Startups 101

The Proper Uses of the Business Plan

June 2008

By Jon M. Garon*

This column is part of a series of book excerpts from Own It: The Law and Business Guide(tm) to Launching a New Business Through Innovation, Exclusivity and Relevance.

The business plan is not a "disclosure document" in the sense that it is not expected to provide the necessary warnings and disclosures regarding the risks associated with the start-up enterprise. The business plan does not have sufficient information to counsel a potential investor regarding the many risks associated with the investment or offering. The business plan should provide a comprehensive overview of the business and the business's potential for success.

In modern business transactions, however, all the information provided by the business owner must be accurate and truthful. Although it is not a disclosure document, neither should it be an investor's sales pitch. It should be accurate and as reasonably objective as the entrepreneur can draft it. Any material mistakes in the facts must be corrected, including statements which might have been true at the time the business plan was drafted but are no longer true because circumstances have changed. One common mistake in business plans is to highlight the success of one or two similar companies without acknowledging the risks associated in the field as a whole. Further, since the sophisticated investor understands these risks, the refusal to acknowledge the risks undermines the credibility of the business plan.

The business plan can, however, contain projections based on speculation. Acknowledging that projections are based on reasonable estimates and not on historical data is acceptable. Often business plans guarantee rates of returns. Again, these are wildly speculative statements and should be more thoughtfully described. The optimistic speculations can be included, so long as the reasoning for these enthusiastic statements is carefully described and balanced with more reasonable assumptions and projections. For example, a restaurant cannot base its revenue on the potential size of the population in the city it serves. Instead, it must base its potential revenue on the number of seats available in the facility and the number of seatings the restaurant hopes to achieve. Once the business plan provides this realistic calculation, it can list the revenue based on full capacity. It should, however, also calculate revenue based on a more conservative estimate of weekly customers and include the number of patrons necessary to break even.

Perhaps the most valuable aspect of the business plan process is the actual planning and exploration of building the business. There are many software products now available to assist entrepreneurs in the creation of their business plans. These may be particularly helpful to the extent that they ask questions of the key personnel and provide financial documents and forms.

The software products carry a significant risk, however, of oversimplifying the questions to be answered. The software should only be used to help write the plan rather than to write the plan. The Federal Small Business Administration and the various state SBAs have links to many sample business plans that can help generate ideas for the entrepreneur's plan. Reading these plans should create questions for the entrepreneur to answer.

The business plan should be drafted as a collaborative exercise. Unless the company will start as a one-person operation, the entrepreneur should be discussing the sections of the business plan with the other key personnel at each stage of the development process. On many occasions, potential key personnel will read draft provisions in the business plan and withdraw from the project or renegotiate the relationship. This means the plan is working. A business is extremely vulnerable if the key personnel are not in agreement regarding their roles in the business's development.

One key use of the business plan is to build a consensus around the business, its goals and its measures of success. If the key personnel cannot reach this consensus, the business will not succeed. In contrast, a business operating with strong internal agreement and a common vision has a much greater chance of weathering the inevitable challenges.

Entrepreneurs generally assume that the primary use of the business plan is to serve as an informational calling card for prospective investors. This assumption overstates the role of the business plan and the effect provisions on financing structure will have on the ultimate structuring of the company.

Nothing in the business plan will stop a potential investor from making an offer different from the proposal put forth by the entrepreneur. Invariably, the offer (when it comes using other documents) will be treated as an invitation to negotiate. Only when there are multiple outstanding offers and a commitment to treat all investors exactly the same will there be no negotiations. Even in this case, the offerees may ask to negotiate. It will simply be harder for the entrepreneur to accommodate them.

In addition there are strict legal limitations on the offering of business interests for sale. The business interests are a form of security, and subject to both state and federal law. As a result, the investors use the business plan to assess the logic of the business operation, the ability of the management to deliver on its promises, underlying market assumptions made by the entrepreneur and the financial status of the proposal. Investors do not rely on the business plan to define the investment offer.

In many ways, the investors are seeking precisely the same information as are the key personnel. They want to know that the investment makes sense. For investors, the question is generally asked at two different levels. First, whether the company has a reasonable chance to deliver what it promises, and if it has taken all reasonable steps to mitigate the risks inevitably associated with the business.

Second, the business must meet the strategic financial objectives of the investor. The potential for a high rate of return and the degree of risk must be introduced. These are highly speculative aspects of the business, so they must be described in much greater detail in the financial offering documents, but the broad, general hopes of the entrepreneur must be described in the business plan and the investor must find the description credible. If the investor does not believe the entrepreneur's projections, the likelihood of any investment becomes extremely low. Similarly, the investor may wish to make a quick return, or may be willing to participate in the enterprise for a much longer period of time. The so-called exit strategy of the investor must coincide with the expectations of the entrepreneur. Closely related, the liquidity of the investment — the ability for the investor to sell his interest — must be understood on the same terms by both investor and entrepreneur. Taken together, these financial expectations must be sufficiently described in the plan, so that the investor remains interested, without providing so much detail that the plan constitutes an offer to sell securities.

Finally, the investor will assess the business opportunity against other opportunities from other entrepreneurs. Here, the question is whether this business plan will better use the investor's resources in the marketplace than the other available opportunities. This comparative analysis is often referred to as the opportunity cost of the investment. The money invested in this enterprise cannot be used in other enterprises. Unless the business plan is financially sound, the economic reward sufficient and the goals of the investor are consistent with the goals of the entrepreneur in terms of liquidity, length of investment and rates of return, there will be no match. In such cases, the entrepreneur is better off waiting rather than taking the money of an investor whose goals are at odds with the business plan.

This is part of a series of book excerpts from Own It: The Law and Business Guide(tm) to Launching a New Business Through Innovation, Exclusivity and Relevance, which provides a step-by-step guide to developing successful start-up companies using concepts of intellectual property in all aspects of business planning and financing.

* Jon M. Garon is admitted in New Hampshire and California.

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