Tough times and exciting innovations

One of the silver linings of a tough economy is that, absent heavy-handed government intervention or regulation, a business will adopt, adapt and improve if it wants to survive. Currently, my real estate developer clients are trying to innovate in an effort to stay alive in a credit freeze.

One of my clients, a commercial developer, tells me that even up to a year ago, when he began a project, he'd have five or six banks competing for his business. Now, however, he has to aggressively search out his own lenders and is lucky to find even one willing to make the loan.

Given this credit drought, I see innovative developers looking for new ways to get the funding necessary to complete their projects. In fact, I'm working with one client to come up with new methods of funding in these difficult times. What are some areas to consider?

1. Private financing. This has been around for a long time. There have always been private individuals or small companies willing to loan money. With large development transactions, I see a few practical issues with this. First, are you going to find any one person or private organization willing to loan you the amount of capital needed--not, say, $100,000 for a house, but perhaps two, three, four, or five million dollars? If not, are you going to have to procure multiple lenders? How will they each be equally secured? Even in boom times, private lenders typically charged a premium interest rate to cover what typically was a higher risk (i.e., if the venture was less risky, the thinking goes, it could've gone to a bank and paid bank rates). I recently saw a loan with a 50 percent interest rate! Most states have interest rate ceilings that mandate maximum interest rates chargeable on loans, but at least in North Carolina, that does not apply to non-consumer development loans.

2. Venture capitalism. I've written in other blog posts about venture capitalism, and v.c. has had a role, and will likely now have an even greater role, in real estate development. The main difficulty for developers is to price the increased cost of this money into its budget plan.

For example, perhaps a developer was creating a build-to-suit lease with an option to purchase for an 80,000 square foot commercial building, with a tenant lined up. The sales price, if the option is exercised, is $4,000,000. Previously, the developer would've created a pro forma (a projection of costs and income), and perhaps the developer worked out that the initial building costs would run at $3,000,000. The developer would also add into this the "carry costs"--i.e., what the loan payments would be. This figure would be pretty easy to figure out, based on standard loan rates or--even better--a promised loan rate from a particular lender.

But what about now? Just to make up numbers, the venture capitalist, approached to enter the deal, may have the money to loan, but may loan the money at a premium rate--i.e., instead of, say, six percent interest, the capitalist is charging 15 percent interest--which means that the carry costs will be higher. In addition, perhaps the venture capitalist wants 25 percent ownership. In such a tough time, these aren't necessarily costs that can be passed on to the tenant through increased rent or purchase price. In the previous example, the developer could count on $1,000,000 profit for taking on a $3,000,000 risk. Now, however, the profit will be less because of the increased carry cost (let's say, hypothetically, $100,000 more costs), and the net profit will then be shared with the v.c., leaving the developer, instead of $1,000,000, $675,000. This is still worth doing, hopefully, but the margins have decreased by one-third, in this example.

3. Stock offerings. Developers will also turn to stock offering in these days to raise capital. Instead of one venture capitalist providing funds, it will be numerous investors. One benefit of such an offering is that the developer's risk is reduced because the money is not a loan but is equity. On the down side, to raise the money necessary for a good sized development, the developer will have to part with a large share of the ownership. Going back to the previous example, if a developer only offered to sell 25 percent of its venture for the $3,000,000 it needs, those stock holders would be entitled, as a whole, to 25 percent of the final profit. Assuming again that the profit was $1,000,000, the stockholders' share would only be $250,000. Are stockholders collectively going to pony up $3,000,000, for a chance at $250,000 (or about eight percent) profit? Probably not. Instead, the developer will have to strike a balance by providing enough of his venture to make stock purchasers want to buy, but leave for himself enough to make it personally worthwhile.

Where will it end? Who knows. If you need advice about investment vehicles for your real estate development, and how to legally structure these vehicles, please contact me at 704-735-0483.

Business sales and having your own attorney

I'm gearing up to help the purchasers of a business that has gone bad, and I'm mad.

My clients came in, and informed me that they'd purchase ABC Business. Once they bought the business, they quickly found out that--contrary to the seller's representations--the business was loaded with debts which the seller intentionally failed to disclose to my clients. Bad, but seems straightforward enough, doesn't it? Surely that would constitute a breach of the sales agreement, wouldn't it? Well, not so fast--here's where things get interesting.

Seller talked my clients into using his attorney to draw all the documents. The documents, at first blush, looked like a standard set of business sale documents, except for the part where the seller's attorney cut out all warranties of title, and basically provided that the buyers were taking the business "as is."

The lawyer, hired by Seller, had his fee paid equally between the buyers and the seller--all the while knowing that the seller was hiding from them tens of thousands of dollars of liabilities. That's a breach of his ethical responsibility, one that may cost him.

It's too early in the game to discuss details of what I intend to do on my clients' behalf, but let me use this opportunity to offer some advice to other potential business buyers.


1. NEVER use the seller's lawyer to represent you in a business purchase. The case I mentioned above is extreme--most lawyers wouldn't purport to represent both sides yet withhold information from one party that the other is lying. But often, this joint representation is "de facto"--i.e., the lawyer represents that he represents the seller only, but the seller is telling the buyer that he really represents both sides. Don't fall for this trap. You need someone to specifically protect your own interests as a business buyer--especially if (as here) you're a first-time buyer.

2. Make sure your purchase agreement contains all the representations IN WRITING that the seller has been making to you verbally. Sounds easy, right? But often, a seller will make lots of verbal statements that for some reason don't find their way into the written document. And the standard sales agreement also contains a clause providing that the only representations being made are in writing, and that no other representations have been made. If you, as a buyer, sign this, you may not later be able to rely on oral representations made to you earlier. In the instant case, the seller, of course, made all sorts of representations about the business being free of any liabilities. But, in the document cooked up by the seller's attorney, absolutely no representations were made--as to amount of property, as to title to the property, or anything else. Think about it: if a seller expects you to give him money for his business, shouldn't he--AT THE ABSOLUTE VERY LEAST--be willing to say "I am the owner of this business, and have good title to the business?" Of course. But with my clients, the owner wasn't willing to do that. They should've smelled a rat right then.

3. Do your due diligence! Many business buyers are investing their life savings to follow a dream of running their own business, but get so excited with the dream, that they blind themselves to the realities. Take the time to look under the hood. Investigate the business finances, do a background search of the seller, do everything a smart person should do to make sure you don't get yourself into a quagmire!

If you're involved in a bad business purchase in North Carolina and need help, call me at 704-735-0483, and set up an appointment.

Partnerships -- an issue of trust

Partners in a partnership are said to owe "fiduciary duties" to one another--that is, they owe a duty each to the other to look out after the others' best interests.

Though partnerships are usually meant to be equal (i.e., equal sharing of responsibilities, equal contributions, etc.), they are, in practice, rarely so. Someone, for example, may handle the actual rental of rental properties in a partnership. Another, for example, may handle the bookkeeping and bank accounts of the company.

Regardless of all the plans that partners make, regardless of the legal mechanisms put into place to make the machinery run more smoothly, one thing any partnership needs to thrive is trust.

The past few weeks, I've been representing partners who desired to dissolve their partnership with a remaining partner. When the partners, who'd been friends, decided to wrap up their business, they asked the partner handling the bookkeeping to give everyone copies of the accounts just to reconcile things. This partner was offended, and told them he'd not give them anything, that they should trust him. Of course, then my clients also got their suspicions up, and claims began being thrown by each way.

At the end of the day, after threats of a judicial dissolution, the managing partner provided us the information we needed, and everything is going to be resolved without the need for a lawsuit. The sad thing is that--other than some very minor disagreements about the way certain things were handled--there appears to have been no dishonesty on either side, just a conflict of personalities.

If you're a partner--even if you believe you're doing the bulk of the work--remember that you owe duties to your other partners to be open, honest and forthcoming. Provide your partners with all information. Be upfront, don't be controlling and--most of all--don't get defensive when you're asked for information.

