Jeff: With real stories from real business owners and associated providers of third-party services, this is Done Deal.
Hi, my name is Jeff Allen, and Done Deal is brought to you by Morgan & Westfield. On this edition, we are going to change things up just a little bit.
Instead of talking with a business owner about their experience selling their business, Dan Cotter is an attorney and partner at Butler Rubin Saltarelli & Boyd in Chicago. We're catching up with him following a successful sale involving one of his clients’ businesses to get a legal professional's perspective on the sale process and how it all worked out for his client, how it all came down, and what his involvement was.
Dan, it's good to talk with you again. Welcome back to the program.
Dan: It's good to talk with you as well, Jeff, and thank you for having me on your program again.
Jeff: Dan, you might remember when we visited the first time on Deal Talk, we had a completely different conversation. It was one involving cybercrime and cybercrime’s threats to valuations. For those people who’d like to go back and listen to that program, all you have to do is visit the Morgan & Westfield website — that's morganandwestfield.com and go to Deal Talk. You can look that show up once again with Dan Cotter on cybercrime’s threats to valuation.
But this time, Dan, we've got you here on Done Deal talking about the follow-up, the post-interview following the sale of a business that you were involved with and your client. Now for legal purposes, we are not able to talk about too many specifics in this particular case. We can't talk about the owner themselves or their specific business necessarily, but we can speak about a number of generalities here, and that's what I would like to do with you, Dan.
To start, give us an idea what kind of business this was, the kind of industry that it was involved in.
Dan: Sure. So this deal, this particular transaction was a sale of assets of a service industry provider. A company that had a number of contracts with customers that were retaining the seller for purposes of providing services to their organizations.
Jeff: Now right off the bat, Dan, when we were talking about contracts, and depending on the type of business that you have, you could be dealing with a lot of contracts insofar as your vendors and suppliers are concerned, and of course your clients, your customers themselves.
When you get involved in a sale where there are a number of contracts involved, whatever those contracts might be, is this something where you know you are going to have a tremendous amount of involvement in? Are there certain challenges and certain legal repercussions that could occur if someone such as yourself, a legal professional, is not involved in this sale of the business?
Dan: That is a great question, Jeff. Yes, there are a number of legal hurdles and potential obstacles. In many cases, sellers — and buyers for that matter — do not want to get advisers, whether it’s lawyers or accountants or deal brokers, involved early in the process. Especially in a deal and a transaction where it is a service industry that’s being bought or sold, it is really crucial, I think, to have lawyers and other advisers early on in the process.
The reason is this: With contracts and service contracts that a seller has — regardless of what side of the deal you are on — you need to take a look at those agreements and determine first and foremost whether or not those agreements have any provisions that would prevent the seller from taking those agreements and assigning them to the buyer.
Oftentimes, what we'll find in service agreements and vendor contracts — and I’ve drafted many of them over the years on both sides — is that the customer wants entity XYZ or individual A to perform the services that are contemplated by that service agreement. And so they have provisions that say that, for example, on the event of a change of control such as a sale of the business, the agreement cannot be assigned to any third party without the customer's consent.
My advice to all of my clients, whether it is an M&A or just another contractual matter, is that it's better to be proactive and have a lawyer that they trust to spend half an hour or a small amount of time to review a contract because if the contract is problematic and they sign it without spending that time, it’s much more costly in the back end to fix or address issues that have come up from a poorly drafted contract.
If you have those types of provisions in the agreements for services, that can present a challenge because unlike a retail store or a company that is selling with inventory, that's what the purchasers are buying. In the instance of a service industry seller, what’s being purchased and sold is in fact just those relationships and those agreements. So that is one of the items that I think is important for advisers, including lawyers, to be involved on the front end.
In addition to that, I think one of the other challenges is that when it comes to having service agreements in place, it is very difficult or can be [difficult] to put a value on the business other than net revenue or net income for a couple of year period and try to figure out a multiple. Again, you are not buying computers, desks, offices, property plant, and equipment. So having the proper advisers in the front will save a lot of headaches for both the buyer and seller on the back end.
Jeff: And you talked about being involved in the early stages, Dan. When you got involved, was this one of those things where you could see, "This is going to take some time here. There's no way that we're going to be able to sell this company within 9 months, within 12 months, within 15 months” whatever the case may be? Were you brought in at such a stage where you knew that there is a lot of prep work in advance, that there was going to be a fairly long period before you knew that the deal could be consummated?
Dan: In this case, I was brought in when the seller had already, I believe, indicated that they were interested in selling their business. I was brought in during the negotiation with the entity that eventually purchased the assets of the business. The letter of intent and the agreement was close to being final and hadn’t been fully realized.
