Getting Closer -- Is this a workable deal for me?

Discussion in 'Growing and Managing a Business' started by kilkenny, Mar 2, 2012.

  1. kilkenny

    kilkenny
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    The current sole owner is very good at the 'job' part of the business, but has no idea how to 'run' a business. I have an accounting degree and have run businesses for 20 years. I have never owned a business though.

    This business started out 2 years ago with Assets equaling Liabilities. There is a business loan for the company of $300k.

    Over the last 2 years, the current owner lost $100k. $60k from business and he drew a salary of $40k.

    Current State:
    Liabilities $300k
    Assets $200k
    Annual Gross Margin $85k ($500k-$415k)
    Annual Cash Flow <$30k>

    I have analyzed all transactions over the last 2 years and there are a lot of things that can change here. If I became 50% partners with the current owner, he would agree to reducing fixed expenses by $30k per year (breakeven!). The proposed cuts by me would not affect the revenue side of the business. We also have plans for increasing business using a combination of our strengths.

    We would agree to not draw any salary until the business had the ability to do so.

    Here is the deal:
    50% partnership at no buy in cost.

    You also need to know that this is my brother and I don't want to see him fail. I am also looking for an opportunity, so it seems we are looking for each other. Does it seem fair to gain a 50% interest in a going business without paying anything and instead taking on half the debt? Is the deal not good enough for me? What other ways can I do this?

    Could I add a clause that states he will be responsible for entire repayment of business loan for the first 2 years (like an opt out clause as if I were never there)? He told me he was ready to close the doors now which makes me believe he's ready to take on the whole debt. I'd hate to buy in just to repay half the debt tomorrow. I guess that's my main concern even though I feel like we can make this thing work.

    Thanks in advance!
     
  2. ArcSine

    ArcSine
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    The boundaries and limitations you have to work within, with respect to how the debt responsibilities are allocated, come from two main issues:
    1. How the entity is legally structured (general partnership; ltd partnership; LLC; corporation)
    2. The terms of the debt agreement
    For example, if your brother has personally guaranteed the debt, then that generally imposes a practical constraint on your ability to freely re-allocate the obligation between the two of you as you choose. For most such changes the lender would have to agree to amend the note's terms.

    Similarly, you need to review the note for any provision that might be triggered upon a significant change in the ownership of the company.

    Possibly working in your favor is the fact that a bank holding a note against an upside-down balance sheet will likely be a bit nervous. They might be amenable to proposed changes in management and operations which hold at least a hope of improving the cash flow picture---and thereby improving the underlying value of their note, versus where it might stand right now under the present cloudy forecast.

    General point being, if your buy-in is to involve some form of re-allocation of the debt obligation between the two of you, you'll need to consider (a) how the entity is structured, and how debt obligations are treated under such structure; and (b) that the lender will probably need to be involved to some extent in any changes. In other words, you and your brother could draft some agreement between yourselves that seems to have the effect of shifting some of the debt obligation over to you, but that agreement wouldn't supersede the agreement with the bank, on which the entity (and your brother, likely) remain as the sole obligors.

    Beyond the debt issue and over to your question of buy-in price fairness, it might indeed be fair to receive some %age of equity for no up-front buy-in payment, depending on the circumstances. For one thing, you're not receiving anything of immediate tangible value, for nothing. If the biz folded the day after you received your 1/2 ownership stake, you'd likely get nothing, based on what you've described of the current asset / liability scenario.

    What your 1/2 share really represents is a cut of some possible future profits, which may or may not materialize, and which likely will require a serious effort on your part in helping to run the biz, if they are to materialize at all. Such equity might have some positive value today, but it's not an asset you'd want to pay big bucks for, given all the uncertainties as to its intrinsic value today. Given your description of the current state of affairs, your proposed 1/2 interest is akin to an out-of-the-money option, an animal which typically trades pretty cheap (depending greatly on how far out of the money the option is perceived to be).