At the end of the day, these ex-partners will have resolved their partnership by splitting everything equally. But if one partner had simply been forthcoming, they could have done this without the added expense of attorney's fees

Staying afloat in tough economic times

Even in the Charlotte Metro area, which has tended in the last decade to better weather tough economic times than most parts of the country, we're filling the pinch of the current economic downturn.

Many of my clients have told me that their business is down: fewer homes are being buit, materials purchased, real estate sold, and so on. This, of course, is no surprise, and many of my clients are currently retooling their business to help bring in additional income during these times.

But staying profitable isn't just about earning money off of new business; it also means that you need to get paid for the business you have already performed. It's easier to lose one job (and the potential income) than it is to perform the job, expend the effort, labor and materials, then not get paid. For many of my clients, it may take two or three paying jobs to cover the cost of one job for which they didn't get paid.

How, then, can you protect yourself so that you get paid for the work you do, so that you get paid?

1. Written contract. Many of my clients are subcontractors (brickmasons, graders, plumbers, etc.), who work on houses, and they rarely get a written contract with the person or company who hired them. However, this is very important. Obviously, a written contract will show proof there's an agreement, but that's the least important factor (after all, if you've done the work, that's proof as well). No, a contract is more important because it will outline the terms of what you are supposed to do, and when you can collect your money, so that your client can't hold you at bay (e.g., saying, "I'm not paying you until the house is finished by everyone"). Also, in North Carolina, you typically can't collect attorney's fees unless you have a contract providing for it, nor can you collect interest on late payments without an applicable provision in your contract. Sure, if you hire an attorney who successfully collects your fee, you're somewhat relieved; but you'll also be disappointed once you subtract his fee, and realize that your money could've been earning interest over the six months it took to collect. By contrast, a well-written contract could provide that the debtor has to pay you 15 percent attorney's fees and legal costs if you have to sue, and can provide for 18 percent annual interest on bills more than 30 days due.


2. Personal guaranty. Many clients simply do business with the "company," even if the company is a one-man operation. If you're doing business, attempt to wrangle a personal guaranty, in writing, from clients. In other words, if you don't get paid, the person with whom you're dealing should personally guarantee payment of the debt. If you're performing contract work for, e.g., Wachovia Bank, this may not be possible. But I suspect most of your clients are small businesses. These businesses' owners have to guarantee their bank loans; make them guarantee payment for your work. If a business owes two bills, and one of them is personally guaranteed, the bill personally guaranteed will be paid first--simply because that bill shall cause the owner personal liability and therefore is more urgent!


3. Cutting off work early. Nobody wants to quit a job or stop supplying a customer, but as a small business owner, you need to be careful not to extend credit for too much work/supplies, nor should you let the unpaid bills linger. Often, a customer may get further in debt trouble the longer your bill lingers. If you haven't been paid in 30 days, do not continue to supply services, material or labor, or you can be getting YOURSELF further indebted to your customers. Some of my clients used to take a "double down" gambling approach: they know they shouldn't keep supplying goods or services, but don't want to make their customer mad and have them walk away. The problem with this approach is that the more the customer owes you, the more desperate YOUR become, and the harder the debt becomes to pay. Get out early, and collect your debt--by lawsuit if necessary. My clients, under my advice, now cut off credit after 30 days and send accounts to me shortly thereafter. Some of their customers get upset, but in the past two years, many of their customers became insolvent--but we got paid because we called our accounts due while there was still money for us to be paid.

If you have questions about account collections or creditors' rights, please contact me for an appointment at 704-735-0483.

The Art of Killing the Deal

I've had the privilege, in my business law practice, to work on transactions and cases with good lawyers not only in my own state, but in other states as well. Each state (and state's lawyers) brings with it its own subculture and quirks. However, I've never, until a recent transaction, worked with attorneys who seemed hell-bent on picking a deal apart until it died a painful death.

I'll caveat what I write next with the possibility that perhaps I and/or my client were played, and (for whatever reasons) were manipulated for reasons we don't understand. But assuming not, I'll try to provide a few non-identifying details. My client, a commercial contractor, has certain niche construction that it has perfected and gained a reputation for in that niche. So much so, in fact, that it has expanded its operations in numerous states all over the U.S.

My client is run by its astute owner, who understands his own risk tolerance. Therefore, in negotiations, once he's received my advice, he accepts some, and rejects other, and we tend to quickly come to agreements with the other party. We negotiate hard, but we're flexible--and my client has become very successful with this.

But this time things simply have not worked out, and they may now crash and burn. We sent the other party a standard document, and what usually would be a process of a couple of negotiating back-and-forths has turned, instead, into months of excrutiating negotiation from the attorneys, nitpicking over minutae, creating far-fetched scenarios to justify their extreme positions. The result of this is that my client may simply be unable to do a deal with this client, and because of the length of time in these ridiculous negotations may no longer be able to enter into this contract anymore. Here then, are my own thoughts about the role of an attorney in negotiating a business transaction.

1. The attorney's role is to inform and protect. Notice that I didn't say just to protect. Of course, an attorney is supposed to protect his client, but in a business transaction, the client needs to understand what is contained in the contract or transaction. I always tell a new business client something like this: "I can protect you in a contract so that you're as protected as you'd ever want to be--but nobody would probably ever sign it." The point is, a contract that is too one-sided in favor of my client would not be commercially reasonable. Therefore, I try to protect my client as much as I can, but there will be issues on which the other party will not budge (perhaps, for example, the seller of a business will only allow my client 30 days due diligence). My job then is to let my client know the tough spots, let him know the risks, and fully inform my client so that he can make an informed risk decision about what he should do.

2. The attorney's role is not to be a roadblock in the way of the client's goals. Business clients, espcially experienced ones, are not children. Your job as an attorney is not to protect a client from himself, and shouldn't argue and negotiate ad infinitim. Some attorneys seem to get some pleasure in negotiating, haggling, and fighting for even the most minute and unimportant provisions in the contract, mentally chalking up points for every single concession they've obtained. I don't know what the "opposing counsel" feels like the score is in the contract I've been working on, but to me, we both score a big fat zero when a perfectly good deal dies as a result of the lawyers. If you want to fight and beat up your opponent, be a litigator! Transactional attorneys are supposed to HELP their clients accomplish goals.

3. The role of a business attorney is to help a client achieve goals, not to thwart them. This particular client has big goals (as do many of my clients). My job is to help these clients meet their goals: by making sure they comply with applicable laws, by drafting contracts that protect them and by helping them perform careful analysis so their dreams do not turn into nightmares. Yes, there are times when it is my job to tell a client, as I did a week ago, that a particular deal SHOULD NOT be done. But with most deals and most clients, it is a balancing act whereby I try to help my client reach what is a workable goal on a workable deal, while protecting the client.

Does this mean that I'm a "yes man" for my clients? Absolutely not. I often have to tell clients that the way they want to do something will, e.g., violate a contract or will not comply with the law. But for a good business attorney, the work doesn't stop there. My job then becomes how to help my client still reach that goal WITHIN the constrictions of law, contract and all practical considerations.

I look back at my clients, and what they have accomplished, and I am proud that I can say I have had a role (however small) in these accomplishments. Do these lawyers to which I refer take pride in how many deals they've killed?

Venture Capital, Part Two

One of the biggest things to consider when entering into (either side of) a venture capital agreement is to determine whether the capital infusion will be treated as debt, as equity, or a mixture of both. I will write this article from the standpoint of the venture capitalist, although you, the reader, will quickly comprehend the different advantages and disadvantages for the recipient of the capital as well.

When providing venture capital for a startup, should you structure your capital as a loan to the company, as partial ownership in the company, or as some combination of both?

First, consider the advantages and disadvantages to treating the capital infusion as a loan.

Advantage One: Security. Venture capitalism is a speculative matter. That is, you, the capitalist, are putting money into a venture that may or may not succeed. If the business fails, will you get all, some or none of your money back? Part of that may depend on whether, if the business goes bust, you are treated as a creditor or as an owner. When a business becomes financially insolvent, any remaining assets or monies are typically paid out according to certain priorities. There are many nuances, but put simply, creditors will be paid before the owners. Therefore, if the business fails, you have a BETTER chance of getting paid if you have structured yourself as a creditor than if you have structured yourself as an owner.