This transaction took, I think, 3 or 4 months from start to finish. Not an extensively long period of time, but the main hurdles even once the letter was entered into, the letter of intent, and the parties agreed on terms is based on due diligence and just a review of everything taking place. There were some adjustments to the eventual purchase price.
Jeff: We are going to talk about the letter of intent or the LOI here in just a couple of minutes, Dan. But what is the process once a seller accepts an offer? What happens from that point? And what role do you play at that stage?
Dan: Sure. Once a seller accepts an offer, that offer is typically memorialized in a variety of ways. It could just be by a simple letter. More and more these days, the prevalence of email as our main communication and a business transactional tool. It could be as simple as the buyer or the seller confirming the conversation that was taking place that would buy X assets for Y price and close on such and such a date.
Then what typically happens is that you would see either a term sheet or a letter of intent. Both of them are just high-level documents that always reference that 1) they are not binding until agreements are fully fleshed out, and 2) they are subject to due diligence and other basic factors.
Jeff: Did you actually help draft those documents, or are you at least a part of the process where you go through and you vet those documents, making sure that they are sound and that they are all legal?
Dan: In this transaction, I reviewed drafts that were put together by the buyer and provided input and recommendations for edits and for finalization. So I was involved in that process.
It is really important once the parties have figured out what it is that they offer in acceptances, they’ve got a meeting of the minds, to really document well what those agreed-upon conditions are. In this case, the letter of intent was pretty well defined in terms of all the different moving pieces, price, and continued retention of the seller for a period of time.
The first step is giving some kind of letter of intent or term sheet to finalize, memorialize, signed by the parties. Once that happens, it is off to due diligence and the process of negotiating the definitive agreements that, unfortunately, are full of legalese and a lot of boilerplate language but are all designed to protect both parties in the transaction as much as possible.
Jeff: We are looking at the sale of a service-oriented business, not from the business owner's perspective but from an attorney's perspective.
Dan Cotter is an attorney and partner at Butler Rubin Saltarelli & Boyd in Chicago. We are glad to have him with us in the program today, once again brought to you by Morgan & Westfield.
Dan, what other parties were involved along with you as part of this deal to make sure that it went through as successful as possible for both parties?
Dan: On the seller side, in addition to myself as legal adviser, we had a broker involved and then we also had the CPA (certified public accountant) for the seller was involved. The reason for that is again there were questions that came up during the deal that come up during any deal in terms of assigning value to assets as part of the sale, tax consequences of the deal, and so on. On the seller side, those were the three groups of advisers that assisted the seller in this transaction.
On the buyer side, they had their lawyers as well. I don’t know if they used other resources, but typically they would have somebody that has expertise in tax, so that’s typically the CPA that’s been doing the books and records and providing the tax filings for their organization.
Jeff: Now who did you communicate mostly with when you were going through the day-to-day? I know that there are different tasks and different responsibilities each day that you would take care of. Who did you find that most of your interaction was in this particular situation?
Dan: In this particular situation, it was the principal, founder and owner, the seller. On a daily basis, we would interact, but I also dealt with the broker as well because again a lot of the questions and the kind of guidance and shepherding through the deal involved him interacting with the principal on a regular basis. But principally, my contact on a day-to-day basis is with the seller and owner of the company that was being sold.
This document [LOI] is important for the seller to understand that it’s not the final agreement. It is not spelling out all terms and conditions. And the seller does not want to be locked into having to sell the business, if the buyer came back and said, "we offered you half a million dollars for your business but we've done due diligence and revised purchase price is $50,000," and there are no caveats in the letter of intent that the seller has the option to turn down a negative offer.
Jeff: I want to ask you two pieces of information that are really, really important. Some drafts and documentation that are critical to the sale of many businesses and you could probably say just about all businesses where there are attorneys such as yourself involved.
Let's talk about the letter of intent for a moment or what is also known as the LOI. This is obviously a very important document that is part of the sale process, and this is presented on the part of the buyer of a business. Let's talk a little bit about what kind of language that document has in it, and why that language is important that we need to make sure that we are very specific in it, and what your advice is for a seller who is presented with this document. They might be tempted to accept it very quickly, especially if it is their first business and they are anxious to cut a deal and move on.
But let's just talk about it, why it’s so important, and what a seller needs to know before they accept a letter of intent.
