In our “From Lexington” series we are following Chris Shotwell as he and his wife embark on a climbing gym start-up in Lexington, Kentucky. In the first episode we learned about Chris and his wife Nicole and the what they hope to achieve with their climbing and fitness gym, L’Escalade Fitness. In this episode Chris tells us about his funding and the process of forming their corporate entity.
The First Years
by Chris Shotwell
We are very confident that we can be successful in our enterprise, but we also know that the first few years in a climbing gym can be slow. In order to accomplish any of the goals we have, we need to make it through the first and toughest years.
We were lucky enough to be able to pursue private equity as a funding method for this project. And because private equity eliminates regular loan repayment it gives us the flexibility to build our business the right way; without worrying too much about a potentially unserviceable debt load. Maintaining a healthy cash flow for the first three years is our top priority and will let us spend enough money on upkeep, advertising, and community support to be around for the long haul.
Making Investors Happy
We expect the initial investment in our project to exceed $4,000,000; this will represent our building, climbing, fitness, and other equipment. As such we are tremendously fortunate to be working with investors that are experienced in the fitness service industry. We expect to begin returning on the investment after three years, at which point we will be looking to return 10% per year. This is a very lenient expectation for an investment of this magnitude and is wholly due to the investor’s prior experience in the industry.
Because of the future value of money, most start-ups are expected to return 15% after their initial incubation stage. We consider that the best way to establish long term success is to continually re-invest in the business. In fitness, this means limiting immediate returns and focusing on the future.
Of course, private equity funding for a project of this size is not without risk. It leaves our investors open to major financial losses and can create possible tension in our personal life. It also can stunt the growth of the business if our investors have a negative perception of past and present financial performance.
It is important that we are upfront about the potential pitfalls to be encountered in the first couple of years, build and stick to a sound business plan, and make sure that we understand our investors goals.
LLC or S-Corp
We decided to incorporate as an S-corp when we formed L’Escalade Fitness, for a variety of reasons. The first and most important to us was that we would be able to protect our investors from liability. We learned that whether we are working with private equity or have a small business loan, it is incredibly important to be aware of liability issues.
Additionally, incorporating makes it easy to manage liability when we look to open a second location. Starting each individual gym as an S-Corporation lets us separate the liability for each gym, meaning that an accident in one won’t affect our holdings in another. Of course, we never want to have an accident of a magnitude that would put our business in jeopardy, but we consider it prudent to protect our business from potential harm.
Finally, incorporating gives us the opportunity to manage our tax liability advantageously. We know that we can go with a rapid depreciation schedule (climbing walls don’t have a ‘standard’ depreciation schedule) to manage our taxable profits. Because we are new to owning a climbing and fitness facility, we feel that we need to have the opportunity to figure out our replacement schedules for fixed assets. Working with this rapid depreciation gives us flexibility in our cash flow that we can use to keep our facility truly world class.
A rapid depreciation schedule can also be friendly to investors that have other major holdings. Taking losses that are largely attributable to depreciation can help to offset income that an investor is making elsewhere. It is important to realize that these paper profits and losses can be used to manage taxation, but they should not encourage you to funnel depreciation into investor payouts. Maintaining a facility for the long haul will almost always be a better investment than diverting depreciation and maximizing dividends in the short term.
Another option we considered when forming our business was Limited Liability Corporation. Unfortunately, LLC’s limit some of the tax benefits that our shareholders could enjoy. For example, if Nicole or myself were part owners of the business, we would be taxed on all of the profits that the gym makes as income. This means that everything gets taxed as employment.
On the other hand in an S-Corp, we will be paid a reasonable salary which we will be taxed on. Residual profit will then be distributed and taxed at a much lower rate. S-Corps are easy to administer and also provide ownership flexibility. This means that it is possible for bonuses to be paid in stock, for owners to sell stock, and for the use of stock in recruitment.
While it isn’t currently common in the climbing industry to recruit with equity, it is common in other industries. Preserving this fluidity of ownership is very important for the future of the business as it will help the business to grow. Both an LLC and S-corp provide excellent liability protection, so the tax benefits and ownership flexibility make the additional difficulty and expense in filing for business formation well worth it.
Forms and the Tax Man
We consulted with a Kentucky based attorney and accountant to help us understand the best possible business structure. Once we had a plan, we were able to easily file all of our paperwork online.
This was especially important for us because we were in the process of selling our California home, moving back to the Midwest, working from Indianapolis, going out and climbing on the road, and forming a business in Lexington.
The secondary benefit of forming a business online is form validation. While it is not impossible to provide incorrect information, form validation makes it impossible to submit a form without all the requisite fields filled. This helped us make sure that we understood which fields applied to us and helped us get more information about anything we were confused about.
We still got hung up at one point when we discovered that we needed to provide the IRS with a physical address. Our plan has always been to buy land and build from the ground up. Before we could purchase any land, we needed to have our Articles of Incorporation filed and our EIN. At the time, our only physical address was in Indiana and our business was formed in Kentucky. After several phone calls to the local IRS branch, we were told that we could register with our out of state address and change to our new address once we purchased land.
The Board of Directors
Once we went through the process of filing our Articles of Incorporation and associated tax filings, we needed to meet and elect a Board of Directors. Our shareholders elected Nicole Brown to be the Chief Executive Officer , while I was elected Chief Operating Officer. Because we are currently a company of two, this constitutes our entire Board of Directors.
At the same time, we immediately purchased our domain name, set up website hosting, and opened our business bank account. We were very careful to select a bank that we were already favorably impressed with. It definitely didn’t hurt that the bank we chose has a very friendly wire transfer policy, great online banking, and easy to set account alerts. Our only annoyance is that they might actually be too helpful!
Finding The Right Incentives
Finally, we began researching local and state incentives for building our facility in Lexington. Because our investors are out of state, we thought it was wise to look into any potential programs that reward out of state investment. We have found a program that will help us to offset some of the sales tax associated with building our facility.
Finding incentives for our business was not easy. We met with a consultant associated with the Small Business Alliance who directed us towards several programs that we could potentially use. We looked into each program, followed leads, and made contacts. While none of the programs he initially suggested panned out, digging deeper got us in contact with a government official that suggested the program that we are currently pursuing.
Finding this information without talking to the right people would be like trying to find a needle in a haystack. Our assumption is that all of this would be easier for a business owner that is physically in town. Making a face to face contact in your local government gets your foot in the door and lets you leverage a relationship. Once you have someone that is interested in helping you, it should be relatively easy to find what you are looking for.
In the next episode Chris takes us through the process of building the L’Escalade Fitness business plan.
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