Advantage Two: Protection. Similar to the first advantage described, structuring the transaction as a loan will give the venture capitalist more protection than as an equity owner. Often, the venture capitalist will not be involved with the day-to-day operation of the company. I have seen numerous instances in which the business operators mismanaged the funds of the "money partner," spending in a deficit until nothing was left. By structuring the capital as a loan--and more importantly, as a loan secured by collateral of the company--the venture capitalist can better protect against the squandering or liquidation of the assets. Using an example, say the operation is run by the two majority shareholders, and you, the venture capitalist, provided $250,000 for a 33 percent stake. If the majority shareholders, who saw the business was floundering, decided to start selling off the company property to keep funds coming (and to pay their salaries), they could do it. And if they did it quickly enough, you would not know about it soon enough to stop it. By the time the company went bust, there would be nothing left to divide. On the other hand, if you were a secured creditor, the shareholder/operators would be unable to sell off the company property without paying you off first (or at least, getting your permission to sell).

Advantage Three: Control. Believe it or not, being a creditor of the company may give you more control than being an equity holder. As a simple shareholder, you can be outvoted on many of the corporate decisions unless you are given a majority of the stock (which is unlikely). As a creditor, however, you can place certain restrictions within the initial loan agreement, such as:
1. Prohibitions against selling off the assets;
2. Prohibitions against the company owners taking excessive salaries or dividends;
3. Prohibitions against taking major company actions without the approval of the creditor.

Of course, there are disadvantages to treating the venture capital infusion as a purely loan transaction. The biggest, and most important, is that a loan limits the amount of profit that can be realized. A loan will contain interest, and some sort of repayment plan. At the end of the day, there is ceiling to what profit the creditor can realize. For example, if the venture capitalist provides a $100,000 loan for five years at eight percent interest,then the capitalist would know that, at best, he would realize a total profit of $21658.36--and that's if the loan is not paid off early! Remember too, that venture capital involves, quite often, higher than average risk, for which a venture capital should expect (if successful), a higher than average reward. There are easier ways to earn eight percent returns than by investing in risky ventures that may completely fail.

Owning equity in the company, of course, allows the venture capitalist a chance to share in both the risks and rewards of the start-up company. In theory, as an equity holder, the capitalist risks losing his investment if the company busts, but shares the potential reward with all other shareholders if the company succeeds.

The disadvantages to being an equity holder are, as you may guess, the converse to the advantages of lending shown above.

1. Security. If the company goes bust, an equity holder is the last in line to get paid from the remaining company assets (and usually, there are none by that time).

2. Protection and Control. As a pure equity holder, the capitalist will have less chance to exert control over the company, and stands a higher chance of being susceptible to abuse by the majority shareholders.


What then is the best approach? There is no solution that fits all, but a typical venture capital deal will try to combine the two approaches: that is, the venture capitalist's money is treated in part, like a loan, but also provides the capitalist an ownership interest in the company. The following are some of the provisions that may be found in this approach:

1. Typical loan provisions, that provide a promise to repay (a promissory note), as well as some sort of security (for example, a lien on company assets).

2. Restrictions that the company cannot take certain actions (selling all of its equipment, for example) while the loan is still outstanding.

3. Sometimes, a provision that, at a given time, part or all of the loan is converted into stock.

4. A certain amount of stock ownership.

5. A guaranteed director or number of directors on the company's board.

6. A shareholder agreement that the company may not issue additional stock without the venture capitalist's approval.

7. A provision that provides the start-up owners the right to buy out the venture capitalist or, conversely, a provision giving the venture capitalist the right to force his stock to be bought.

If you have questions about engaging in a venture capital agreement in North Carolina, please contact me for an appointment at wldeaton@ppd-law.com

Venture Capital, Part I

A client came to me last week with the opportunity to be a venture capital investor in a small start-up company. He knew how much he wanted to invest, had some clear ideas about what he wanted back out of the company, and then left it to me to prepare a venture capital agreement.

Venture Capital is simply a term for money obtained by a company that needs to change its position. Perhaps that position is that it needs to actually get started ("start-up capital"). Perhaps the company is on the verge of collapse. Often, as in this case, an already-existing company needs additional money in order for it to successfully grow in order to keep up with its new business.

Often, the business can raise money by debt--that is, by borrowing money (either from a bank or from private lenders). But borrowing, however, is tied in with risk--and most lenders do not want an exceedingly risky loan. If a business is brand new, or is getting ready to expand or change direction, there may be certain risks involved such that a traditional lender is unwilling to take the loan risk, considering that its return would likely be somewhere between six and ten percent per year.

On the other hand, there are investors who may be willing to invest their money or capital in riskier propositions--if they believe the risk will be appropriately rewarded. These are venture capitalists. These investors quite often will infuse money into a company that may have more risk, in return for the possibility of greater reward. In the next few blog posts, I'm going to discuss items to consider if you're asked to invest capital into a small or start-up company. But for today, the major considerations are as follows:

1. Debt versus Equity: Is your investment going to be treated like a loan, like ownership in the company, or like a mixture of the two?

2. Period of the investment: Is this open-ended, or do you want a specific time-frame in which your investment return should be realized?

3. Control: What rights of control will you have in the company?

4. Operation of the Company: What can the company do with your money? How much can the owners pay themselves?

Hopefully, this discussion will help both potential investors, as well as company owners looking to find investors.

Common Reader Questions Regarding Partnership Disputes

I got some reader questions this week. While I normally don't respond (it's not that I don't want to help, but I don't like giving advice to someone whose laws may be different), I thought I could perhaps give general advice to situations like these.

I will caveat that my law license is limited to just North Carolina. However, I hope to give some general principles that can help:

"I just recently opened up a company but the amount of problems and arguments that I am having with my business partner is unbelievable. We are always arguing, during working hours she will just sit there going on about things that are not even necessary, wasting time and money and she will complain over the smallest thing. She has asked me to buy her out but she wants way more money than she actually put in to opening the company--which I am not agreeing to. The company has not even made that amount of money as yet so I don't know what to do. I can not work with the lady anymore ,its come to a stage where I don't even want to work myself but its my company so I am going to have to find a solution to this matter SO CAN I PLEASE GET SOME ADVICE ON WHAT TO DO?"

Unfortunately, your problem is one of the most common. You've not told me whether you are equal partners, or whether there is some unequal distribution of ownership. You've also not told me if your contributions were equal and in-kind (i.e., did you each put in the same amount of money? Or is she putting in money, and you're putting in sweat-equity?). Finally, you've not said if you have a written agreement (though I guess not).

Knowing so little about your situation, at least let me throw an idea your way that I talked about in my last blog: offer a buy/sell deal (see previous blog entry from July 26).

In other words: go to your partner, let her know that you appreciate things need to be resolved one way or another. Then make the offer I discussed in my last blog, and put the ball back in your partner's court.

1. Tell her that one partner should by the other out.
2. Tell her that you'll give her the choice: either you can set the value for the whole business, and then she can decide whether she wants to buy or sell at that value; or she can set the value, and you get to decide whether to buy or sell.

This works even if you're not equal partners (e.g., if you're 60/40, for example, the value would be set at the price for the whole company (assume your partner set value as $100,000), and then you'd decide whether to buy the partner out for $40,000, or sell to her for $60,000.

Here's the good thing that I gathered from your scenario: you're early on in this business relationship. What would be more difficult is if, three years from now, you were wildly successful (no thanks to your partner), and she wanted to be bought out--in essence, getting paid for the equity you created in the company. At this stage, however, you've not turned a profit yet. Also, you know she wants out. Most likely, if she has any sense, she'll let you choose the price of the company. Be sensible, and don't go too low, or she may buy you out. If, however, she wants to set the price of the company--then let her. After all, if she really does think it's worth so much, she may make you an offer that will financially reward you!

Hope this helps.

Here is one very similar:

"Hi Wesley.
A scenario for you:

My partner came up to me and said it would be a good idea to open a shop in
the area [certain medical equipment]. I agreed.