    It might also be a good deal for your brother as well, if the alternative is that the biz soon flames out, on its present track. It's better to have a chance at 1/2 of something, rather than owning 100% a guaranteed nothing.

    Best of luck with it, and I hope it ends up being a deal that has you and your brother raising a glass of bubbly, toasting your mutual success down the road.
     
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  3. kilkenny

    kilkenny
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    Great take Arcsine. So you know, the lender is also family. They don't want to lose their money so I would suspect they would draft up any reasonable changes to the note.

    What is your take on my last statement about gradually taking on the debt? What about 10% immediately, then 25% in a year, then the full 50% after 2 years? Is this an absurd request? My take is that I want to be sure my brother is fully engaged in this and does his part before I take half his debt.
     
  4. ArcSine

    ArcSine
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    Well, addressing that one and determining its practical import first requires a clear definition of the context. To what extent is your brother actually responsible for the debt, in a personal sense? The debt might be directly collateralized by some or all of the biz's assets, but then is it secondarily collateralized by your brother's personal guarantee? Or if not, does your brother feel a compelling unwritten obligation to make good on the note? Not as silly as it first sounds---it's not inconceivable that a deep-pocket relative might extend the loan as a non-recourse deal, with the admonition,

    "Here, take this loan and start your business. I believe in it. If it flies, you repay me with interest. If it doesn't, then I'll just eat the loss. I don't want tensions between us arising from your living in a cardboard box trying to repay me with money you don't have. On the other hand, as a prudent investor, I'm going to charge you a rate of interest that sufficiently compensates me for taking the risk of extending this loan on a non-recourse basis." (In other words, this loan's characteristics are more equity-ish than debt-ish.)

    I.e., if it was done on a truly arm's-length basis, with an interest rate or terms that were market-reasonable for a non-recourse loan, then your assumption of part of the obligation wouldn't really have much economic substance or meaning, as the lender's ability to collect extends only as far as the left-hand side of the company's balance sheet, while your personal assets remain out of danger.

    But on the other hand, if it's a debt for which your brother's personal obligation is fixed and unconditional (whether by the explicit terms of the note, or by his general sense of personal responsibility), then in such case any shifting of some portion of the obligation to you represents a bona fide transfer of value from you to him. And that's a value-transfer for which you should be compensated in some way, in the terms of your buy-in arrangement.

    It's pretty common for a significant portion of a buy-in price to be in the form of debt assumption. You could certainly structure it in steps, as you've suggested, as a risk-mitigating mechanism on your part. Such an arrangement would give you the chance to see the business prove its viability to you, before you bite off bigger chunks of debt responsibility. But it's also true that once the company does begin to prove itself, your future increases in debt responsibility have diminishing value to your brother, as it becomes decreasingly likely that your brother would have to personally come out of pocket to make good on the note.

    For the same reason, as a company begins to prove itself with an actual track record of profits, it naturally becomes more valuable, as the previous uncertainties fade somewhat. Hence the buy-in price ratchets up accordingly. Whereas $X of debt assumption might get you Y% of a company's equity when the company is in dire straits and circling the drain, that same $X of additional debt assumption would likely get you something less than another Y% of more equity later, when the company's prospects are somewhat rosier.

    Sorry to be all over the page with this one without any concrete answers, but more precise answers depend heavily on a number of situation-specific factors. What you're asking---a tiered buy-in via an incremental debt assumption arrangement---is certainly doable, but exactly how it should be priced, and exactly how much equity should be transferred, etc., are numbers that can only be determined after careful evaluation of all the attendant facts.
     
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  5. kilkenny

    kilkenny
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    Yep, I see what you're saying. The way I see things occurring over then next 2 years is to prove there is a business. I highly doubt anything huge for the positive happens over that time period, especially when it comes to the balance sheet. Those changes would come after year 2, which is when I would want to make the decision to fully vest the $50k. Food for thought.
     
  6. lynda27

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    Interesting post very good.
     

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