address the issue regarding artists' fear that their work will be commoditized?
$20,000. She bootstrapped the now-profitable Net venture for less than $1,000, with the help of contacts who donated time to get the site running. She now runs it with a staff of five (plus contractors), who also operate her gallery and a third venture, photo com- petition Hey, Hot Shot! that leads her to many of the photographers for 20x200. She splits profits 50-50 w ith the artists, and her art-world cred assuages artists' fears that their work will be commoditized . People know that I am not just moving product, she says. But the product moves nonetheless. The e-gallery has shipped more than 40,000 prints, with $1.2 million in revenue in 2008.*
Her Web site is officially called 20x200, but founder Jen Bekman calls her online mart the gateway drug to the art world. The Manhattan gallery owner launched the site in September 2007 to sell limited-edition prints and photography at prices low enough to at- tract first-time collectors, starting at $20 for a print from a run of 200. Bekman, 39, worked for Internet companies including Meetup before opening Jen Bekman Gallery, where prices range from $1,000 to
*Source: Reprinted from April 28, 2009 issue of Business Week by special permission, copyright© 2009 by The McGraw-Hill Compa- nies, Inc., www.businessweek.com. "America's Most Promising Startups," www.businessweekonline.com/smallbiz by Nick Leiber.
272
long as they do so within the model established by the company. Founders Larry Page and Sergey Brin have chosen a very flat organizational structure that they believe provides more flexibility and in the long run provides the customer with a better product and better ser- vice.U Steven Jobs also believed in this approach. He moved key personnel to a separate building and allowed them to spend all their working hours developing the new-generation computer of that time, the Macintosh.
Fourth, it is necessary to spend extra time in the hiring process. There is sometimes a tendency to want to hurry the process of finding the appropriate skills to fill the orga- nization's needs. As stated earlier, there is more to a person than his or her skills. Char- acter is also an important factor in building an effective organization culture. One thing that can be implemented is a hiring plan that establishes the procedure for screening, interviewing, and assessing all candidates. Job descriptions, along with specifications of the type of person who will match the desired culture, should be documented for this process.
Next, the entrepreneur needs to understand the significance of leadership in the organi- zation. Leadership should help to establish core values and provide the appropriate tools so that employees can effectively complete their jobs. An approach such as, "We're all in this together, no one is bigger than anyone else, and here are the rules we live by," can lead to greater challenges and job satisfaction. A reward system, even to the extent offered by Brad Nierenberg's firm discussed earlier, can play an important role in providing consistent and positive behavior patterns.
Finding the most effective team and creating a positive organization culture is a chal- lenge for the entrepreneur but is just as critical as having an innovative, marketable prod- uct. It is an important ingredient in an organization's success.
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THE ROLE OF A BOARD OF DIRECTORS An entrepreneur may find it necessary in his or her organization plan to establish a board of directors or board of advisors. The board of advisors is discussed in the next section. The board of directors may serve a number of functions: (1) reviewing operating and capital budgets, (2) developing longer-term strategic plans for growth and expansion, (3) support- ing day-to-day activities, (4) resolving conflicts among owners or shareholders, (5) ensuring the proper use of assets, or (6) developing a network of information sources for the entre- preneurs. These functions may be a formal part of the organization, with responsibilities assigned to the directors depending on the needs of the new venture.
Most important in establishing these responsibilities is the consideration of the impact of the Sarbanes-Oxley Act passed in 2002. Passage of this act resulted because of accounting irregularities, fraud, bankruptcy, insider trading, excessive management compensation, and other illegal or unethical actions that have become newsworthy in the years leading up to 2002 (see Chapter 6 for more discussion of the Sarbanes-Oxley Act). Although there is still some concern about the effectiveness of the new law, its intent is to establish a more independent functioning board. This is particularly relevant in public companies where the board mem- bers must represent all shareholders and are responsible for "blowing the whistle" on any discrepancies that may be suspected. In spite of its intent, this act has come under criticism in light of the economic crisis that led to the demise of a number of large financial services companies. However, many feel that it is not the law that is the problem but more the issues of having the right mix of board members. It is expected that because of the economic crisis there will be a greater demand on boards to master the reforms of Sarbanes-Oxley and to be more attentive to the expertise of appointed board members. 12
Many start -up ventures do not plan to have a formal board of directors. However, if there are equity investors, they will usually insist on the formation of a board and at least one board seat. Julia Starnberger and Pam Jelaca, cofounders of Go Picnic, a company that sells snack boxes and packaged meals to airlines, corporations, hotels, and event planners, did not have a board in place and realized after their infusion of equity financing that they would need to establish one. They found that the experience of the board was very positive because it forced them into a discipline of financial reporting that they tended to avoid in the past. This financial focus has helped them to prioritize things that are essential to their fast-growing business. 13
As we can see from the preceding example, the purpose of the board of directors is to provide important leadership and direction for the new venture, and it should be carefully chosen to meet the requirements of the Sarbanes-Oxley Act and also the following criteria: 14
• Select individuals who can work with a diverse group and will commit to the venture's mission.