So I found the location, came up with the business name, discussed things
with real estate agents, distributers, employed staff etc etc.
My partner has done minimal work, much to my frustration.
Thus we have decided that one should buy the other out due to this and
we cant see eye to eye on decisions.
We have a lease for 18 months.
The shop isn't open yet and therefore no stock purchased.

We have put in $X each.

Does one just pay the other that $X back?

Do we get more than that from the other because I did more than my partner
or that it was his initial instigation not mine?
Does this count at all?

Do we just work out a number randomly?"

Ok, lots of good questions here. First, my usual disclaimer is that your jurisdiction (while another common law country) is not the same as mine, so remember that my free advice MAY be just worth what you've paid for it!

That being said, let me take care of the biggest question: since you're equal owners, unless your courts are different than ours, you'll be unlikely to get paid more for your share than your partner's. Sorry. The good news though, is, like the other reader, you didn't get too far into the relationship before realizing its inequalities.

I'm going to give you very similar advice to what I gave the other reader, with a few additional opening questions:

1. First, are you enjoying this business? I.e., would you want to continue it if you could buy your partner out?
2. Second, can you afford to continue the business?

It sounds to me as if, now that the ball is rolling, you'd like to try and make a go at it if you could.

3. Is it more likely that your partner would just like to be bought out and leave?

If so, offering your partner his initial start-up money might buy him out.

If you're not sure as to question number 3, then you might want to make your partner the offer I suggested to the first reader:

Offer them a buy/sell workout. One of you sets the price, the other gets to choose whether to buy or sell at that price. In my mind, the best thing in the world that could happen to you (or the reader above) is that your partner would want to set the price. In such situations, the partner (who truly wants to be bought out anyway), could set the price so high in their greed that you'd rather take a buyout, and start a new business.

But considering that your partner will be scared of this happening, he'll most likely ask you to make the price. Unfortunately, then, you've got a hard decision. Probably, in your mind there's one price you think HE should be bought out at (a low price), and a different price that YOU'D be content with being bought out at (the high price). The buy/sell price you make, will likely need to be somewhere in between.

The best advice I can give you for the price you set is not really legal advice--it's more practical. Set a price, and then make yourself comfortable--before offering it--that, come what may, you'll be happy with the results. Think of all the benefits you'll get if you can buy your partner out. But then think of the freedom you'll have if your partner buys you out and you go your own way (perhaps you can start your own business now, or take a regular job with shorter hours, etc.).

Finally, there is a legal consideration. As part of this buy/sell deal that I suggest you offer your client, you need to agree, as part of the deal (before either of you makes a decision), that the BUYING partner will take over the lease and all partnership obligations and indemnify the SELLING partner from any liability therefrom. Even better, if at all feasible, see if the landlord will be willing to release the SELLING partner from the lease's liability (I'd say chances are against it, but at least try).

It's only fair to the selling partner that he (or you) not have to worry about any partnership liabilities creeping back in the next 18 months.

For both of the individuals above, I'd suggest that if your disgruntled partner takes you up on the offer, that you then hire a qualified attorney/solicitor to draw up the paperwork. I'll be happy to recommend someone in your area if you desire. And please, let me know how things turn out!

The easiest and fairest way to resolve a partnership dispute

If you read my posts regularly, you know that in my business practice I run across business ventures in which--for whatever reason--the owners no longer have the same goals. Sometimes, they outright dislike each other, in others, they simply want to do different things. Sometimes these differences involve LLCs, corporations or true partnerships (and here, I'll refer generically to the co-owners as "partners").

Hopefully, a good organizational agreement will provide for a way to resolve these disputes between partners, but, as you have seen in previous posts, they don't always.

What I'm going to provide you today is the easiest, fairest, most common sense way to resolve a dispute between two partners over the direction of the business. First, however, a few caveats:

1. You'll need to have your finances in order.
2. You'll need to understand the possible ramifications that will result from this method.
3. You'll need to prepare yourself to be satisifed with whichever result occurs.

Those warnings are cryptic, aren't they?

Here it is, then: If you and you partner are at odds, or are wanting to go in different directions and can't resolve your differences, meet with your partner, and make him this offer (and for this example, I'm assuming two partners who are equal owners).

1. You think that the partnership between the two of you is going in different directions.
2. The best thing for everyone is if one partner buys the other one out.
3. One partner should set a value for the business (i.e., what that partner thinks the partnership, or at least his half of it, is worth).
4. The other partner then gets to decide whether to sell at that price, or to buy at that price.
5. You give him the option to decide whether he wants to set the price, or whether he'd rather decide whether to buy or sell.
6. You wait.

Think about how absolutely, finally, quickly and fairly this can effect a business buyout and a resolution of the dispute--whether you're running a lucrative partnership or one that is barely struggling along.

I was involved with a buyout, recently, where this occurred. One partner decided to make this offer to the other. Before he made the offer, he searched his soul, and made a decision at what value he'd place on a partnership interest. Then he determined that he'd be happy either way--if he got bought at for that price, he could live with it, or if he was asked to buy the partner out at that price, he'd live with it.

He then approached his partner, and made the suggestion for a buy/sell. The other partner agreed. Now, think about how easy things become at this point: My client had already decided his value point. If the other partner decided to set the value, my client could make his buy/sell decision in about 30 seconds, simply based on whether the offer was higher or lower than my client's buy/sell point he had already mentally set.

Or if (as was the case in this instance) the partner asked my client to set the price, my client could offer the price he'd already decided, and then sit back and wait for the partner to make the decision of whether to buy or to be bought out.

The two hardest parts about this mechanism are (1) coming up with a value that you can live with whether you buy or sell and (2) convincing the other partner to do this (for example, perhaps the other partner would only want to sell, or would only want to buy, etc.). But once the other partner agrees to this mechanism, the buyout will be fair.

In my client's case, if his partner had thought the price offered was too low, then the partner had the right to buy my client out at that low price. If he thought the price was unrealistically high, then he could sell out to my client at that price. Conversely, my client had to be realistic about the price. Perhaps he would've liked to have sold for a higher price, or to have bought out his partner for a lower price, but since he did not know which choice his partner would make, he had to make a price that he could live with either way.

If you have any more questions about partnership issues in North Carolina, feel free to schedule an appointment at 704-735-0483.

Limited Liability Company Buyouts

A client and his wife came in a few weeks ago with some questions. He, his wife, and another couple had formed an LLC for a new business venture. Each member owned 25 percent. The venture was still fairly new, though experiencing some apparent success already, when one of the two couples decided it wanted out. My clients, who wanted to keep the business going, came to me for some counsel about what to do.

Fortunately for all parties, we reached a very easy and amicable solution by which my clients will, next week, buy out the other couple for a sum representing their initial investment. It's a good thing that everyone was reasonable, however, because the Operating Agreemeent did not provide a good "dissolution" mechanism, in the event that the discussions had become acrimonius, and it made me realize the importance of a good buyout provision in these operating agreements.

The operating agreement, like most in our state, was written so that the departing couple could not have sold its interest in the company without my clients' approval. And without my clients' approval, they'd have been out of look. Worse yet, my clients owned the physical location of the LLC's business, and, if they'd wanted, could have evicted the LLC from the location and simply set up a new LLC to run practically the same business.

Of course, the departing husband and wife were decent people, and my clients were decent people, and they quickly and fairly negotiated a fair resolution that was mutually beneficial.

The majority of limited liability companies I set up seem to be two parties (usually two men, but sometimes two couples), and in these LLCs, when you're setting them up, think about the exit provisions:

1. Consider putting in a provision that would allow you to sell your interest to a third party if the remaining owners are not willing to buy you out; and/or

2. Consider a provision that will value your interest and set up a payment plan so that while you can force the remaining parties to buy you out, conversely a mechanism is in place so that they can do it without ruining their cashflow.

Of course, picture yourself in the reverse provision: what if you want to stay in but your co-owners do not? A good operating agreement will provide provisions that will provide you a comfort level so that if you start going different ways, you'll already ahead of time know that Agreement has provided a way for all of you to easily separate your interests.

