Smal Business Investor
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.
Return to Newsletter List
Return to Content Index
Home Page