• Select candidates who understand the market environment or can contribute important skills to the new venture's achievement of planning goals.
• Select candidates who will show good judgment in business decision making.
Candidates should be identified using referrals of business associates or from any of the external advisors such as banks, investors, lawyers, accountants, or consultants . Ideally, the board should consist of 3, 5, 7, or some odd number of members to avoid deadlock and with limited terms to allow for continuous infusion of new ideas from different people.
Board of director performance needs to be regularly evaluated by the entrepreneurs. It is the chair's responsibility to provide an appraisal of each board member. To provide this appraisal, the chairperson (and/or founders) should have a written description of there- sponsibilities and expectations of each member.
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274 PART 3 FROM THE OPPORTUNITY TO THE BUSINESS PLAN
Compensation for board members can be shares of stock, stock options, or dollar pay- ment. Often the new venture will tie compensation to the performance of the new venture. Compensation is important since it reinforces the obligation of board members. If board members were only volunteers , they would tend to take the role lightly and not provide any value to the entrepreneur.
THE BOARD OF ADVISORS Compared to a board of directors, a board of advisors would be more loosely tied to the or- ganization and would serve the venture only in an advisory capacity for some of the func- tions or activities mentioned before. It has no legal status, unlike the board of directors, and hence is not subject to the regulations stipulated in the Sarbanes-Oxley Act. These boards are likely to meet less frequently or depending on the need to discuss important venture de- cisions. A board of advisors is very useful in a family business where the board of directors may consist entirely of family members.
The selection process for advisors can be similar to the process for selecting a board of directors, including determining desired skills and interviewing potential candidates. Advi- sors may be compensated on a per-meeting basis or with stock or stock options. Just as in the case of the board of directors, the members should be evaluated as to their contribution to meeting the mission of the new venture.
Boards of advisors can provide an important reality check for the entrepreneur or owner of any noncorporate type of business. Robin Chase, the founder of Zipcar, a self-service car rental business, regularly calls on a group of advisors to help her hash out ideas, provide recommendations for advancing her company, or just get a sanity check.l 5 Agiliance Inc., a leading provider of IT risk and governance solutions, recently added five members to its board of advisors. Having had great success with the concept, the company still felt that it needed additional expertise in key areas of its growth strategies. The five new members all represent significant expertise in the defined areas of growth. 16 As we can see from these two examples, the board of advisors represents an alternative or complementary option to the entrepreneur in providing expertise in needed areas. The flexibility in size, background requirements, number of meetings, and compensation makes these boards a very desirable alternative to the more formal boards of directors.
THE ORGANIZATION AND USE OF ADVISORS The entrepreneur will usually use outside advisors such as accountants, bankers, lawyers, advertising agencies, and market researchers on an as-needed basis . These advisors, who are separate from the more formal board of advisors, can also become an important part of the organization and thus will need to be managed just like any other permanent part of the new venture.
The relationship of the entrepreneur and outside advisors can be enhanced by seeking out the best advisors and involving them thoroughly and at an early stage. Advisors should be assessed or interviewed just as if they were being hired for a permanent position. Refer- ences should be checked and questions asked to ascertain the quality of service as well as compatibility with the management team.
Hiring and managing outside experts can be effectively accomplished by considering these advisors as advice suppliers. Just as no manager would buy raw materials or supplies without knowledge of their cost and quality, the same approval can apply for advisors. Entrepreneurs should ask these advisors about fees, credentials, references, and so on, before hiring them.
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SUMMARY
CHAPTER 9 THE ORGANIZATIONAL PLAN 275
Even after the advisors have been hired, the entrepreneur should question their advice. Why is the advice being given? Make sure you understand the decision and its potential im- plications. There are many good sources of advisors, such as the Small Business Adminis- tration, other small businesses, chambers of commerce, universities, friends, and relatives. Careful evaluation of the entrepreneur's needs and the competency of the advisor can make advisors a valuable asset to the organization of a new venture.