Business Litigation, pt. 2 Victory

We won our trial, and now I can describe more details about it. My client, a real estate developer, had been sued for issues arising from a former partnership. My client and three other men had formed a partnership to develop a tract of land. One of the partners, who happened to work for my client, was bought out years ago. However, in 2006, when the partnership sold its last lots in 2006, the former partner sued, saying he was still a partner and entitled to partnership proceeds. The Plaintiff lost and received nothing. My client received satisfaction and bragging rights--but at what cost? Here is what I believe my client learned from this lawsuit:


1. Get everything in writing and keep good records.

My client had evidence that he'd gotten, in writing, something showing the Plaintiff had given up his interest, but that the file mysteriously disappeared when the Plaintiff quit working for my client. What could my Plaintiff have done differently? He could've had his lawyer at the time draw up the document, make it legally clear, and keep triplicate originals--one for the client, one for the man who gave up his interest, and one for the lawyer (just to be safe). Also, my client could have kept his employee files locked (the testimony was that the files weren't locked).


2. Understand the sheer randomness of a jury.

I always tell clients that you never know what a jury is going to do in a trial, and I really couldn't tell, until they returned a verdict in our favor, what the jurors were thinking. I try to pick up on body cues (do they appear bored when I talk? Are there arms crossed? Are they attentive), but this is not an exact science, and worse yet, an attorney (or his client) can drive himself crazy trying to put meaning into every action of a juror. At one point, the jury sent a question to the judge, and when it was read, my client thought we had lost. Instead, we won; jurors create an emotional rollercoaster for the parties involved, and I think my client knows this now.



3. Place a value on your opportunity costs and your time. This case, in the grand scheme of things, did not involve a lot of money. In fact, early on it became clear that--if carried to its finish--my fees would eclipse the value of the case. However, this case involved (to my client) principle, and, honestly, a bit of a grudge between two individuals. My client was fully prepared to to pay my costs to the end. However, I believe if he were to be asked now, he'd rethink settling earlier, not for the fees he's having to be me, but for the amount of money he probably lost having to sit at trial for a week. My client is an entrepeneur, a commercial real estate developer, who travels the country. During the time he spent in trial, my client missed an important meeting with his largest customer in South Carolina (who, in fact, was going to present him with an achievement award), and also had to forego trips to other parts of the country to oversee and/or initiate start-up projects. The greatest loss, for a client like this, is not the court costs, but the missed opportunity costs.

Things aren't all bad, however. I obtained this client because he was on the opposite side of a lawsuit about five years ago and, though I'd handled many cases for him in the interim, they'd all either gotten dismissed or settled. This was the first opportunity I'd had to show my client how I reacted in the stressful setting of a courtroom in a week-long jury trial. Many corporate lawyers sit behind their desks advising clients, but I hope that my client has now seen my advice put to action.

The Business of Business Litigation

In cities larger than the one in which I practice, most attorneys either fall into the category of litigators (i.e., trial lawyers) or office attorneys who never see the inside of a courtroom.

I've volunteered to be part of a working group of the Bar Association's Business Section, that is comparing the corporate laws of North Carolina versus the analogous laws of Delaware. I'm going to have to miss the group's first face-to-face meeting next week because it appears that I'm going to be in court trying out a partnership case.

The benefit I believe I bring to the table for prospective business clients is that, when I'm advising them or drafting something for them, my experience comes not just from a knowledge of the law or from what someone has taught me, but quite often from my experience in litigating similar issues.

When I reach a trial, I already feel in a sense as if I've failed, because I have been unable to reach a resolution of the case (whether through obtaining a court dismissal or a settlement) for my client. At trial, you see, there comes a point at which the result will be out of the hands of myself and my client: that is, the jury will take over.

In my experience, juries really do try to do the right thing, and also in my experience, I've found they most times have done the right thing. We've all heard the stories of runaway jury verdicts that appear to rape justice, but at least where I practice, the jurors have good common sense and try to do the right thing.

Still, a business tries to control uncertainty as much as possible. Sure there's risk--without which, we wouldn't have entrepeneurism--but most businesses I represent don't want uncertainty (which is different than risk). A jury trial is the ultimate uncertainty. I can do my best for a client in court, but on any given day, something can happen--a bad judge, a runaway jury, whatever--and the unbelievable happens.

Therefore, though I'm happy to litigate for clients, I always advise them that they need to be in the business of THEIR business--not in the business of fighting in court. Because no matter how good your lawyer is, and no matter how good your case is, there are always two sides, and there's always uncertainty.

Minority Shareholders, Revisited

A friend of mine finally resolved a longstanding situation in which he was involved, and I thought I'd revisit a commonly queried subject of mine--buying shares of stock in startup companies.

During the Dot Com bubble, my friend, and many other intelligent, financially astute professionals, were talked into investing in a startup corporation. What it did or was supposed to do don't matter for the purposes of this discussion, but recently, the corporation was bought out by a larger company. My friend received five cents on the dollar for his investment, and by the time it had arrived, was happy that he even saw that much of his money back--he'd resigned himself to having lost it all.

The purpose of this blog is not to speak to that company's business plan, or why the business never really took off. However, in retrospect, my friend's experience demonstrates a cautionary tale for investors who are buying minority shares in a startup company.

1. Understand what you're buying into. Ok, in the strictest sense, this isn't legal advice, but it bears repeating. At the time this company was started, technology companies were the rage, and everyone wanted to be a part of a new tech startup that "took it public" (sounds like the recent "flipping" craze, doesn't it?). I listened to my friend and other investors describe the company's goals, but I never could understand it--and I don't consider myself too terribly slow. What I heard were lots of big academic words, such as "shifting of paradigms," but I never was satisfactorily told exactly WHAT the company would do. Looking back on it, I'm not sure my friends understood either. If you don't understand what it is the company is supposed to do, I'd submit that you shouldn't invest in it.

2. Understand what it means to be a minority shareholder. Being a minority shareholder means that, unless specific safeguards are put into place, you have very few rights. For example, you can't force the sale of a company, you can't get your money back upon demand, and you pretty much have to do what the majority dictates.

3. Understand the value of stock offered. Let's say this startup corporation issued 100,000 shares, each of which were valued at $1.00. Pretty simple right? You put in $25,000, and you own 25 percent of the company. Except you might not. Unless a shareholder's agreement is put into place, there's no restriction against the company issuing additional stock. Stock can be issued when needed to bring in additional money. For example, using the above example, if the corporation needed another $100,000, it could issue 100,000 more shares. But what if some of the shareholders were issued shares because they were the startup engineers (i.e., the "idea men")? What if, even though your stock was valued at $1.00 per share, the company issued 100,000 shares to monetary investors, and then 200,000 shares to the two guys who thought up the idea, yet put no money into the company. That simple math can show you that the company would take quite a bit of growth before the stock you had might really sell back at $1.00 per share. Worse yet, what if the two original startup guys decided to issue more stock--to themselves? They might be able to do it--they're the majority, after all.

When buying stock in a startup company, understand the real value of the stock--in other words, is its value initially diluted by investors who are holding stock but have contributed no money or assets? Can the stock value later be diluted by the issuance of additional stock without your consent? Think about these things. In the case of my friend, the only person who appears to have profited from the corporation was the "idea guy," who'd issued himself so much stock with having placed a minimal amount of money into it that, even being paid a nickel on the dollar, he has profited well.

4. Understand what it means to own stock that's not publicly traded. Lots of stocks on publicly traded exchanges gain and lose value every day, sometimes because of the poor acts of the officers or directors. However, when you buy publicly traded stock, you know that, at the very least, you're not captive--you can sell your stocks on the open market for whatever price it will bring. However, when stock is in a very small company and isn't publicly traded, you may simply be stuck--as my friend was. He knew for years that the company was doing poorly, and simply had to watch as the value of his stock went down the drain.

There's nothing wrong with investing in a private startup company--in fact, I've both invested and started such companies. However, at least understand your rights when you invest!

Arbitration, Part 3 -- Right of Appeal

Binding arbitration is designed to be a quick and final extrajudicial disolution to disputes. However, experience has shown that this forced expediency often sacrifices accuracy and correctness.

Typically, binding arbitration does not allow for a right of appeal--either through an appellate arbitration panel or through judicial appeal. This means that the entire dispute will be decided by one individual.

