Volume 4 Issue 3 -- May/June 2000
We've all heard of a marriage made in heaven (or another place beginning with "h"), but have we all heard of a business marriage? The following is an account of an actual case of mine.
Ed managed a restaurant for a company that was selling the facility at a very reasonable price. Ed wanted to re-open the restaurant under a new name, Tomains, Inc., with new owners.
He arrived in my office with Tom and Suzy, who were executives in a manufacturing business and who had no experience in the food industry. Ed knew them from the tennis club, trusted them, and assumed they would contribute importantly to the corporation.
Tom and Suzy together advanced approximately $20,000 for their stock in Tomains. Ed could have borrowed the same amount from a bank, but elected not to do so. This is how the business marriage of Ed, Tom, and Suzy began.
As explained in an earlier newsletter, creditors get paid off and are gone once the debt is paid. Equity investors, like Tom and Suzy, are financially joined to Ed via their stock ownership in the business.
Several years after forming Tomains, Ed came to my office and made the following observation. "I don't need, nor did I ever need, Tom and Suzy. They don't contribute to the restaurant; I do all the work." Ed ruefully observed that he could have borrowed the funds to purchase Tomains, and would thus not be in a business marriage with Tom and Suzy.
Often, clients and advisers fail to look down the road at the consequences of having unrelated investors in a small business. And, in many cases, the operators-shareholders of smaller businesses are not fully aware of the option to borrow funds as opposed to soliciting investors.
If the would-be entrepreneur cannot raise investment funds from traditional lenders, the only alternative may be obtaining stock-holder-investors. If, however, Ed has funds of his own, or can borrow from a bank, he should be made aware of this option before bringing business associates to a meeting to form the entity. If the business is successful and the would-be investors are ignored after promising to invest, they may allege that they were initially involved and then deprived of a business opportunity they helped create.
There are also other approaches to the money-raising formation problem which may satisfy Ed, Tom and Suzy. For example, Ed could be given a contractual right to purchase the interest of Tom and Suzy at some date in the future. This could be premised upon a reasonable return on the investment of Tom and Suzy. Thus, say, after five years, Ed could purchase the interest of Tom and Suzy at a pre-agreed price.
Another matter often overlooked in configurations like those of Tomains is that, without a promise by Ed not to compete, he could open a second restaurant across the street from Tomains. Such a move by Ed could destroy the investment of Tom and Suzy, and probably lead to a lawsuit. While Ed may not want to hear about such restrictions, it would be, in my opinion, unprofessional if the subject were overlooked. This is why I include the topic on my entity formation checklist.
Another point to consider is the death, divorce, or incapacity of the
principals, Ed, Tom and Suzy. These contingencies can best be addressed using an
agreement, sometimes called a stock redemption agreement, cross-purchase
agreement, or simply buy-back agreement, that requires the entity (corporation
or LLC) or the owners (cross-purchase) to purchase the interest (stock) of an
owner in the event of death, disability, or other contingencies.
Unlike real marriages, business marriages should not be driven by hormones and impulses. Instead, it is better to exercise foresight. Since no one can see the future of a business marriage, the best substitute for clairvoyance seems to be planning.
If you want to see the checklist I use for this process, please contact my office
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