One of the most important decisions the entrepreneur(s) must make in the business plan is the legal form of business. The three major legal forms of business are the proprietor- ship, partnership, and corporation. Each differs significantly and should be evaluated carefully before a decision is made. This chapter provides considerable insight and com- parisons regarding these forms of business to assist the entrepreneur in this decision.
The 5 corporation and the limited liability company are alternative forms of business that are gaining popularity. Each of these allows the entrepreneur to retain the protec- tion from personal liability provided by a corporation as well as the tax advantages pro- vided by a partnership. There are important advantages as well as disadvantages to these forms of business, and entrepreneurs should carefully weigh both before deciding.
The organization plan for the entrepreneur also requires some major decisions that could affect long-term effectiveness and profitability. It is important to begin the new venture with a strong management team that is committed to the goals of the new venture. The management team must be able to work together effectively toward these ends.
The design of the organization requires the entrepreneur to specify the types of skills needed and the roles that must be filled. These would be considered part of the formal organization. In addition to the formal organization, the entrepreneur must consider the informal organization or culture that is desired to match the strategy stip- ulated in the business plan. This organization culture represents the attitudes, behav- iors, dress, and communication styles that can differentiate one company from another. Both of these are important in establishing an effective and profitable organization.
A board of directors or board of advisors can provide important management sup- port for an entrepreneur starting and managing a new venture. Boards of directors are now governed by the Sarbanes-Oxley Act, which was passed because of a rash of ille- gal and unethical behaviors that were newsworthy. The intent of this new law is to make the board of directors more independent and to make its members accountable to the shareholders. The law is particularly relevant to public companies and has less impact on privately held companies. The board of advisors is a good alternative to a board of directors when the stock is held privately or in a family business.
In spite of the new regulations, a board of directors or advisors can still provide ex- cellent support for an organization. Either one can be formed in the initial business planning phase or after the business has been formed and financed. In either case the selection of board members should be made carefully, so that members will take their roles seriously and will be committed to their roles and responsibilities.
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Advisors will also be necessary in the new venture. Outside advisors should be eval- uated as if they were being hired as permanent members of the organization. Infor- mation on their fees and referrals can help determine the best choices.
RESEARCH TASKS
c 1. In this country, what proportion of all businesses are (a) proprietorships, (b) partnerships, (c) private companies, and (d) public companies? Provide an example of an industry that has a large share of proprietorships. Why is this the case? Provide an example of an industry that has a large share of partnerships. Why is this the case? Provide an example of an industry that has a large share of private companies. Why is this the case? Provide an example of an industry that has a large share of public companies. Why is this the case?
2. How much does it cost to set up a private company? What are the ongoing costs?
3. Study the local newspaper and choose three good examples and three poor examples of job advertisements. Be prepared to explain your choices.
4. Interview five entrepreneurs about their use of a board of advisors. Ask who is on the board, how the members were selected, how they were encouraged to join the board, how useful the board has been, and so on .
CLASS DISCUSSION
,_tff 1. Why would entrepreneurs open themselves up to personal financial losses by
choosing a proprietorship rather than a company form of organization?
2. Why do suppliers sometimes ask entrepreneurs of small companies to provide personal guarantees for a line of business credit? If an entrepreneur is asked (forced) to provide personal guarantees, then what personal protection does a company as a legal form really provide?
3. Does the old saying "You get what you pay for" apply to a board of directors or a board of advisors?
4. Design a structure for the following organization, and detail the changes that you would make (if any) to that structure as the company develops. a. Stage 1. You are the CEO of a company ("Party On") that specializes in the sale
of party merchandise (e.g., paper cups, plates, and streamers). You have a retail store and three employees, and you serve the local area , A differentiation strategy is used. What structure (configuration, prime coordinating mechanisms, and type of decentralization) are you going to implement and why? Which is the key part of the organization?
b. Stage 2. After five years, Party On has expanded to 150 stores throughout the United States. The company is still following a differentiation strategy, selling primarily the same range of products in each store. What structure (configuration, prime coordinating mechanisms, and type of decentralization) are you going to implement and why? Which is the key part of the organization?
c. Stage 3. After a further seven years, Party On has expanded to 225 stores in the United States, 57 stores in the U.K., 30 stores in Sweden, 10 stores in France, 8 stores in Mexico, and 5 stores in Germany. The company's strategy is to sell its range of products through company-owned stores at a premium price. What
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CHAPTER 9 THE ORGANIZATIONAL PLAN 277
structure (configuration, prime coordinating mechanisms, and type of decentralization) are you going to implement and why? Which is the key part of the organization?
