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www.downloadslide.com Book VI Planning and Budgeting for Your Business Managing inventory can boost profits. Discover various strategies for managing inventory cost-effectively by visiting www.dummies.com/extras/accountingaio for free guidance. www.downloadslide.com In this book… ✓ Structure a business to attract capital and issue stock shares to raise capital. Find out more about what potential investors really want to see in a company’s financials. ✓ Choose the appropriate legal structure for a business — sole-proprietorship, partnership, LLC, C-corp., S-corp., or something else. The right legal structure provides valuable legal protection and potential tax savings. ✓ Draft a business plan that increases your chances of securing loan approval or attracting eager investors. Tell your company’s growth story to prospective shareholders. ✓ Build a budget to help executives and managers make better business decisions and boost their organization’s bottom line. Budgeting not only keeps your business on track financially but also helps inform spending decisions so you get the most bang for your buck. ✓ Tweak your budget to accommodate different levels of production and other potential variables. Play “what-if” with different production and product-development scenarios to plan production and sales and maximize profit. ✓ Get a handle on long-term debt to reduce interest and improve cash flow. Make informed decisions about how much cash your business needs to operate and how much of that cash you’ll generate through debt. www.downloadslide.com Chapter 1 Incorporating Your Business In This Chapter ▶ Structuring the business to attract capital ▶ Taking stock of the corporate legal structure ▶ Issuing and managing stock shares T he obvious reason for investing in a business rather than putting your money in a safer type of investment is the potential for greater rewards. Note the word potential. As an owner of a business, you’re entitled to your fair share of its profit, as are the other owners. At the same time, you’re subject to the risk that it could go down the tubes, taking your money with it. Ignore the risks for a moment and look at just the rosy side of the picture: Suppose the doohickeys that your business sells become the hottest products of the year. Sales are booming, and you start looking at buying a fivebedroom mansion with an ocean view. Don’t make that down payment just yet — you may not get as big a piece of the profit pie as you’re expecting. Some claims to that profit may rank higher than yours, and you may not see any profit after all these claims are satisfied, because the way the profit is divided among owners depends on the business’s legal structure. This chapter shows how legal structure determines your share of the profit — and how changes beyond your control can make your share less valuable. Securing Capital: Starting with Owners Every business needs capital. Capital provides money for the assets a business needs to manufacture products, make sales, and carry on operations. Common examples of assets are the working cash balance a business needs for day-to-day activities, products held in inventory for sale, and long-life operating assets (buildings, machines, computers, office equipment, and so on). www.downloadslide.com 350 Book VI: Planning and Budgeting for Your Business Assume a typical business in your industry needs capital equal to one-half of annual sales revenue. You would plan your financing efforts to raise that amount of capital. Of course, this ratio varies from industry to industry. Many manufactures need a high ratio of capital to sales, so they’re described as being capital intensive. One of the first questions that providers of business capital ask is how the business entity is organized legally. That is, which specific form or legal structure is the business using? The different types of business legal entities present different risks and potential rewards to business capital providers. Whatever its legal structure, a business gets the capital it needs from two basic sources: debt and equity. Debt refers to the money borrowed by a business, and equity refers to money invested in the business by owners plus profit earned and retained in the business (instead of being distributed to its owners). No matter which type of legal entity form it uses, every business needs a foundation of ownership (equity) capital. Owners’ equity is the hard-core capital base of a business. In starting a new business from scratch, its founders typically must invest a lot of sweat equity, which refers to the grueling effort and long hours to get the business off the ground and up and running. The founders don’t get paid for their sweat equity, and it doesn’t show up on the balance sheet. Contrasting two sources of equity Every business — regardless of how big it is, whether it’s publicly or privately owned, and whether it’s just getting started or is a mature enterprise — has owners. Virtually no business can get all the capital it needs by borrowing. Your firm can obtain equity financing from two sources: ✓ Investors: Outside investors can provide the business with both start-up and a continuing base of capital, or equity. ✓ Owners: The firms’ founders may provide their own capital in exchange for equity. Without the foundation of equity capital, a business wouldn’t be able to get credit from its suppliers and couldn’t borrow money. As they say in politics, the owners must have some skin in the game. Considering what investors want The equity capital in a business always carries the risk of loss to its owners. So, what do the owners expect and want from taking on this risk? Their expectations include the following: ✓ Share in profits: They expect the business to earn profit on their equity capital in the business and to share