In Court, though the process is admittedly often too long, too expensive, and too arbitrary, one benefit is that the judicial procedure provides for sufficient checks and balances that will prevent many egregious judicial errors. If the judge inappropriately dismisses a case before trial, the courts of appeal will typically reverse the trial court's decision and remand (send) the case back to the trial level.

If the trial judge makes an error of law in his ruling, the appellate courts will likely catch this error and reverse it. Furthermore, most, if not all state courts (and the federal courts) provide for additional layers of appellate oversite such that there are appellate courts to which you can appeal the decisions of other appellate courts.

All of these layers of judicial oversite create a heavy cost to taxpayers and to the individual litigant. However, of all the criticisms of the judicial system, one that you rarely hear is that, at the end of the day, after all appeals are through, that the courts got it wrong.

In the Arbitration proceeding, however, if a party is unhappy with the Arbitrator's decisions, there is little recourse. The aggrieved party will not be able to seek further redress within the Arbitration procedure. Furthermore, the party will not have access to the courts either. Typically, the role of the courts is limited to (1) enforcing an arbitration award into an official enforceable judgment or (2) to set aside arbitration awards in only the most egregious circumstances (i.e., beyond just mere errors of law and erroneous rulings).

This means that your entire case is in the hands of one arbitrator, sometimes not even an individual trained in the law, who holds your interest in the palms of his hand, secure further in the knowledge that--whatever he does--he likely will not be overturned.

Therefore, before entering into an agreement for binding arbitration, decide whether accurate and correct rulings should be sacrificed to the potentially arbitrary and unappealable ruling of an arbitrator.

Arbitation, Part 2: Cost

One of the supposed benefits of Arbitration is the decreased costs in comparison to traditional litigation. The arbitration process is more compact and is briefer, and attempts to dispense with extended discovery (in fact, often opting for no discovery at all), thus reducing the costs of numerous lawyer's hours, court reporter's hours, deposition transcripts, etc. While in the case I just finished, it is true less money was spent on attorneys and depositions, the other costs that were incurred at the very least were equal if not greater than traditional litigation fees.

First, unlike in traditional litigation, the parties are required to pay the "judge" (i.e., the Arbitrator), whose fees per hour will rival or even exceed his attorney counterparts. While from a purely abstract libertarian perspective, I like the idea that the parties to a dispute pay the full costs of the legal proceedings rather than burdening the taxpayers through tax-funded courts and personnel, as a practical matter, this can sometimes end up being more costly for a client than simply going through the state- or federally-funded litigation process.

Second, in my specific case, the costs were trebled through legal maneuvering from the other party's attorneys. The case at issue involved an owner/contractor disagreement, involving three different properties the contract was constructing for my client. Instead of filing one lawsuit or one arbitration, the contractor filed three. In traditional litigation, a judge likely would have combined all three into one case for the sake of judicial efficiency. In this case, however, the arbitrator assigned to rule just on this motion (whom had to be paid separately) ruled against it. That meant my client was required to ante up money for three different arbitrators, assigned to three distinct cases, when one paid arbitrator could have decided it in about the time it would cost to hear one case. It was an interesting tactic, because I believe my client was more able to absorb the costs than his opponent.

We estimated that the case, if consolidated, would take about a week to try, but unfortunately, because each arbitrator would be hearing his particular case anew, each time we'd need to spend a few days simply laying out the facts. Instead of paying for one week's arbitration, we would now pay for approximately three. Do the math on arbitrators who charge about $300 per hour, assume eight hour days, times 21 days. It's not cheap. Now add in attorneys for each side who will also be litigating for three weeks.

Finally, even though trial litigation can be expensive, the reality is many cases never make it that far--not because of settlement (which of course happens often)--but because the case is disposed of earlier by motions. I've litigated numerous cases for this particular client, but more than half of them never made it to trial because I got them dismissed early on. Because the arbitration procedure does not typically rule on such dispositive motions, and simply lets it go to a hearing (and if you think about it, it's in the arbitrator's financial self-interest to keep the case going so he can be paid), my client would have spent far more if those cases had been arbitrated than it did by litigating them.

Although I am sure each arbitration varies on its merits, my experience thus far is that arbitration has not been less expensive than litigation, and in fact has been more so.

Arbitration and Arbitration Clauses in Contracts -- Overview

Many of my more sophisticated clients, for whom I draw contracts, commonly ask if we should put in a provision to require "Binding Arbitration" in the event of a legal dispute.

The idea, in theory, is a good one. Arbitration, it is said, will reduce the legal costs otherwise incurred in court; will produce fairer results less dependent on technicalities and based more on the merits and equities; and will resolve matters more quickly.

I'd sat on the sidelines for a long time and advised against them, primarily from cases I had watched and from my own personal convictions that I was able to use the mechanics of the legal system to obtain a more favorable result for most of my clients.

However, I finally got the benefit of putting Arbitration to the test, recently, when a client of mine got into a dispute with a large commercial contractor over several projects. Each project was governed by a separate contract, each of which provided for binding arbitration in the event of a dispute, and the contractor, pursuant to his rights, demanded binding arbitration. Because the contractor's attorney was a litigator who specialized in construction litigation, and because I did not want my first experience in arbitration to be against an experienced specialist when hundreds of thousands of dollars were on the line, I associated a colleage of mine who was also a construction litigation specialist.

Through the process, I got the opportunity to watch how binding arbitration worked, to see its advantages and disadvantages in action, and now feel more qualified than before to speak about arbitration.

First, my opinion: putting binding arbitration clauses in contracts is still, in my opinion, a bad idea. Arbitration, in my experience, does not adequately deliver on its promised benefits (costs and fairness), while subjecting its participants to a procedure and to rulings that are only loosely bound by a rule of law and, for the most part, are non-appealable.

Next, in the upcoming articles, I will discuss the structure of binding arbitration, its alleged benefits and its drawbacks, and allow the reader to draw his own conclusions. Stay tuned....

Reader's questions about minority shareholders

A reader recently wrote a very good question about minority shareholders, and I thought the situation would be worthy of posting. Here is the question, and answer, with permission.

"Hi,

I read your article about minority shareholders. I got an offer to become a shareholder of a small company without paying anything, just because I have been working for them for a period of time.

However, my plans are to go to grad school and then after a year or two look for a position in a large company. Can I then go to work for another company if now I've agreed to become a shareholder of the small company that is just starting? If not, can I, after a year or two, tell that small company that I don't want to be a shareholder anymore? I'm being told by the other shareholders that everything will need to be confidential, so I don't know if my husband and I can show the shareholder agreement to a lawyer."

--------------


First, understand that I am only licensed to practice in North Carolina, and this does not constitute legal advice.

Second, at least in North Carolina, but usually in other states, it is a general industry practice that any agreements which would involve you personally but are labelled "confidential" can still be studied, shared, reviewed by legal counsel before you decide to sign it. Still, the best practice is to let the others know you'd like your personal attorney to review the documents.

Finally, there are two things which may prevent you from joining a big company while still a shareholder of the smaller one. The first is that (assuming their businesses are similar), if you're involved with the smaller company, you owe a duty of loyalty to that smaller venture. If you go to another company, you are not able to use your best efforts for the smaller company. In fact, your actions may go further and violate specific provisions of your shareholders' agreement.

The second issue is also a serious one: what if you just give up your stock rights and leave the company; will that solve everything? There still may be a problem if the remaining shareholders allege that you are using proprietary or confidential information you obtained while a shareholder in the small company. This may specifically violate terms of your shareholder's agreement (which may contain a non-disclosure provision) or it may violate your state's common law rules (i.e., civil rules created by caselaw) regarding what information from your former employer/partnership/venture/etc. that you can use once you leave.

The best thing you can do? Be upfront with the other shareholders, and negotiate a provision that, while protecting their interests, allows you the freedom one day to leave for bigger things: e.g., perhaps an agreement that allows you to leave and join a competing business, but provides that the remaining shareholders can buy out your interest at a fair price (the determination of which would be a subject in itself). If they won't agree to this, both sides are already on notice that there will be a potential conflict in the future--so why buy into it? Either walk away, or understand you may have a fight on your hands when you leave.