d. Stage 4. Not long after the new structure has been put in place, a consortium of department stores offers you a very lucrative contract to sell Party On's products in its stores worldwide. Its requirement is that Party On's current retail stores must be closed over a five-year period (it doesn't want to compete with Party On), and it wants to offer the products at lower prices. You accept the terms and conditions of the deal. What structure (configuration, prime coordinating mechanisms, and type of decentralization) are you going to implement and why? Which is the key part of the organization?
e. Stage 5. The contract has been enormously successful. Further, a number of other opportunities have arisen. First, the founder and CEO of your major supplier of party merchandise died and you were able to purchase the company at a very reasonable price. Second, rather than close your outlet stores, which are in excellent positions, you decided to sell sporting collectibles (e.g., baseball cards, signed photographs, and jerseys) at a very nice mark-up indeed. However, while U.S. sporting collectibles are somewhat popular outside the United States, each country is quite different. What structure (configuration, prime coordinating mechanisms, and type of decentralization) are you going to implement and why? Which is the key part of the organization?
SELECTED READINGS
Cooney, Thomas M. (June 2005). Editorial: What Is an Entrepreneurial Team? Interna- tional Small Business Journal, vol. 23, no. 3, pp. 226-35.
This article focuses on the role of the entrepreneurialteam in industrial success. It argues that it is typically a myth to assume that the entrepreneur is a lone hero battling the storms of economic, government, social, and other environmental forces. These individuals play an important role in helping the venture through these external forces.
Ellentuck, Albert B. (October 2005). Converting a Sole Proprietorship into an LLC. Tax Adviser, vol. 36, no. 10, pp. 648-49.
This article presents a case study on the conversion of a sole proprietorship company to a limited liability company (LLC). It describes the filing information necessary and tax implications in the conversion.
Ellentuck, Albert B. (February 2009). Using a Limited Liability Partnership as the Entity of Choice. Tax Adviser, vol. 40, no. 2, pp. 124--25.
A case study regarding liability protection is presented in this article. The author notes that the limited liability partnership (LLP) or the registered limited liability partnership (RLLP) are very similar to the limited liability company (LLC). LLPs evolved because of the persona/liability issues faced by partners in law and accounting firms. The article also lists the states where the LLP liability protection is similar to that afforded to LLC members.
Feltham, Tammi S.; Glenn Feltham; and James J. Barnett. (January 2005) . The Depen- dence of Family Businesses on a Single Decision-Maker. Journal of Small Business Man- agement, vol. 43, no. 1, pp. 1-15.
This study focuses on the implications of dependence on a single individual in fam- ily businesses. It suggests that family businesses are highly dependent on a single
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278 PART 3 FROM THE OPPORTUNITY TO THE BUSINESS PLAN
individual and that this dependence decreases with the age of the owner/manager and is significantly greater when the owner/manager's family has voting control. In addition, a number of other factors are noted as related to the degree of depen- dence on a single individual.
Fiegener, Mark K. (September 2005). Determinants of Board Participation in the Strate- gic Decisions of Small Corporations. Entrepreneurship: Theory & Practice, vol. 29, no. 5, pp. 627-50.
Agency, strategic choice, and cognitive perspectives are used to identify the condi- tions under which chief executive officers of small private corporations involve the board of directors in strategic decisions. Boards are more likely to participate in strategic decisions when the firm is larger, the board has a critical mass of outside directors, or CEO power is low.
Gesiko, Agnes. (November 2008). Structure Counts! The Tax Implications Arising from the Formation, Operation and Liquidation of C Corporations, S Corporations, Partner- ships and Limited Liability Companies. Corporate Business Taxation Monthly, vol.1 0, no. 2, pp. 39-49.
This is a very comprehensive article that describes the differences in each of the organization legal structures available to an entrepreneur. The article focuses on both the tax and non tax implications of each of these legal business entities. Included are also advantages and disadvantages of each.
Goold, Michael; and Andrew Campbell. (March 2002). Do You Have a Well-Designed Organization? Harvard Business Review, pp. 117-24.
Creating a new organizational structure is one of the toughest-and most politically explosive-challenges that an executive faces. This article provides nine tests of organization design, which can be used either to evaluate an existing structure or to create a new one. Using this framework will help make the process more rational, shifting it away from issues of personality and toward strategy and effectiveness.
Hilzenrath, David S. (August 23, 2008). Sarbanes-Oxley Upheld by Court as Constitu- tional. Washington Post, p. D1.
This article describes the recent case challenging the heart of the Sarbanes-Oxley Act. The court dismissed the attempt to eliminate the nonprofit board that is set up to audit and police the accounting firms that audit public companies. The chal- lengers argued that the accounting oversight is a drag on the economy and they plan to appeal the decision. The article also provides more insight regarding the purpose of Sarbanes-Oxley.
