Cliff Ennico

“Three years ago, I started a business with two other guys.  We set up a limited liability company (LLC), and split the ownership 40%, 40% and 20%.

The business grew for about a year but then really tapered off when the recession hit.  All three of us had to take ‘day jobs’ just to make ends meet, but we kept the business going on life support in the hopes things would get better when the economy improved.

Two years ago our 20% partner (let’s call him “Joe”) got a full-time job and decided he didn’t want to be partners with us anymore.  The trouble was he had put $25,000 into the business and didn’t want to write it off.

So, in exchange for his withdrawal from our company we agreed to pay him $25,000, plus interest, in two years.

Three months ago the two years was up.  We still owe the $25,000, plus another $250 in interest.  Our business has some sales but isn’t showing a profit and there’s no way we can make the payment.  We tried to contact Joe and offer to extend the loan for another two years in the hopes things would improve.  He hasn’t returned our phone calls, and a certified letter we sent to his home was returned to us as “unforwardable”.

So now we have a problem.  We’re pretty sure Joe doesn’t have the money to sue us to collect the debt, and even if he did, our company has no money to make the payment (fortunately, the remaining partner and I didn’t personally guarantee Joe’s loan so our houses are not on the line).

How should we deal with Joe at this point?  Can we just blow him off?”

I agree that it is highly unlikely Joe will sue you to enforce his debt, at least right now when your company has no assets.  But there are three reasons you should not “blow Joe off” in this situation:

O  in most states, the statute of limitations for “breach of contract” (such as a loan default) is quite long – sometimes as long as three to five years – so Joe has plenty of time to wait until your company is growing and making serious money before he “lowers the boom” and brings a lawsuit against you;

O  in such a lawsuit, Joe is likely to argue that the two of you didn’t run the business seriously enough, in an effort to persuade the court to “pierce the corporate veil” and allow him to go after your personal assets, even though you did not personally guarantee his loan;

O  if anyone expresses an interest in investing in your company, you will have to disclose your default on Joe’s loan and your outstanding debt to Joe as a “contingent liability” of your company – a sure “turn off” for any potential investor.

You should make every effort to find Joe and get him to the bargaining table.  His full-time employer should be able to give you a forwarding address, even if Joe no longer works there.  Hire a private investigator if necessary.

Once you track down Joe, you should definitely offer to extend the loan but will need to include some “bells and whistles,” both to make the deal more attractive to Joe and make sure you don’t find yourself in exactly the same situation two years from now.

Here are some ideas you should run by your attorney:

  • a “call” provision allowing the LLC to convert the debt back into a 20% equity stake in the company if the debt isn’t paid on time;
  • a “preemptive right” provision allowing the LLC to convert the debt back into an equity stake in the company if someone invests $250,000 or more into the company (the conversion price would be the same paid by the new investor);
  • a “net proceeds of sale” provision giving Joe 20% of the “net proceeds” (basically gross proceeds less brokers’ commission, legal and accounting fees, and other transaction expenses) of any sale of the company during the two-year period; and
  • an “equity kicker” provision giving Joe options or warrants to acquire shares in the company, in addition to the interest on his loan.

It might be that Joe is in a better position than he was two years ago and is willing to write off his $25,000 investment in your company.  If he does, though, be careful of unintended tax consequences.  The federal tax laws treat the “forgiveness of debt” as income to your company.  Since your company is an LLC, that $25,000 in “phantom income” would pass through to you and your remaining partner and you would each have to pay taxes on your share.

In fact, if Joe really hated you guys and wanted to get back at you, the best way for him to do that would be to send you notice forgiving the loan.  Hopefully he’s not reading this right now.

Cliff Ennico (www.succeedinginyourbusiness.com), a leading expert on small business law and taxes, is the author of “Small Business Survival Guide,” “The eBay Seller’s Tax and Legal Answer Book” and 15 other books.

Getting the “Three Stooges” Out of Your Limited Liability Company by Cliff Ennico

Cliff EnnicoGUEST POST By Cliff Ennico

“I just started a limited liability company (LLC) with three partners. Our attorney drafted an Operating Agreement for us, but I’m a little confused by the buyout provisions he drafted.

The agreement says that if one of us dies, becomes disabled, or otherwise withdraws from the company, we have to buy his shares in the company so the remaining partners can retain control.  So far, no problem.

The problem is that the agreement doesn’t spell out the buyout price.  It says each of us (the company and the withdrawing partner) must pick an appraiser; the two appraisers then meet and determine the buyout price.  If they don’t agree, the two appraisers must appoint a third appraiser, who will arbitrate the dispute and ultimately decide on the buyout price.

I’m not a lawyer, but it seems to me that this procedure is going to be very expensive and time-consuming.  If one of us wants to leave the company, we certainly want to be fair, but we don’t want this dragging on for months.

