Does Your (Small) Business Need a Physical?

Introduction

Just like you, your business needs a periodic physical to prevent future problems and determine if there is anything wrong that needs fixing.

If yours is like the vast majority of businesses, it hasn't had a "physical" since the day it was born. It is easy to give birth to a business. It can be formed with a handshake or an informal verbal agreement. Some businesses may require a bit more formality, like filing articles or other formative documents with the secretary of state. But overall, the process of forming a business can be deceptively easy. This ease of formation situation can lead to a sense that everything has been done that is necessary to get the business started and the only thing that needs to be done is to start doing whatever the business does to make money.

This belief will often lead the business on a dangerous course that could destroy not only the business but its owners as well. The purpose of this article is to prevent this from happening. This article speaks primarily to businesses other than sole proprietorships.

Business that have not had an initial examination and periodic examinations thereafter run the risk of damaging attacks from creditors, disgruntled customers, government agencies, divorcing spouses, angry co-owners, just to name a few. If you did not complete all the steps required to establish your business completely and have not kept your business records and actions up to date, your risk increases significantly.

Your First Physical

Your first physical should occur at or just after your business is officially born. It will help assure that your business will get a good start.

What should happen at this first exam?

During the first exam, the "incorporator" will transfer control of the business to you, the initial managers, directors, and officers will be selected. The owners will review the business partnership agreement, LLC operating agreement or bylaws. These documents should be carefully reviewed because you and your business will have to follow them. Often new business owners will not read these documents and may be attacked later for not following them by creditors, government agencies, customers, and supplies. Yes, they can be confusing or even boring, but don't let that stop you from reading them.

Recently a potential client told us that she was being sued be her former fiancé. She stated that the fiancé had purchased two homes through her as real estate broker. They formed an LLC and transferred the homes into it. They did not have an operating agreement, they had no organizational meeting, no buy/sell agreement, and no llc minutes. Now the fiancé is suing for damages based on fraud, misrepresentation, and the potential client is counter-suing. Both parties have a difficult battle ahead because they have little written evidence to support either case. A proper physical would have gone a long way toward preventing this dispute and the misery and expense that will result from it.

Also at your initial physical, you should identify your chosen bank, accountant, and legal counsel.

If you are a corporation and you want to elect S Corporation status, you should do that now and complete form 2533 and approve it.

You should also review and complete your initial capital contributions to start your business. Before you actually formed the company, the prospective owners should state what will contribute to start and fund the business. This is done using a subscription agreement. Each prospective equity holder must determine what they will contribute to start the company, if property other than cash is contributed, then its fair market value must be determined. Sometimes this is not an easy task and can be expensive.

At the organizational meeting, you should issue membership interests and record them in your company ledger. If you have more than one owner, make sure that the president and treasurer are not the same person since it is not allowed.

There are several other less important tasks that must be accomplished at the first physical, but I think you get the idea. There is a lot that needs to be done other than just filing your formative documents. Failure to complete the organizational physical can cause serious problems down the road.

The Second Physical

Once the business is formed and organized, you can't stop getting your annual physical. Within a short period after organizing, other things need to be accomplished. Face it, you can never completely let the business run itself. There will always be routine maintenance to perform.

Shortly after you organize your business, you should consider drafting a buy/sell agreement for the business owners. Most business owners do not have a buy/sell agreement yet. It is an extremely important document. It will provide a method for sale or other transfer and valuation of owners' equity interests. It can provide protection for the business from prior owners and the use of business technology and know-how.

During the first year, you may be called upon to file a business information statement for the secretary of state, listing current business ownership and location. This form can be completed by a check mark on a small card and mailing to the secretary of state, a seemingly very small task. If, however, it is not done on time, your entity can lose its right to do business, its limited liability protection, its name, its ability to sue or defend a lawsuit. A disaster for your business! Small actions or inactions can have huge consequences!

I know how disastrous such a "small" omission can be. A long standing client whose office had filed this statement religiously for over eleven years, did not file on time last year. Their company was suspended. Unfortunately for the company, they were facing possible litigation. The potential plaintiff found out that my client was on suspended status and took my client's name demanding it stop conducting business in California under its name. Also, if my client was sued, he would be unable to defend a lawsuit. The owners lost limited liability and would be personally liable for the company's action while suspended. The failure to check a box on a small information card could have destroyed the company and its owners. Only through considerable effort and money was the client able to survive.

Also during your first year, don't forget to keep records of all important actions you take throughout the year. These actions should also be approved by owners. Failure to do this can give someone attacking your limited liability ammunition.

Conclusion

The taking of actions and certain preparation of documents discussed above are some of the major ones you should have checked at your organizational and first annual physicals. If you haven't done these things, it may not be too late to recover. Have your organizational meeting, update your minutes, complete your bylaws, or operating agreement before it is too late.

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