By Derek Larsen-Chaney and Jason Pill, Attorneys with Phelps Dunbar, LLP

Part 1 of CBJ’s series on corporate expansion looked broadly at the reasons for internal or external expansion of a climbing gym, and Part 2 discussed the options for external expansion, including mergers and acquisitions. In Part 3, the final part of the series, attorneys Derek Larsen-Chaney and Jason Pill explore the liability implications when expanding a gym across state lines, and they conclude the series with final takeaways on the question of expansion.

Expanding a Corporation

States encourage most new businesses to begin operations in their state, so the process to relocate or expand is typically not onerous. Corporations expanding into another state have multiple options available to them. If you wish to expand your operations into an additional state while continuing to operate in your home state, you must register as a foreign corporation doing business in the new state. This typically requires submitting a brief application with the new state’s division of corporations. The new state will want to confirm that your company is in good standing in its home state before allowing it to operate within the new state’s borders. If you wish to move the corporation and its operations from one state to another, you will need to complete a process called domestication, which requires a handful of forms to be submitted in both states. Or, you may form a corporation in the new state and have the old corporation merge into it, a process referred to as reorganization. You are responsible for paying duplicative annual report and/or franchise taxes if you maintain the old corporation and register to do business in a new state. However, reorganization for a C corporation can be entirely tax-free since there is no tax on the merger, but only if you choose to have the merged corporation not recognized in its original state. In this case, there may still be liquidation issues which result in income taxes being imposed on the corporation and its shareholders.

Key Considerations: The most important issue to be aware of when expanding a corporation across states is that operating in multiple states may expose you to being sued in multiple jurisdictions. An entity can be sued in its home state, regardless of where a cause of action occurs, so you may be forced to defend a lawsuit far from your new location. This risk would be diminished if you can stop liabilities from flowing from one location to another by operating each location as its own dedicated entity. You will also need to make yourself familiar with the corporation laws of each state in which you do business. Annual filing and tax fees vary wildly from state to state.

Expanding an LLC

Like corporations, LLCs have the option to continue in the old state and register as a foreign LLC in the new state. Similarly, this would result in duplicate reporting and tax fees. By contrast, there are no federal tax consequences for liquidating an LLC. LLCs are known as pass-through entities and, therefore, are not required to report any gain from liquidation. Unlike expanding a corporation through a merger, forming an LLC in the new state and merging the existing LLC into it—or domesticating the existing LLC in a new state—is viewed as a continuation of the old LLC. Provided the LLC members from the old state continue to own at least a 50% interest in the capital and profits of the LLC in the new state, there will be no immediate tax consequences.

Key Considerations: As with corporations, it is typically considered “best practice” to hold locations in separate entities—one LLC for Tampa operations and another for Denver operations, for example. Doing so minimizes the risk of liabilities stemming from operations at one location—an injury to a customer or employee, or other—from attaching to another location. In all instances, for both LLCs and corporations, in order to enjoy the personal liability protection and the protection of one entity from another, it is imperative to follow all requisite formalities, including avoidance of comingling of funds, so that there is a clear line between owners and entities. Creating and maintaining separate LLCs can be a cumbersome organizational endeavor, and each entity will require its own corporate records, operational documents and bank accounts. But this separation can also be beneficial for payroll, tax, and regulatory purposes, since those matters may be distinct from state to state.

Making a Decision

Some owners of small businesses choose not to expand—sometimes because they started their small business with the intention of remaining small so they could maintain their close connections with customers and employees and be free from the burdens of wide administrative management. Remaining small has some perks, such as keeping loyal customers, maintaining control, and reducing expenses spent on additional employees and facilities. Not to mention, choosing not to expand provides business owners schedule flexibility to devote time to family and other interests (like climbing) that may otherwise be allocated to expansion efforts. However, even without the desire to expand, the inability to manage rapid business growth may lead to dissatisfied customers, mismanagement of profits, a damaged reputation and, possibly, a need to close the business. For example, if a gym experiences unplanned growth, it is almost inevitable that it will also experience periods of crowdedness and receive customer complaints, which may include a demand for a new facility. Staying the course is not always possible.

Business owners often take a great deal of time before making the decision to expand, but too often owners reflect on their own independent and private desires when making the decision. Ultimately, the decision should be based on the betterment of the business, not personal aspirations. Sometimes business growth demands expansion, while other times businesses need to remain small in order to succeed. We conclude this series on corporate expansion by providing broad takeaways to consider when deciding whether to expand your climbing gym.