Our attorney is telling us there’s really no other way to handle the situation as we’re just starting in business and there’s no foolproof way to value a startup company.  Is that true?”

What you have described is what is commonly called a “pyramid” appraisal clause.  I call it a “Three Stooges” appraisal clause.

Lawyers and accountants love this clause because, at least on paper, it seems very fair.  Your attorney is right that there’s no foolproof way to value a startup company that doesn’t have revenues or profits yet, so why don’t let a team of experts figure it all out when there are some real numbers to look at?

The problem is that what looks good on paper doesn’t always work well in practice.  In my experience when a “Three Stooges” appraisal clause is invoked by a withdrawing partner, what happens looks an awful lot like . . . a Three Stooges comedy.

First, the parties take forever to appoint the first two appraisers.  Then, the appraisers take forever to review the company’s books and decide on a meeting date.  Then, you get into tax season (the appraisers are often accountants or CPAs) so nothing happens for a few months while the appraisers clear their calendars.  Then, the appraisers can’t agree on the buyout price and decide they really don’t like each other.  Then, the appraisers stop talking to each other so a third appraiser cannot be appointed to resolve their dispute.  And so on and so forth.

Meanwhile, your company is paying all these folks, probably by the hour, which I’ve always suspected is the primary reason lawyers and accountants love the “Three Stooges” appraisal clause – it’s a guarantee of future business (nyuk, nyuk, nyuk).

While your attorney is right that no single formula can properly value an early-stage company, there is a way to get the buyout price determined quickly, efficiently and fairly when a partner decides to leave the company (or is forced to withdraw).

Here’s how it works.

First, the Operating Agreement should clearly state that if a partner withdraws from the company, the buyout price will be:

  • if the company is profitable, the withdrawing partner’s percentage share of the company’s average annual pretax earnings (EBIT) over the preceding five years (or the time the company has been in business, if less);
  • if the company is not profitable, the withdrawing partner’s percentage share of the company’s average annual sales of the company over the preceding five (years) or the time the company has been in business, if less);
  • if the company has neither profits nor sales (i.e. your company is still a startup), the withdrawing partner’s “capital account” (using the IRS definition of that term) as of the date the partner withdraws from the company; or
  • if the withdrawing partner has no capital account (or a negative capital account, which sometimes happens), a nominal value such as One Hundred Dollars.

Second, the Operating Agreement should state that the company’s average annual pretax earnings and annual sales, and the withdrawing partner’s capital account, will be determined by the company’s independent accountant, “which determination shall be conclusive and binding on the parties in the absence of manifest arithmetic error.”

Third, in the case where a partner dies, the buyout price should be the “greater” of the amount determined above or the proceeds of any policy of life insurance the company has maintained on the deceased partner.

Lastly, the Operating Agreement should state that if a partner’s withdrawal is due to his bad behavior (for example, he committed a crime, embezzled money from the company, or failed to perform his duties), the buyout price is One Dollar.

While not 100% perfect, this method ensures a fair, reasonable and quick calculation of a withdrawing partner’s buyout price, enabling the remaining partners to do what they do best – run the business – without having to look out for flying cream pies.

Cliff Ennico, a leading expert on small business law and taxes, is the author of “Small Business Survival Guide,” “The eBay Seller’s Tax and Legal Answer Book” and 15 other books.

Toilet Paper Entrepreneur on eCom Connections Tomorrow!

Mike Michalowicz Mike Michalowicz has a driving passion for entrepreneurialism. It is his belief that anyone that has the desire, even a fleeting ‘what if’, has been touched by an inspiration that must be satisfied.

Mike started a company called Obsidian Launch with the sole purpose of giving first time young entrepreneurs a partner in growing their concepts into industry leaders.

Here are a few of the things he has done:

- Founder and former President of Olmec Systems, Inc., a regional computer network integrator. (sold in 2002)

- Co-Founder & Managing Partner of PG Lewis & Associates, LLC , a national provider of data forensic services (sold to Fortune 500 in 2006)

- Reocurring guest on CNBC’s The Big Idea with Donny Deutsch

- SBA Young Entrepreneur of the Year (NJ) in 2000

- 2004 graduate of Inc.’s & MIT’s “Birthing of Giants” Entrepreneurial Program.

- Featured in Inc., New York Times, and international publications.

- Author of “The Toilet Paper Entrepreneur”

- Guest lecturer for entrepreneurial groups at Harvard, Boston College, Penn State, UPenn, Seton Hall, Rown, TCNJ and other colleges throughout the US

- Member of EO (Entrepreneur’s Organization)

Mike believes that if he can achieve all these things and more, then you, too,  can achieve whatever you set your heart, and your beliefs, to.

eCom Connections is excited to have Mike as an interviewee on tomorrow’s show (May 16, 2011) and we will be asking Mike about the differences between marketing and advertising, the use of a marketing calendar and allocating time & money for marketing and advertising your small business. Join us and ask your questions.

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