No. 19: Building a Business Around Equity (Part 2 of 2)

Many Professional Service owners begin as forces of one, and if not as an actual sole proprietorship, then a single owner S-Corporation or LLC. From this point on, I’ll refer to the preferred entity structure as “Newco, LLC”, or “Newco” since it can basically adapt to any cash flow or tax structure, upon election, that an owner desires. As I outlined in Part 1 of Building a Business Around Equity, at some point early in the process, a seismic shift must occur in which the assets of the individual entrepreneur or service provider are legally transferred into Newco.   

Think about this as moving from owning a book, or a practice to owning and building a business, or at least one of the major steps in that process. The assets of a Professional Services sole proprietorship are basically these, regardless of the profession one is engaged in:

(a) the clients being served

(b) the annualized cash flow generated from serving the clients

(c) any tangible property (the physical tools of the trade or profession, whatever they may be), and

(d) goodwill.

Sometimes there may be intellectual property of appraisable value as well. Collectively, we refer to these as your Capital Assets.

Using a series of legal agreements, all rights, title and interest in the Capital Assets of the individual owner(s) are transferred into Newco in exchange for a proportional amount of equity. Newco then becomes the legal owner of those assets, including all future related revenue. The contributor or contributors become shareholders of Newco. All of this typically happens privately, quietly, and without government oversight or input when setting up a new LLC, and/or having it file a tax election as either a DE (Disregarded Entity for one owner) or a Partnership (for two or more owners). And at this point in the starting process, everything changes!

To further delve into this important concept, consider Newco’s decision to be taxed as a DE or Partnership, with 1,000,000 authorized voting shares in a single class—as we apply corporate attributes to Newco to simplify this process. The lone contributing owner in this example, Bob, moves from individual or sole proprietor to shareholder with his conveyance of his Capital Assets to Newco. Now, Bob owns 1,000,000 authorized and issued shares of voting stock and Newco owns all the Capital Assets.

An appraiser can now value the Capital Assets that Newco legally holds and effectively determine a price per share. If the Business is valued at $2,500,000, for example, then each share of stock that Bob owns is objectively worth $2.50/share. This is the first step in building a Business that is valuable and investable.

It is also possible, even likely in a Professional Services model, that several affiliated individuals or Book owners, could simultaneously make such contributions into Newco upon its set-up, effectively resulting in a quasi-merger of those individual Books via a series of tax-neutral exchanges. In such a case, Newco now owns all the contributed Capital Assets with each contributor owning Equity, proportionally, in Newco in exchange. Newco might begin operations with two, three or four partners at one time. In most cases, this exchange process can be accomplished with no cash payments being involved, or any tax consequences to the participants, if the rules are carefully followed.

The point is not to impress upon you that these maneuvers are easy. They are not. But these are common building blocks in the world of business building for PSP’s and you need to know how the mechanics work to even ask the right questions of your legal and tax counsel. If you know enough to ask, an answer can usually be found.

This is the first step in building a valuable, profitable, investable and sustainable business – an Equity-Centric business!

Thanks for reading,

David Sr.