How to Structure a New Enterprise

How to structure a new enterprise and capitalize it is fundamental to any new initiative. Whether it’s a business, not-for-profit, charity, NGO or foundation, you need a solid base to start from.

Here then are some things for you to consider:

-is this a sole proprietorship or a partnership?

-if it’s a partnership, remember, “There are two chairs in heaven waiting for the first two partners to get there and still like each other” so only go into business with people you like and trust

-if it’s an organization with social goals consider incorporating a non profit–it’s relatively inexpensive to do–much easier than incorporating and operating a charity or foundation, which have much more government oversight

-many for-profit businesses will eventually have some form of a non profit organization associated with them much as I did with the NHL’s Ottawa Senators, where the member club is (supposedly)

a for profit

business and the Ottawa Senators Foundation is a registered charity or what Tony Greco did with Greco Lean and Fit (for profit) and his Foundation to Fight Obesity in Children

-if you don’t want to be a sole proprietor or in a partnership, do you want to incorporate or form a limited partnership?

-do you want to have a co-venture agreement/shareholder agreement that specifies who does what, who brings what skills to the project, what each party’s rights and obligations are, and what to do in case of dispute, dissolution, change in control, sale (full or partial) or exit?

-how much money are you committing to the project?

-how much money is (are) your partner(s) committing to the project?

-do you want to be 50/50 partners (which can sometimes lead to deadlock)?

-if not, who should be the final decision maker?

-do you want investors?

-if so, how much do you want to raise?

-who are your target investors?

-is this something that angel investors or VCs would be interested in?

-if it’s a large number of investors you are looking for (ie, it’s a quasi public offering), do you need an officially sanctioned (by, for example, the SEC,
Securities and Exchange Commission, or OSC,
Ontario Securities Commission) offering memorandum?

-are you open to the possibility of having sponsors—how many sponsors can you think of, and how much are you going to ask each of them for? 

-in the US, it’s legals first and business second since it is such a litigious place

-in Canada, Australia, New Zealand and the EU, it’s often business first and legals second since they have many fewer lawyers per capita than the US

-KISS, keep things as simple as you can, but no simpler

-try not to spend a mini fortune on legal, accounting and other professional fees when setting up your new enterprise, which

can

not only put your startup at risk, it can cause lengthy delays

-have investors put in some of their funds in the form of debt so your founders’ equity is not unduly diluted

-get a coach (I’m available)

Here’s an example of one I just did for a learning game company; I changed the names and the amounts, but principals are the same:

Note that investors, in this instance, have put 90% of their funds in the form of sub-debt, ie, it ranks behind lead debt (often bank debt with a first place charge). 

This works for investors because: 

a) debt (even sub debt) is usually more secure than equity, 

b) they get some interest on the money (8% pa in this example),

c) there is a term to the debt–it matures in 5 years and is amortized over the term so each month they are getting some of their principal back, 

d) they nearly full exit after the sub debt matures, but still own a big chunk of the company with very little money left in (25% ownership), 

e) if they like and trust the entrepreneurs involved (Henry and Ed, and who would be crazy enough invest in any new enterprise where they don’t like or trust the principals?), they get (hopefully) decent returns on their debt and spectacular returns on their equity without having to put in a lot of time and work themselves,

f) if the entrepreneurs muck up, they can use security provisions of their debt instrument (usually much simpler to do than relying on provisions of a shareholder agreement) to change management (ie, kick Henry and Ed to the curb) or force a sale, dissolution or liquidation, 

g) upon sale, 

dissolution or liquidation, debt outranks equity, 

h) investors can insist that they be issued preferred shares, which outrank common shares, so again on 

sale, dissolution or liquidation, they get paid before the principals (Henry and Ed), 

i) pref shares can have dividend protection provisions (like no dividends on common shares without matching dividends on pref shares, but not the other way round so pref shares can be issued dividends without having to give common shareholders anything), 

j) when pref shares are redeemed, at least part of the funds are or can be tax free in the hands of investors, 

k) pref shares can have tag-along provisions–if an offer is made to buy commons shares, a similar offer has to be made to the pref share class.

Holy smokes this sounds great for investors, but what about for Henry and Ed?

We call this structure “Mad River” financing after one of the first deals we ever did using it–in where else–Mad River Mountain (that’s in Ohio). 

Well it’s great for Henry and Ed too because:

-it lets them keep 75% of equity for themselves

-think about it, they’ve gotten 75% of a business with a total capitalization of $500,000 (made up of equity, debt, sub-debt and bootstrap capital, ie, sponsorship money they raised) for just $30k

-if the project works, they’re in the money with an IRR (internal rate of return) that is off the charts (often 30%, 40% or even 100% or more)

-if it doesn’t, it’s on to the next big thing

-no structure is worth a bean if it doesn’t sell in the marketplace, ie, no sponsors, investors or lenders will back them so Henry and Ed have to be generous

-in fact, many entrepreneurs I know are even more careful/respectful of OPM than they are of their own money and these are the only type of entrepreneurs that 

sponsors, investors or lenders should back anyway

You will also note in the above example that Henry and Ed have pre-sold 3,000 games at $30 each. Maybe they did this via a crowdfunding platform or via old fashioned shoe leather (these days more email based than anything else). This is part of their capitalization plan, but you should know that the $90,000 they raised this way is impressed with a trust, ie, it shows up on their balance sheet as a liability. 

Huh? How can cash in your bank account be a liability?

It is and will remain that way until the service or product is delivered to the customer, whereupon it can be brought into revenue. So Henry and Ed can use the funds to launch their business, but not to buy themselves a fancier car, say, a nice beamer.

Lastly, sponsors usually put in money for two reasons: a) because of their CSR, corporate social responsibility goals and b) CPM, cost per thousand pair of eyeballs to advertise their products/services. So they usually ask for much less than investors or lenders do. In a way, it’s a free source of (bootstrap) capital.

@ profbruce

postscript: please also read–

https://profbruce.tumblr.com/post/125337410374/how-to-get-sponsors-for-practically-anything-how

https://profbruce.tumblr.com/post/131222512814/benefits-you-can-offer-sponsors

https://profbruce.tumblr.com/post/122074364799/registering-a-business-in-ontario-registering-a

https://www.eqjournal.org/?p=4119

E&OE