in that profit by receiving cash distributions from profit and from increases in the value of their ownership shares, with no guarantee of either. www.downloadslide.com Chapter 1: Incorporating Your Business 351 ✓ Participate in management: They may expect to directly participate in the management of the business, or they may plan to hire someone else to manage the business. In smaller businesses, an owner may be one of the managers and may sit on the board of directors. In very large businesses, however, you’re just one of thousands of owners who elect a representative board of directors to oversee the managers of the business and protect the interests of the non-manager owners. ✓ Share in sales proceeds: Looking down the line to a possible sale of the business or a merger with another business, they expect to receive a proportionate share of the proceeds if the business is sold or to receive a proportionate share of ownership when another company buys or merges with the business. Or they may end up with nothing in the event the business goes kaput and nothing’s left after paying off the creditors. When owners invest money in a business, the accountant records the amount of money as an increase in the company’s cash account. And, using doubleentry accounting, the amount invested in the business is recorded as an increase in an owners’ equity. (See Book I, Chapter 2 to find out about doubleentry accounting.) Owners’ equity also increases when a business makes profit. See Book IV, Chapter 2 for more on why earning profit increases the amount of assets minus liabilities, which is called net worth, and how this increase in net worth (due to profit) is balanced by recording the increase in owners’ equity. Dividing owners’ equity Certain legal requirements often come into play regarding the minimum amount of owners’ capital that a business must maintain for the protection of its creditors. Therefore, the owners’ equity of a business is divided into two separate types of accounts: ✓ Invested capital: This type of owners’ equity account records the amounts of money that owners have invested in the business, which could have been many years ago. Owners may invest additional capital from time to time, but generally speaking they can’t be forced to put additional money in a business (unless the business issues assessable ownership shares, which is unusual). Depending on the legal form of the entity and other factors, a business may keep two or more accounts for the invested capital from its owners. ✓ Retained earnings: The profit a business earns over the years that has been retained and not distributed to its owners is accumulated in the retained earnings account. If all profit is distributed every year, retained earnings has a zero balance. (If a business loses money, its accumulated loss causes retained earnings to have a negative balance, which generally is called a deficit.) If none of the annual profits of a business are distributed to its owners, the balance in retained earnings is the cumulative profit the business has earned since it opened its doors (net of any losses along the way). Book VI Planning and Budgeting for Your Business www.downloadslide.com 352 Book VI: Planning and Budgeting for Your Business Whether to retain part or all of annual net income is one of the most important decisions that a business makes; distributions from profit have to be decided at the highest level of a business. A growing business needs additional capital for increasing its assets, and increasing the debt load of the business usually can’t supply all the additional capital. So, the business plows back some of its profit for the year into the business, rather than distributing it to its owners. In the long run, this may be the best course of action, because it provides additional capital for growth. Leveraging equity capital with debt Leverage refers to the idea of using debt to add capital to your business. Leverage is a good strategy if the company can generate more in earnings than it pays in interest expense and fees on the debt. If a business is interested in leverage, the first consideration is how much of the balance sheet should include debt. Suppose a business has $10 million in total assets. ( You find assets in the balance sheet of a business — see Book IV, Chapter 3.) The balance sheet equation (in Book I, Chapter 1) is Assets less Liabilities equals Equity. $10 million in total assets doesn’t mean that the company has $10 million of equity. You have to subtract liabilities from assets to compute equity. Assuming the business has a good credit rating, it probably has some amount of trade credit extended for purchases, which is recorded in the accounts payable liability account (see Book IV, Chapter 4). Other kinds of operating liabilities may also come into play. Suppose its accounts payable and other operating liabilities total $2 million. At this point, you’ve identified $10 million in total assets, less $2 million in liabilities. That leaves $8 million to account for. The $8 million could represent other liabilities. Some of the $8 million may be equity. In a sense, you’re filling in the numbers in the balance sheet equation: $10 million total assets – $2 million liabilities = $8 million to be identified (either more liabilities or equity) Some businesses depend on debt for more than half of their total capital. In contrast, others have virtually no debt at all. You find many examples of both public and private companies that have no borrowed money. But as a general rule, most businesses carry some debt (and therefore, have interest expense). The debt decision isn’t really an accounting responsibility as such; although once the decision is made to borrow money, the accountant is very involved in recording debt and interest transactions. Deciding on debt is the responsibility of the chief