Newland's Business Notes

Smal Business Investor

Volume 18 Issue 2 -- March/April 2014

Ted and Liz Tara opened a restaurant known as “Tara-Gone with the Wind” about 10 years ago. The restaurant has been only moderately successful.

Ted and Liz met Rhett Buffler, who recently retired from a high tech company in Spain, where he learned about the preparation of tapas, a popular Spanish food.

With some of his  retirement money, Rhett wanted to invest in Taragon LLC. Ted and Liz each owned 50% of the LLC, but they were not sure how Rhett’s money was to be invested, as a loan or as a purchase of an interest in the LLC?

 Eventually they decided Rhett would invest $150,000 to redo one of the rooms of Tara-Gone to emphasize Spanish décor and food. In exchange Rhett would receive a 40% interest in the LLC.

This newsletter will look at what can happen with such an arrangement in both good times and bad. First, the good times.

As a result of the changes, the restaurant did well, but after a while Rhett decided he really was not cut out to be in the restaurant business. Soon he accepted an offer from a nearby high tech firm and became only a passive investor in Taragon LLC.

With Rhett gone most of the time, all of the work of running the restaurant fell on Ted and Liz. While they were pleased that the path of the restaurant was going like the wind, they were not pleased that Rhett received 40% of the profits without actually doing very much in the business.

As time went by, Ted and Liz began to think they would have succeeded without Rhett or his tapas by using borrowed funds from a bank to accomplish much the same degree of financial success, but now they are “in bed with him” so to speak, forever.

This aspect of investing in a small business is often overlooked. If the business is relatively small and it is desired that all of the investors-owners be active in the business, it is necessary to agree and spell this out at the beginning.

Another point on which Ted and Liz should have concentrated is meeting with a knowledgeable attorney/business advisor and going through checklists of issues to consider concerning the relationship between the investor and the business. Passive ownership in a small business can be problematic.

Suppose on the other hand that that after an initial growth spurt, the novelty of the décor and food wore off, and the business began a downward slide. Soon the business had no money to pay Rhett or anyone else.

Rhett could either have loaned the funds to the restaurant or he could have invested or purchased an equity interest in the LLC. To Rhett, the advantage of an equity interest is that he gets profits in perpetuity, if there are profits. The disadvantage is that if the business fails, Rhett will likely be lose it all.

On the other hand, if Rhett had loaned the $150,000 to the restaurant, he would have a different set of risks and benefits. If the LLC failed to repay Rhett, he would have recourse by suing the LLC and possibly Ted and Liz to obtain repayment, although success in such situations is far from certain. Conversely, if the business succeeds, the most that Rhett can get is the amount of interest specified in the note.

Stated differently, there is a big difference between a creditor who can demand repayment even if the business is failing and an investor who can expect nothing if the business fails.

In any endeavor of this sort, it is important for potential investors to do their business detective homework, for example, by considering the items listed in the business purchase checklist on our website. It is usually advisable for the owners to meet with their attorney before subsequent meetings with the investor.

Unfortunately, in many instances, particularly if there are personal connections, the parties do not perform due diligence and rely on friendships and intuition. It is better to contact a business attorney to assist in performing due diligence and in structuring the relationship as the parties intend.

If you need assistance in areas such as this, please contact Newland & Associates.

Copyright 2014

Published by the law firm of Newland & Associates, PLC
9835 Business Way
Manassas, VA 20110
Call us at (703) 330-0000 for a full range of business law and tax-related services.

While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.

Redistribution or other commercial use of the material contained in Newland's Business Notes is expressly prohibited without the written permission of Newland & Associates, PLC.

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