Purchasing a Business and using Brokers

On a weekly basis I represent individuals who are buying and selling small businesses. Occasionally, these clients employ the services of a business broker who, like a real estate broker, brokers the sale of the business, often representing the interests of both buyers and sellers in setting up a deal.

I've met some very knowledgeable brokers who have found niche specialties--such as one with whom I worked last month who only brokers the sale and purchase of pharmacies. However, just as with real estate brokers, there are very good ones, and then there are those who add little value to the deal other than putting a willing buyer with a willing seller.

The purpose of this post is not to discourage business buyers or sellers from using a business broker (after all, the broker can sometimes put you in touch with another party and connect you in ways you could not do yourself). However, there are at least two areas in which you need to be careful and protect yourself when using a business broker.




1. Do not let the business broker draw up your contract. Going back to the real estate analogy, in residential (and often commercial) real estate transactions, the broker often draws up the contract to be signed by the parties. However, these contracts have often been developed over time and adopted by your state's realtors association as well as the state bar association. These contracts have been used and revised enough that they can fairly well cover the exigencies involved with real estate.

A business sale, however, is far more complicated and multi-faceted, and does not lend itself well to a one-size-fits-all form contract. Furthermore, a business broker (unless he is a specialist broker, and often even not then) will not have sufficient legal understanding of all of the issues which are involved (and the laws governing them), to adequately protect the buyer and seller in a business sale contract.

Take, for example, a form contract I recently reviewed for a client in the construction industry. He'd agreed to sell his business for a price certain, and the buyer had agreed to purchase my client's building, within 60 days of the business sale, for an additional price. The parties had also agreed in theory--as is often the case--that my client would stay on as a consultant on an as-needed basis for a certain length of time. Pretty simple, isn't it? Perhaps, but the form contract drafted by the broker left some glaring holes:

1. First, though the broker was only responsible for listing the business (and thus receiving a commission on the business), he'd written the real estate sale into the form contract such that the broker would receive a 10 percent commission on the sale of the real estate as well--more than doubling what his commission would have been!

2. The purchaser wanted my client to sign a 100-mile radius non-compete for three years, which the broker had written into the form contract. However, such a wide-ranging non-compete would likely not be upheld in the state of North Carolina. The broker didn't know this.

3. The contract provided that my client would work as a consultant, but didn't specify his hours or his rate of pay.

In addition, the broker attempted to steer both parties to one attorney who would close the deal for both of them (more on that later). By the time my client came to me, the two parties were arguing over all the gaps which had been left in the contract but were now needing to be filled in.

A broker's form contract for the sale of the business is inadequate unless it is to operate merely as a non-binding letter of intent which just ensures the parties, in theory, have an agreement.

A well-written business purchase agreement is large, often contains lots of legalese, and will sometimes take quite a bit of negotiation. However, the beauty of it is that, once it is signed, the parties know exactly what the terms of the deal are, and now can move forward to closing with a clear understanding of what the seller is selling and the purchaser is purchasing. In the last two closings I handled, the actual "closing" of the business, in the attorney's office, took about 30 minutes each!

A good purchase agreement should be clear on the details, and, once signed, allow the purchaser to move forward with his due diligence and the seller to prepare for the conveyance of his business without having to haggle over details.

In the case above, the parties were able to sign an agreement quickly, but over the ensuing months of trying to fill in the details, have now become somewhat at odds with each other. This doesn't need to happen.

2. In a business purchase or sale, each side should have his own attorney. Often, brokers attempt to funnel both buyer and seller to a supposed "neutral" attorney, who simply draws up the conveyance papers based upon what was agreed upon in the form contract. Often, I've found, these forms state something like, "You should hire your own attorney to review these documents," but in practice, my clients tell me that the broker has discouraged them from doing this, saying one lawyer is enough.

Sure, it sounds self-serving, but in a business transaction each side should have his own counsel. In many real estate transactions, one lawyer can adequately (and, at least in North Carolina, legally) represent both sides. However, a business sale is much more complicated.

In the example above, the attorney recommended by the broker was good and was honest. In fact, he was so honest that he felt he should only represent the purchaser's interests and not try to represent both sides. My client came to me with proposed closing documents that included:

1. A consultation agreement requiring him to work at the purchaser's will for less than half of his normal hourly pay rate;
2. A property lease that allowed the purchaser to lease--with no obligation to purchase--the seller's real estate, notwithstanding the provisions of their form contract.
3. A non-compete that was so overbroad and vague, it would have prevented my client from getting work that was realistically not in competition with the purchaser's acquired business.

Furthermore, if both parties go to a supposedly "neutral" attorney, what is that attorney's obligation to point out (or even correct) legal flaws created in the original form contract? In this case, the hired attorney pointed out that the originally agreed-upon non-compete was overly broad and unenforceable in our state. But what if he had not? Would he have overreached against the seller? Or would he have been negligent and committed malpractice as to the purchaser, who, if he needed to enforce the non-compete, would have been unable to do so?

In sum, though business brokers are a valuable source of information when buying and selling your business, you'd be best served to hire counsel to advise you through the process.

If you need help or representation in buying or selling your business, you can set up a consultation with me by calling 704-735-0483.

The Family Business -- Finale

In the last few weeks, I've been discussing what to do with your family business, specifically focusing on the issues inherent to passing the business on to your family members. Today I'll go through a few of the remaining issues to consider.

1. (If you're selling) Should you sell for cash to your family or owner-finance? As a practical matter, your family will likely be unable to pay for the business unless you can owner finance. If you really want to cash out, you'll probably need to find an arms-length third party buyer.


2. Should you stay or should you go? One issue to consider is, when you convey your business to your family, should you request or offer to stay on in some limited capacity (e.g., as a part-time employee, a consultant, etc.)? When selling your family business to an outsider, the buyer usually should have a desire to keep you on, if for no other reason than to (1) help retain the business's good will and (2) create a smoother transition period.


Family businesses offer different dynamics, however; no matter how much you love your family, can y'all work together?

Anecdotally, from my past experiences, most parents do not stay on after conveying their business to their children. I suspect that, by the time they hand it over, they're ready to see if the business can sink or float on their children's efforts, and quite frankly know that they would drive themselves (and their children) crazy if they hang on and offer advice. A small exception to this, however, is that some parents I've seen stay on as "consultants" (usually, at most a nominal title) so that they're able to stay "employed" by the business and keep some type of needed medical insurance.

3. Anything else I should consider? Most likely, but your business is special, and it's unique to you. One of the joys of my practice is that I've learned the quirks and specialties of numerous small business, as well as the idiosyncracies of each of their individual owners. No two businesses--even within the same industry--are alike, so you need to make sure you're represented by competent tax and legal professionals. Preparing a succession plan for your business will only happen once in your lifetime--make sure it's treated importantly. If you would like to talk further about your specific situation, contact me at 704-735-0483, and set up an appointment.

The Family Business, Part 3: Give or Sell?

I've been blogging in the past few weeks about the "family business"--i.e., that small business set up by an entrepeneur, and nourished to fruition--and issues that any successful small business owner should consider when getting closer to retirement age.

First, I discussed the issue of whether the family members had the desire or even the ability to carry on the family business, because in my anecdotal experience, fewer than half of entrepeneurs have families who are both willing and able to carry on the family business.

But for this week, let's assume your family falls into that category. If a member of you family has both the desire--and the ability--to keep the family business running, what you should consider next? Based upon my experience with family businesses, I would suggest that you next consider whether you should sell your business to your family, or whether you should give your business to your family.

The average non-entrepeneur I'd hazard would be be a bit aghast at the idea of selling his business to his family. The average non-entrepeneur believes that his or her job should be to share his wealth with his children, to the extent possible. However, entrepeneurs--many of whom came by success with some difficulty--are more open to the idea. There are many non-legal reasons why perhaps you should consider the issue of sale versus gift (i.e., anything worked for is much sweeter, in an entrepeneur's mind), but I'm going to focus on legal and tax implications for considering this question. As always, there is no generally right or wrong answer--the issue needs to be carefully considered, with the help of both tax and legal counsel. Here are just three things to think about when considering this issue.