The biggest benefit of expanding is brand exposure. More locations can result in an increase in revenue and, at a certain point, a reduction in overhead costs. This leads to another benefit: the financial ability to introduce new products and services to your customers (you can finally try that organic juice bar you’ve been thinking about for years). New locations can also enable you to target new communities, and expansion can lead to greater efficiency and economies of scale which allow you to undercut your competitors in those communities. Expansion can also put you a step ahead of the competition when customers who typically would not have used your services because of distance now make use of your brand-new gym nearby. Similarly, if you expand through mergers with a former competitor, you can diminish your competition outright.

One of the most critical challenges with expansion is money. Expansion can be expensive no matter which expansion strategy you use. In addition, expansion calls for a new demand on management that includes more pressure to perform proactively. If service quality drops, you may lose customers to competitors, and staff turnover may increase due to the heavy workloads. Expansion can also lead to a weakened business culture for owners when they must allocate their time to multiple locations, which may strain their relationships in the original local community.

The decision to expand is a critical decision facing every successful climbing gym owner, and every choice comes with perils. Expansion, therefore, must always be deliberate and methodical.

Note: The content of this article is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. The reading of or reliance on this article or the Climbing Business Journal’s web site does not create an attorney-client relationship between the author or the Climbing Business Journal and the user or reader.

By Derek Larsen-Chaney and Jason Pill, Attorneys with Phelps Dunbar, LLP

Part 1 of CBJ’s series on corporate expansion surveyed some of the underlying reasons for expansion and identified external expansion as a costlier—but ultimately quicker—route for business growth than internal expansion. Part 2 takes a closer look at the main types of external expansion, exploring the pros and cons and providing industry examples of each option.

Merger

In a merger, two or more separate companies mutually agree to the formation of a new single company. Typically, the companies are similar in size and share common goals, including the goal of expansion. After the merger, the companies operate as a new entity and share ownership, profit, and control. Sometimes the new entity will have a new name, keep one of the company names, or take on a combination of the two. If one of the companies is more reputable, merging companies may choose to operate under this brand name. A climbing gym brand wanting to expand by means of a merger may seek out another like-minded and well-known gym chain.

Example: In 2018, the two popular climbing gym chains Earth Treks—based in Maryland—and Planet Granite—based in California—merged to form the parent company El Cap.

Pros: Combined resources of two (or more) established companies, often united in a friendly business environment. The merger should allow the new entity to gain an instant presence in a broader market or reduce competition in the same market. Ideally, the merger expands the footprint of the joint enterprise and results in more efficient and complementary gym operations.

Cons: Accepting the weaknesses of each company—debt, damaged reputation, etc. There may also be employee and location redundancies that need to be addressed post-merger.

Acquisition

An acquisition consists in the purchasing of one company by another company. The company that acquires the other company is known as the acquiring company, while the acquired company is considered the target company. The target company is almost always smaller in size, structure, finance and operations than the acquiring company. There are two forms of acquisition: acquiring ownership of over 51 percent of the target company’s share capital or purchasing all the assets of the target company. The former is less common in the climbing gym industry because few gyms (if any) have shares that can be bought or sold. A climbing gym wanting to expand by means of acquisition may consider purchasing all the assets of a smaller gym or smaller chain of gyms.

Example: In 2019, El Cap acquired the Movement Climbing and Fitness gym chain in Colorado, extending the El Cap network to 16 climbing gyms and 4 million patrons annually.

Pros:  Similar to a merger, the goal of an acquisition is to combine resources and expedite growth.  In an asset purchase, the acquiring company may be able to pick and acquire only the more attractive assets of the target company and exclude assumption of some or all liabilities.

Cons:  An acquisition is not always a friendly procedure, can be extremely expensive (including costly legal fees) and entails managerial risks for the acquiring company. It’s also difficult to avoid assuming some liabilities of the target company since the sellers will want or need to satisfy debts before relinquishing control.  In addition, there may be a premium to be paid based on the “enterprise value” or “goodwill” associated with the target company. In the worst-case scenario, a backlash can ensue by the loyal clientele of the target company.

