Small business break ups

Based on the comments I get from readers, one of the hottest topics on my blog are posts dealing with small business break-ups--be they partnerships, corporations or LLCs. As I've written before, within those disputes, one of the biggest struggles involves the inequality among partners or business co-owners, i.e., what happens when there are equal owners making unequal contributions.

What often happens in such cases is that the business breaks up. In worse cases, the disputes end in massive lawsuits, ugly recriminations, and financial ruin.

Where I've found this potential to be at its greatest is with the formation of those businesses where the co-owners are bringing different things to the table. For example, maybe one person is bringing money, another one is going to do the work, and perhaps a third is contributing an invention or patent that's going to make a million dollars. Each person is bringing something to the business, such that the whole is greater than the sum of its parts. Ironically, however, over time, these very differences can breed resentment among the partners and eventually cause business break-ups.

For example, at the beginning of the above hypothetical venture, the "worker" is getting the best of the deal: the money man risks losing capital, as, to a certain extent, does the inventor. The worker just risks losing his time, but nothing more.

Five successful years later, however, the dynamics may have changed. The capitalist and inventor are enjoying a nice return on their investment. The worker, however, is resentful: the business would stop without him. Whereas the capitalist and contributor have received back their investment (and then some), the worker continues to have to invest his time, effort and labor into the business.

I have also watched similar situations play out in a different manner. I've watched an "idea man", perhaps willing to do the work, who gathers up willing monetary investors. He's promised the investors great potential, and wonderful returns some time in the future. When things get successful, it turns out that he's issued himself so much stock, he effectively controls the company. The investors get little in the way of dividends, because by the time the idea man has paid himself a nice salary and benefits, there's little left. Theoretically, their stock is creating equity, but because their company isn't publicly listed (or, in an alternate scenario I have seen, they learn the shareholders' agreement has a provision requiring them to offer their stock back to the company at preferential rates prior to selling to a public buyer), the investors now have little hope of ever seeing a meaningful return. In other words, the passive investors' investments are held hostage.

Although attorneys do a good job of foreseeing the "worst case" scenario--i.e., what happens when things go awry--we also need to prepare for best case scenarios--i.e., what happens when things are going very well, and the equities have changed.

Here are just a few ideas to allow the continuation of a small business, even when the business contains different types of investors:

1. Provide benchmark dates at which the investments are vested, and any future contributions are paid for at arm's-length. This is a hard idea to pin down, except by way of example. Go back to my initial example of three different investors, each with a very different type of investment. Each investor, theoretically, could be benefited more than the rest, or less than the rest, depending upon how the company was structured. But they could all be treated fairly, if they come up with success benchmarks that allow them to treat their investment as having been fully paid in.

In the example of the worker, the company's organizational agreement could state, for example, that after the company reaches $X sales per year, the worker will be paid a salary--or perhaps, can hire staff and no longer have to contribute his own services. He is no longer captive: he's either now an investor and a paid-employee (in the first example), or else a passive investor like the rest (in the latter example).

For the inventor, perhaps the same agreement should state that after some benchmark (perhaps Y years), the inventor's patent will simply be licensed to the company, on a yearly basis, for a certain sum of money.

In other words, to avoid disparities later in the company's existence, you create a system so that the investors' later contributions of time, effort, or whatever, are compensated on an arm's-length basis.

2. Create, at the outset, scheduled pay-outs or buy-backs. In the other example, of the passive monetary investors, they contribute all the risk, but the idea man, as the business becomes successful, effectively shuts them out and sews up their contribution. Investors should recognize this as a risk, and ask for organizational documents that create some type of guaranteed payout--be it through a guaranteed buy-back, guaranteed dividends, or the like.

3. Create, in the organizational documents, forced buy-out or buy-back provisions. At the very least, you could place in the organizational documents provisions by which you can force a buy-out or buy-back, at an agreed upon price (or agreed upon pricing mechanism) during a certain time period or after a certain triggering event.

Interestingly, of the small business disputes I've seen, at least as many of them stem from business success as do from business failure. When setting up or starting a small business with numerous investors, don't just think about the worst-case scenario: ask yourself, what problems arise if the best case scenario occurs?

(Somewhat) Off-topic: The Economy and Temperament

I've been speaking to my law partner lately, and we've together come to the conclusion that the populace, in the past year, has just gotten a little ... meaner.

My business practice consists of both transactional work (e.g., the buying and selling of businesses) and business-related litigation. While I'm not surprised by the fact that transactional business is currently down, I've been surprised at how much business-related litigation has picked up (and this is not counting collections and debt-related litigation). Sure, some of the cases I've picked up involve the fact that someone is now financially unable to perform the terms of the contract, but many of the cases involve malice, opportunism, fraudulent behavior.

The tide of meanness doesn't just stop with clients, however. I've spoken to some of my fellow attorneys, many of whom are extremely frustrated. Some are just wanting to get out. In tough times, when an attorney is involved in a transaction, if something goes wrong, everyone looks to the attorney as a sort of insurance policy or bank, expecting him to pay for everyone's mistakes--and this is what a couple of my colleagues are feeling right now. Others have started to fight among themselves, even to the point of spreading rumors about some of their fellow attorneys' impending shutting down of offices.

Beyond the legal profession, I've seen more bitterness in the local newspapers (who seem more than usual, to engage in rumor mongering and yellow, opinion-based journalism), in consumers, and in the population at large.

When pointing this out to my partner, he agreed, and we discussed what we thought about this ugly mood that we're seeing. Here, I believe, are some of the causes:



1. Economic Difficulties. This, of course, should be no surprise. My insurance clients tell me that more questionable claims have arisen, and claimants are quicker to threaten suit if they don't receive a settlement they believe is fair. Folks, desperate to hold on, want someone--anyone--to bail them out, and so they appear to be quicker to point the finger of blame and expect compensation. Anyone who is married knows that when money is tight, you tend to argue more, and with an American populace collectively feeling the pinch, there are a whole bunch of ornery people out there right now looking to fight.

2. Political Difficulties and Change. In the last year, the country has seen a sea change of politics. The political minority is scared about the direction being taken by a decidedly leftist administration. Some realists within the political majority are coming to see that a smooth-talking man with a cult of personality is not the panacea they hoped. It's all different now. And the politics have gone from an understanding that government is no solution, to one in which a desperate population is willing to give up its collective freedom for financial security.

3. Changing of the Rules. With all of the political and economic change described above, many of the rules we've all gone by suddenly have been thrown out the window. Real estate, the way to sure riches, suddenly has become a burden and a source of loss. Whereas two years ago we were all reading books and dreaming of how to leave the boring office cubicles to live an exciting life of entrepenurialism and self-employment, most of us now are just thankful for (or even worse, still wishing they had) those same boring jobs.

While I expect the effects of all this change to eventually settle in (for better or worse), the current instability has created an ugly mood in our area. The only lesson, perhaps, to be drawn from this is that in this world, when depending on the temporal, it can all be taken away, and if that is the base of a person's life, it, like a foundation created on sand, can wash away in a great storm.

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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.