financial officer and chief executive officer of the business. www.downloadslide.com Chapter 1: Incorporating Your Business 353 In medium-sized and smaller businesses, the chief accounting officer (controller) may also serve as the chief financial officer. In larger businesses, two individuals hold the top financial and accounting positions. The loan contract between a business and its lender may prohibit the business from distributing profit to owners during the period of the loan. Or the loan agreement may require that the business maintain a minimum cash balance. Generally speaking, the higher the ratio of debt to equity, the more likely a lender is to charge higher interest rates and insist on tougher conditions. That’s because the lender has higher risk that the business may default on the loan. A high debt-to-equity ratio means the company has more debt for every dollar of equity. When borrowing money, the president (or another officer in his or her capacity as an official agent of the business) signs a note payable document to the lender. In addition, the lender may ask the major investors in a smaller, privately owned business to guarantee the note payable of the business as individuals in their personal capacities — and it may ask their spouses to guarantee the note payable as well. The individuals may endorse the note payable, or a separate legal instrument of guarantee may be used. The individuals promise to pay the note if the business can’t make payments. You should definitely understand your personal obligations if you’re inclined to guarantee a note payable of a business. You take the risk that you may have to pay some part or perhaps the entire amount of the loan from your personal assets if the business is unable to honor its obligation. Recognizing the Legal Roots of Business Entities The U.S. legal system enables entities to be created for conducting business activities. These entities are separate and distinct from the individual owners of the business. Business entities have many of the rights of individuals; for example, the rights to own property and enter into contracts. In starting a business venture, one of the first tasks the founders must attend to is to select the type of legal structure to use — which usually requires the services of a lawyer who knows the laws of the state in which the business is organized. A business may have one or more owners. A one-owner business may choose to operate as a sole proprietorship, a limited liability company, or a corporation; a multi-owner business must choose to be a partnership, a limited liability company, or a corporation. The most common type of business is a corporation (although the number of sole proprietorships would be larger if part-time, self-employed people were included in this category). No legal structure is inherently better than another; which one is right for a particular Book VI Planning and Budgeting for Your Business www.downloadslide.com 354 Book VI: Planning and Budgeting for Your Business business is something that the business’s managers and founders need to decide when starting the business. The following discussion focuses on the basic types of legal entities that owners can use for their business. Incorporating a Business The law views a corporation as a real, live person. Like an adult, a corporation is treated as a distinct and independent individual who has rights and responsibilities. (A corporation can’t be sent to jail, but its officers can be put in the slammer if they’re convicted of using the corporate entity for carrying out fraud.) A corporation’s “birth certificate” is the legal form that it files with the Secretary of State of the state in which the corporation is created (incorporated). A corporation must also have a legal name. You’re not allowed to use certain names, such as the State Department of Motor Vehicles. Consult a lawyer when choosing a name for your corporation. The corporate legal form offers several important advantages. A corporation has unlimited life; it stays alive until the shareowners vote to terminate the entity. The ownership interests in a corporation, specifically the shares of stock issued by the corporation, are generally transferable. You can sell your shares to another person or bequeath them in your will to your grandchildren. You don’t need the approval of the other shareholders to transfer ownership of your shares. Each ownership share typically has one vote in the election of directors of a business corporation. In turn, the directors hire and fire the key officers of the corporation. This provides a practical way to structure the management of a business. Just as an adult child is an entity separate from his or her parents, a corporation is separate from its owners. For example, the corporation is responsible for its own debts. Assuming you didn’t cosign for one of your parents’ loans, the bank can’t come after you if your parents default on their loan, and the bank can’t come after you if the corporation you invested money in goes belly up. If a corporation doesn’t pay its debts, its creditors can seize only the corporation’s assets, not the assets of the corporation’s owners. This important legal distinction between the obligations of the business entity and its individual owners is known as limited liability — that is, the limited liability of the owners. Even if the owners have deep pockets, they have no legal exposure for the unpaid debts of the corporation (unless they’ve used the corporate entity to defraud creditors). The legal fence between a corporation and its owners is sometimes called the “corporate shield” because it protects the owners from being held responsible for the debts of the corporation. So when you invest money in a corporation as an owner, you know that the most you can lose is the amount you put in. You may lose every