O'Brien, Jeffrey M. (February 2, 2009) . Zappos Knows How to Kick lt. Fortune, vol. 159, no. 2, pp. 54-60.
Tony Hsieh, CEO of Zappos, an Internet footwear retailer, promotes an upbeat cor- porate culture that emphasizes having fun and even acting weird. As the founder of a company that has become one of the best places to work, he stresses core val- ues that includes such tenets as be humble, create fun, and deliver service, to name a few. Even though he had to lay off 124 workers, he still managed a 5 percent mar- gin on net sales and has also been able to maintain a high level of enthusiasm among existing employees because of his corporate culture approach.
Sonnenfeld, Jeffrey A. (September 2002). What Makes Great Boards Great. Harvard Business Review, pp. 106-13.
In light of the recent meltdowns of many once-great companies, enormous atten- tion has been focused on the companies' boards. And yet a close examination of those boards reveals no broad pattern of incompetence or corruption. They passed the test that would normally be applied to ascertain whether a board of directors was likely to do a good job. This article argues that it is time for fundamentally new
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CHAPTER 9 THE ORGANIZATIONAL PLAN 279
thinking about how corporate boards should operate and be evaluated and that it is important to consider not only how the work of the board is structured but also how the board is managed.
Ward, John L.; and Corey Hansen. (July 2008). How To: Assemble a Board of Advisors, Inc., pp. 61-64.
This article provides some guidelines when there is a need to assemble a board of ad- visors. It begins with a determination of the venture's key success factors. The board members should be considered only if they fulfill the need to build the business. Thus, the experience should be consistent with the long-term goals of the venture.
1. SeeS. Greenhouse, "How Costco Became the Anti-Wai-Mart," New York Times (July 17, 2005), Section BU, p. 1; Jeff Chu, "Thinking Outside the Big Box," Fast Company (November 2008), pp. 128-32; "Costco Wholesale Corp-First Quarter Operating Results for Fiscal 2009," Market News Publishing Online (December 11, 2008); Mark Hamstra, II Jim Sinegal," Supermarket News (July 21, 2008), p. 56.
2. Daniel S. Kleinberger, "The Closely Held Business through the Entity-Aggregate Prism," Wake Forest Law Review (Fall 2005}, pp. 827-81.
3. Agnes Gesiko, "Structure Counts! The Tax Implications Arising from the Forma- tion, Operation and Liquidation of C Corporations, S Corporations, Partner- ships and Limited Liability Companies," Corporate Business Taxation Monthly (November 2008), pp. 39-49.
4. Zev Landau, "Recent Reform and Simplifications for S Corporations," CPA Journal (November 2005), pp. 46-50.
5. Gesiko, "Structure Counts!", pp. 39-42. 6. See Albert B. Ellentuck, "Using a Limited Liability Partnership as the Entity of
Choice," Tax Advisor (February 2009), pp. 124-25; and Andrew Rinn, "S Corpo- ration Planning Opportunities: More Than Meets the Eye," National Under- writer (October 6, 2008), pp. 32-33.
7. Robert M. DiGiantommaso, "LLC and LLP Issues for Small Privately Owned Busi- nesses," Tax Advisor (January 2005), pp. 24-25.
8. J. W. Lorsch, "Organization Design: A Situational Perspective," in J. R. Hackman, E. E. Lawler Ill, and L. W. Porter (eds.), Perspectives on Behavior in Organizations, 2nd ed. (Burr Ridge IL: McGraw-Hill/Irwin, 1983), pp. 439-47.
9. Steven T. Barnett, "Culture Is Critical to a Company's Success, II Seattle Post- lntelligencer (April 14, 2003), p. C1.
10. Chris Penttila, "Employee Benefits in Today's Economy," Entrepreneur (January 2009), pp. 51-55.
11 . David LaGesse, "Engine of Fun and Profit," U.S. News and World Report (October 31, 2005), p. 26.
12. Michael P. Kelly and Dona E. Roche-Tarry, "Reshaping Your Board for Hard Times," Corporate Board (March 9, 2009), p. 6.
13. David Worrell, "Board Relations," Entrepreneur (November 2008), p. 56. 14. Nicole Gull, "Assemble a Board of Directors," Inc. (October 2004), p. 102. 15. Stephanie N. Mehta, "Experts for Hire," Fortune Small Business (May 1, 2002), p. 67. 16. "Agiliance, Inc. Expands Board of Advisors," Business Wire (April1, 2008).