1. ESTATE PLANNING. One thing to consider is the tax consequences of your conveyance to your children (both income and estate). Chances are, the actual "book" value of your company (i.e. the value of its hard assets) is much less than you'd actually accept for it if you sold it on the open market. Perhaps, if you own a golf course, your land is worth $1 million, and your equipment is worth another $1 million. However, if your golf course is wildly successful, you might not be willing to sell it for less than $6 million (this value added to the hard value is what is commonly referred to as "good will"). Sometimes, tax lawyers or accountants will advise a sale of the company to children in order to reduce estate taxes.

Using the above example, even if you aren't willing to part with your golf course for less than $6 million, suppose your tax advisor tells you that--since you've never received an offer for your company and it has a book value of $2 million--you could legitimately sell it for $2 million to your children. You have effectively--and legally--gifted $4 million to your children without having to pay estate taxes.

Again using the above example, had you gifted your children the golf course with a book value of $2 million, that would not, at this time, create an estate tax consequence, but if you died leaving them much more property, you might very well create an estate tax burden for them (the subject of estate taxes is too lengthy and complicated to go into at depth; if you have any questions, please contact me and I will refer you to an excellent tax attorney).

Therefore, arms-length sales are sometimes an effective means by which to reduce your estate tax burden before you die.

2. REDUCING INCOME TAXES. Sometimes, a sale versus a gift can reduce the income taxes your family may pay on its property in the long run. This is especially important if you are considering, in the short term, a sale of the business to an outside investor. Using the golf course example, again, let's say that, when all the equipment and land were purchased, their book value was $300,000. If you were to sell the business right now for $6 million, you would pay taxes on your gain (Sales price of $6 million, minus original basis of $300,000 = taxes on $5.7 million). If, however, you could in good faith sell your family business to your family for its book value ($2 million, in my example), your family would pay taxes on the gain of $6 million minus $2 million, which would reduce its taxable basis. (Understand that I'm using simplistic examples: a tax advisor may tell you to hold your business until you die so that your children could get a "stepped up basis"--in this case, $6 million; so please understand there is no one formula that fits all).

3. SELLING YOUR BUSINESS TO FAMILY CAN PROVIDE YOU INCOME. Let's say that you family is willing and able to run you business, and your tax advisor believes that an arms-length book-value transaction is the best idea for your business. There's another good reason to sell your business versus giving it away: it can provide a steady stream of income. First, an assumption: almost no sale of family businesses to another family member involves an actual cash purchase. Instead, they typically involve selller financing. In addition to providing you tax savings, selling to your family can provide you a steady stream of income in the form of seller financing payments back to you on a promissory note. This is often important anyway, but if I am representing the spouse of a deceased entrepeneur, often this is even more important. Selling to the children, and owner-financing the sale, can provide to the seller a steady stream of income during the seller's golden years, while at the same time giving his or her children tax benefits and a leg up in this world.

If you have any questions, please call my office and set up an appointment at 704-735-0483.

The Family Business, Part 2

When considering a succession plan for your family business, start with one of the most basic questions: who should succeed to your business in the event of your passing? A basic question, to be sure, but before you start planning your business plan wrap up, you need to determine whether it should descend to your family or not?

If you are like most entrepeneurs, you'll typically want your family to share in the successes of your business, but you may need to decide whether they should take on your business, or whether you should just pass to them the fruits of your business. When thinking about this, ask yourself these questions:


1. Does your family have the desire? First, ask yourself: does your family even want to continue your business? I've never done a formal survey, but anecdotally, I'd estimate that no more than half of the entrepeneurs I represent has families who even desire to take over the business. Often, the children have watched their parents sacrifice their private lives and time with family to build a successful business, and the children determine that they don't want to live their lives that way. I also suspect that for many of these children, who have enjoyed the financial fruits of their parents' labor, they subconsciously disconnect the labor necessary obtain those benefits. What do I mean? I've seen numerous children of successful entrepeneurs decide to work in lower-paying jobs--becoming teachers, social workers, and other idealistic professions. Some of these, I believe, decide to follow a calling such as this because in the back of their minds they know that they have their parents' financial resources to rely on.

If you're like most of my entrepeneur clients, your children have enjoyed the benefits of you owning the business: but do they want to own the business?


2. Does your family have the ability? Even if your family members do desire to take over the business, ask yourself this brutally honest question: do they have the ability to successfully continue (and even expand) the business you worked hard to create? Anecdotally, again, I've found that in more than half the cases, if a family member actually desires to continue the family business, that family member probably also has the ability. You've ingrained into him or her the work ethic necessary, and your family hopefully will share many of your same values that helped make your business a success. However, your family's ability is not a given. Just because you have a brilliant medical practice does not mean that your child can share that gift you have. Make an honest appraisal of your family members and your business. Does your business require mainly hard work and a certain ethic? If so, your child's desire to continue the business may see him through. Does it also contain certain talents or gifts that most people don't possess? Consider it more closely, then.



3. What do you do when there are multiple family members? I've been writing this article almost as if you only have one child, but the average family, of course, will have two or three children. This could bring multiple complications--all of which can be overcome with planning, but which need to be considered. I've seen all of the following issues:

--A brother and sister both want to run the family business, but don't get along.

--There are three brothers, two already in the family business, but one who is much younger and a minor.

--One child has always been in the business, and the other has never had anything to do with it, and the parent is trying to figure up how to divide his estate fairly between both of them.

None of the issues I have mentioned should keep you from making a succession plan with your family business. To the contrary, they are matters to be considered, and, with good planning from an attorney, an accountant, and perhaps even an investment advisor, they can all be taken into consideration when creating a successful plan regarding your business.

Passing on the Family Business

Passing along a family business may seem like a pretty simple process. The entrepeneur builds a successful business, makes a solid living, then passes it along to his or her children. Easy, right? Unfortunately, those entrepeneurs fortunate enough to have created a successful business have found, when the time actually comes for them to pass the torch, that things aren't so easy. If you own a successful business, here are some issues that may come your way. In future blogs, I'll go through these different issues and describe how they can be overcome. But for now, give them some thought well before the time comes for you to pass down your business.


1. Do your children want the business? The first, and most basic question to ask yourself is, do your children really want the business? Do they have a desire to carry on the family business; do they have the same passion (and ability) to do what you are doing; and are they currently involved in your business? Or, have your children enjoyed the benefits of your business (e.g., annual gifts of cash, a company job at an inflated rate, a higher standard of living than their career would otherwise allow), but don't seem to have an interest in doing what you did to provide those benefits?

If your children are already adults (and you're considering retiring), chances are you probably already know this answer. But knowing the answer, and making future plans for yourself and your family, are two different things. If your family is not interested in joining, working at, or perpetuating your successful family business, then it's time to start thinking about your own future. You may want to consider selling the business while you are still healthy, and while the business has goodwill. Because if you have no one to succeed you, and you hold on to your business until you die, your business' value will wither quickly while your children try to orchestrate a quick liquidation.

If, on the other hand, your children are interested in taking over and continuing your business, you need to consider how best to accomplish such a handover. The way you accomplish this may have profound consequences, affecting your own standard of living during retirement; the net worth of your children; and estate taxes that may be suffered by your estate after you die.


2. Give or sell the business? Assuming one or more of your children do want to own the business, how should you convey it to them? Should it be a gift? Or should you sell it to them? While many people, at first blush, might be aghast at the idea of making their children pay them money, the decision on how to handle this shouldn't be made without the collective advice of tax and legal professionals.


3. Should you keep any control? When you convey the business to your children, should you walk away? Or should you retain the right to make business decisions even after you no longer own it? The decision you make should depend on the particular circumstances of the family members who will be taking over your business.



4. If you sell the business, should you take cash or owner finance? A cash payout will provide you hard, liquid assets that will allow you to live out your retirement goals. Owner financing, however, also has its own benefits--both for you, and the family members buying from you.

If you live in North Carolina, and have questions about a family business, feel free to contact my office to set up an appointment:

wldeaton@bellsouth.net
704-735-0483.