dollar you put in, but the corporation’s creditors can’t reach through the corporate entity to grab your assets to pay off the business’s liabilities. (But to be prudent, you should check with your lawyer on this issue to be sure.) www.downloadslide.com Chapter 1: Incorporating Your Business 355 Issuing stock shares When raising equity capital, a corporation issues ownership shares to people who invest money in the business. These ownership shares are documented by stock certificates, which state the name of the owner and the number of shares. (An owner can be an individual, another corporation, or any other legal entity.) The corporation has to keep a register of how many shares everyone owns. Many public corporations use an independent agency to maintain their ownership records. Stock shares are commonly issued in book entry form, which means you get a formal letter (not a stock certificate) attesting to the fact that you own so many shares. Your legal ownership is recorded in the official books, or stock registry of the business. The owners of a corporation are called stockholders because they own stock shares issued by the corporation. The stock shares are negotiable, meaning the owner can sell them at any time to anyone willing to buy them without having to get the approval of the corporation or other stockholders. Publicly owned corporations are those whose stock shares are traded in public markets, such as the New York Stock Exchange and NASDAQ. The stockholders of a private business have the right to sell their shares, although they may enter into a binding agreement restricting this right. For example, suppose you own 20,000 of the 100,000 stock shares issued by the business. You have 20 percent of the voting power in the business (one share, in this case, has one vote). You may agree to offer your shares to the other shareowners before offering the shares to someone outside the present group of stockholders. Or you may agree to offer the business itself the right to buy back the shares. In these ways, the continuing stockholders of the business control who owns the stock shares of the business. Offering different classes of stock shares Before you invest in stock shares, you should ascertain whether the corporation has issued just one class of stock shares. A class is one group, or type, of stock shares all having identical rights; every share is the same as every other share. A corporation can issue two or more classes of stock shares. For example, a business may offer Class A and Class B stock shares, giving Class A stockholders a vote in elections for the board of directors but not granting voting rights to Class B stockholders. State laws generally are liberal in allowing corporations to issue different classes of stock shares. A whimsical example is that holders of one class of stock shares could get the best seats at the annual meetings of the stockholders. But whimsy aside, differences between classes of stock shares are significant and affect the value of the shares of each class of stock. Book VI Planning and Budgeting for Your Business www.downloadslide.com 356 Book VI: Planning and Budgeting for Your Business Common stock and preferred stock are two classes of corporate stock shares that are fundamentally different. Here are two basic differences: ✓ Fixed dividend amount: Preferred stockholders are promised (though not guaranteed) a certain amount of cash dividends each year, but the corporation makes no such promises to its common stockholders. (The company must generate earnings to pay any type of dividend, including dividends on preferred stock.) Each year, the board of directors must decide how much, if any, cash dividends to distribute to its common stockholders. ✓ Claims on assets: Common stockholders have the most risk. A business that ends up in deep financial trouble is obligated to pay off its liabilities first and then its preferred stockholders. By the time the common stockholders get their turn to collect, the business may have no money left to pay them. In other words, the common shareholders are last in line to make a claim on assets. Neither of these points makes common stock seem very attractive. But consider the following points: ✓ Preferred stock shares are promised a fixed (limited) dividend per year and typically don’t have a claim to any profit beyond the stated amount of dividends. (Some corporations issue participating preferred stock, which gives the preferred stockholders a contingent right to more than just their basic amount of dividends. This topic is too technical to explore further in this book.) ✓ Preferred stockholders may not have voting rights. They may not get to participate in electing the corporation’s board of directors or vote on other critical issues facing the corporation. The advantages of common stock, therefore, are the ability to vote in corporation elections and the unlimited upside potential: After a corporation’s obligations to its preferred stock are satisfied, the rest of the profit it has earned accrues to the benefit of its common stock. Although a corporation may keep some earnings as retained earnings, a common stock shareholder may receive a much larger dividend than a preferred shareholder receives. Here are some important points to understand about common stock shares: ✓ Each stock share is equal to every other stock share in its class. This way, ownership rights are standardized, and the main difference between two stockholders is how many shares each owns. ✓ The only time a business must return stockholders’ capital to them is when the majority of stockholders vote to liquidate the business in part or in total. Otherwise, the business’s managers don’t have to worry about stockholders withdrawing capital. If one investor sells common stock to another shareholder, the company’s capital balance is unchanged.