Partnership

Partnerships can be like mergers but do not always entail the combining of two or more companies. A gym that wants to expand but does not have the financial status to do so may seek private partners to assist in the funding of their expansion vision. In addition to financial assistance, outside partners can also help promote and market the expansion. Pursuing external expansion through partnerships is not uncommon in the climbing gym industry.

Example: Before merging with Planet Granite, in 2017 Earth Treks partnered with Tengram Capital Partners—a private equity firm that specializes in consumer brands—to open new climbing gyms in Earth Treks’ existing markets and expand into new ones.

Pros:  For new and emerging businesses, institutional sources of financing may be hard to come by. Taking on private partners, whether they are actively involved in the business or passive investors, is often the easiest way to raise capital and diminish personal risk.

Cons: The term partnership does not always mean together. Private partners tend to be a lot like private lenders—some expect to receive a large percentage share in revenue made, while others contract based off credit and interest. Partnerships can also lead to a significant reduction in the control an owner has in his or her business and, unfortunately, partners who were initially aligned do not always stay aligned. There may be a need to allow or force a partner out of the picture and that can be costly, even in the best circumstances.

Franchise

Franchising is a separate form of external expansion that enables a business’s brand to be publicized broadly. Franchising involves the right to use a company’s brand and business model for a set period of time. The franchisee pays the franchisor to use its brand and the franchisor’s success depends on the success of the franchisee and his/her application of the business model. Given the unique nature of climbing gyms, the franchise model has not been common in the US.

Example: In 2014, the Gravity Vault in Middletown, New Jersey, became the first franchised climbing gym in the US when it opened. Gravity Vault has since expanded to nine locations, with four more climbing gyms coming soon to New Jersey, New York and Pennsylvania.

Pros: Franchise benefits include instant name recognition and established “back office” infrastructure. Typically, the payment of franchise fees and royalties entitles the franchisee to—among other things—accounting, payroll, and benefits help, which can be otherwise burdensome to put in place. When franchisees succeed, franchisors can avoid the liability of a chain and the burdens of investments while enjoying the success of its brand expanding into new regions and territories, thus opening new market opportunities and sales channels. The franchisee also has a greater incentive than a direct employee because they, too, have a stake in the business.

Cons: Franchising only works if there is preexisting demand, an established customer community in a given location, and guaranteed profitability for both the franchisor and the franchisee. If a franchisee fails, it impacts the reputation of all businesses under the brand name. Franchising is very challenging in the climbing world because most gyms are defined by the unique experiences they provide customers (such as the quality of routes, shapes of the walls, unique layout and assortment of educational programs) and are not easily replicated when compared to a cookie-cutter fast-food restaurant or clothing store. Bringing in new owners (especially those without climbing expertise) can create differences in customer experiences at different gym locations, and these differences can dilute or devalue the brand. Additionally, franchise agreements require strict compliance with the franchisor’s operational guidelines, which may limit the franchisee’s ability to run the gym the way he or she desires.

Note: The content of this article is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. The reading of or reliance on this article or the Climbing Business Journal’s web site does not create an attorney-client relationship between the author or the Climbing Business Journal and the user or reader.

By Derek Larsen-Chaney and Jason Pill, Attorneys with Phelps Dunbar, LLP

Most large corporations began as small businesses, typically with one location, before expanding into multi-billion-dollar companies and nationally recognized chains. Before becoming the world’s largest restaurant chain, McDonald’s was simply a hamburger stand. In the fitness industry, LA Fitness is a +700-club chain that started off with one location. How does a business—specifically, a climbing gym—know when it would be an optimal time to expand?

Part 1 of CBJ’s series on corporate expansion looks broadly at the topic of expansion and dives into the two main options available to climbing gyms: internal or external expansion. Whether merging with another gym chain, opening additional locations, moving into a larger venue, or adding new products or services to your business, this three-part series will address basic principles of expansion that every gym owner should know before starting the process.

Know the Underlying Reasons for Expansion

Business growth—here defined as more demand and more revenue for a business—is often identified as a need. Business growth can be determined by various factors, but pursuing internal or external expansion of a business’s supply is often seen as a step in the right direction which validates an entrepreneur’s success. Yet, with expansion comes change, including different managerial, legal, and financial challenges.

Chris Warner, Founder of Earth Treks (now part of the El Cap family of gyms), once explained to CBJ that many owners “underestimate the luck” and fortunate circumstances which played a part in opening their first gym and gain a false sense of security when they try to expand too quickly. Sometimes, this mistake can be fatal. Expansion must be deliberate. Expanding even a small business can be a complex process. Throughout the process, it will be important to research targeted markets and understand corporate formation and how businesses grow.

Business growth can be planned or completely unexpected. Planned business growth is ordinarily achieved through the aspiration of the owner(s). The owner has a desire to see the business achieve its full potential and makes changes to reach more customers and increase revenue. Common methods of achieving planned growth include, but are not limited to, expanding the range of products or services offered—by selling more of the same and/or something completely different—or changing the underlying business concept.

As for unexpected business growth, it can be a benefit and a danger. Unexpected growth occurs when a business begins to experience an increase in demand for its products or services despite no additional internal efforts to do so. While the increase in demand may bring with it an increase in business revenue, if a business is not prepared to effectively manage this demand then it can result in careless decisions which lead to business failure. Expanding by scaling up and adding new locations is not always the right answer for gyms experiencing a surge of business.

Determining the best way to create or respond to business growth calls for strategic planning. The type of business strategy an owner ultimately chooses will depend on several factors, including the goals for the future, the size of the business, and the capital available. It is imperative that business owners understand the risks and rewards of each type of expansion and determine which (if any) is best for their desired growth levels in the long run.

Consider Internal Expansion First

Internal expansion concentrates on expanding the business by using the resources of the company. In addition to using the company’s own established finances, owners are often required to use their personal investments, money, and time. Businesses that participate in internal expansion typically keep the same brand name and services. Internal expansion provides the business owners with the flexibility of maintaining control over their products and services. A huge bonus in expanding internally is the high rate of financial return because the money is staying within the business itself, as opposed to being shared with external forces.

When a gym decides to expand internally, it can do so in various ways. For one, a gym can expand its venue. Venue expansion is necessary when the business has outgrown its original facility. This usually occurs when more customers are consistently interested in the services the gym is providing and, in order to meet these demands, a gym decides to relocate to a larger venue or add more space for climbing, fitness or other onto the existing one.

A gym also can open additional facilities. The gym must decide where to open the new location(s) and the types of services to provide (maybe a shiny new bouldering gym?). At first, it may be beneficial to open a location not too far from the original one because the business has already established a strong customer base in that area. Additionally, although the first location may be crowded because of growth in demand, some customers may not be willing or able to travel to a distant new location, even if doing so ensures fewer lines and fresh holds.

Internal expansion does not always call for opening a new facility or adding onto the old one. Sometimes, internal expansion can simply be the addition of new products or services within your current facility. A gym can expand by adding services such as yoga classes, personal training, nutrition advice, etc., and possibly experience comparable financial success from offering new services as from operating new locations. Some gyms begin as fitness centers with only machines and weight equipment and then add a climbing wall as an additional service.

All three options for internal expansion give the business owner(s) control over the process and allow funds to be reinvested into the business. However, remodeling a gym or building a new one takes time, and internal expansion is therefore often considered a slow and steady process.

Research the Risks and Rewards of External Expansion

Unlike internal expansion, external expansion depends on seeking outside assistance in order to expand. External expansion is known to be the riskier of the two forms of expansion because there is generally more money involved. However, external expansion is also considered the faster option and can happen almost overnight. External expansion uses corporate funds to purchase other companies or obtain additional resources and can include mergers, acquisitions, or partnerships. This can result in a gym coming together with other gyms, purchasing and acquiring other gyms, allowing itself to be acquired, or taking on new private partners. External expansion can help a business manufacture more products, enter into a new market, and gain the customer loyalty cultivated by another brand.

While external expansion is attractive because it often provides a quicker path for growth, the owner(s) almost always loses some form of control during the process. Typically, the infusion of external investment brings about new loan conditions, increased collateral securitization and, in some instances, a dilution of the owner’s stake in the company. External expansion which results in an increased ownership base can change the entire power dynamic of the company and impact the gym operations (e.g., the new investor receives voting rights and now must approve all major decisions or expenses above a certain threshold).

Given the complexities of external expansion and the kaleidoscope of options, the next article in this series will dive deeper into the various forms of external expansion, with insight into the pros and cons of each one.

Note: The content of this article is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. The reading of or reliance on this article or the Climbing Business Journal’s web site does not create an attorney-client relationship between the author or the Climbing Business Journal and the user or reader.