Dan: Sure. A number of reasons why the LOI or letter of intent is so important to the transaction. First and foremost, again, it sets forth the kind of high-level understanding of the parties about what the purchase price is, what assets are being purchased, or if the entire company is being sold. Is it a stock purchase agreement or unit sale, if it’s an LLC? Typically it will have some caveat language that says that the letter of intent is subject to due diligence period and that the price and other terms and conditions will be negotiated between the parties based on what comes up in due diligence.
You know oftentimes as you mentioned, Jeff, sellers are tempted, and sometimes buyers as well, to just use a form, an LOI, or to enter it without incurring any outside adviser fees or expense.
That is a bad idea, and I can give you an example of a situation from about 2 years ago. I was brought into a transaction where the letter of intent had already been signed. I asked for that as part of my process when I first interviewed, in this case, it was the buyer of a retail establishment and received a letter of intent. It was a very brief letter of intent but it had some very bizarre language in it. For example, it said that the buyer represented, warranted, and gave assurances that the financial statements of the seller were fully accurate. That’s problematic because if you are buying something, how can you be in the position to attest that the financial statements are accurate, right?
Dan: That was one problem that was in this case, there was an earnest money deposit where the buyer immediately agreed to give the seller a sum of money for the deal. There was nothing about it being refundable. So there were other problems with it.
So, again, this document is important for the seller to understand that it’s not the final agreement. It is not spelling out all terms and conditions. And the seller does not want to be locked into having to sell the business, if the buyer came back and said, "we offered you half a million dollars for your business but we've done due diligence and revised purchase price is $50,000," and there are no caveats in the letter of intent that the seller has the option to turn down a negative offer.
In addition, oftentimes what you see in a letter of intent is a period of exclusivity where the buyer has the only ability to interact with the seller for a period of time. It may be 3 months, it may 6 months, it may be 30 days. Again, the seller needs to understand what that means in terms of being able to shop the business, especially if they’ve put their business up for sale, and what that does to interacting.
My advice to all of my clients, whether it is an M&A or just another contractual matter, is that it's better to be proactive and have a lawyer that they trust to spend half an hour or a small amount of time to review a contract because if the contract is problematic and they sign it without spending that time, it’s much more costly in the back end to fix or address issues that have come up from a poorly drafted contract.
Jeff: Is that a relatively common mistake that you see, Dan Cotter, from time to time that you understand these stories whether they are presented to you in person by actual clients that you have taken on because they ended up accepting something that just is not just going to fly? Or there are just not the proper documentation to back up certain terms in the language in the contracts and so they end up coming to you after the fact, saying, "hey, there are some stuff that we need to clean up” or “there is something that just is not right."
I cannot tell you how many times I’ve had a friend or former internal executives, when I was in-house, or other folks inquire about what their ability is to move on to something else ... oftentimes when you ask them why they signed something without reviewing it or thinking about it, they will respond that they had no choice. But it is better to be proactive and penny-wise rather than pound-foolish.
Dan: That is often the case and that's understood. A lot of small and mid-sized business, even the large ones, they look at what the legal market is and the costs that are involved in it. Oftentimes, I think the legal profession is seen as being a profession that inserts hurdles and issues where none don't exist. But again, it will oftentimes.
I've have had situations where business owners, they might be co-owners and partners in a deal, will come when they want an exit or sell or move on to something else, and oftentimes the documents that they have entered into did not really address how they can amicably separate their ways.
It happens in M&A as well, it happens with letters of intent, it happens with almost every type of contract there is. That is just natural. It occurs in many instances. It happens in employment, transactions, offer letters, non-competes, non-disclosure agreements.
I cannot tell you how many times I’ve had a friend or former internal executives when I was in-house, or other folks inquire about what their ability is to move on to something else. And oftentimes when you ask them why they signed something without reviewing it or thinking about it, they will respond that they had no choice. But it is better to be proactive and penny wise rather than pound foolish.
Jeff: Dan Cotter with Butler Rubin Saltarelli & Boyd, an attorney in Law in Chicago is with us. We are talking a little bit about, speaking in general terms about his involvement in helping business owners sell their companies and why it is so important to have an attorney involved in the process. Speaking about a business in general terms that he recently just completed the sale with Morgan & Westfield on a service-based business where there are a lot of contracts involved. Some terms that we often hear come up involving the sale of a business, Dan Cotter, reps and warranties.
Now that sounds like a legalese, but when you get down to it, you get representations. We know what a warranty is, but tell us when you take and combine those two, reps and warranties. What is involved in that language? What does that mean to us as a business owner or to the buyer or seller of the business, and why is it important that we also have these examined by our attorneys before we move forward with any deal?
Dan: Sure and just so that we can use the definition that’s been tried and true, Black’s Dictionary defines a representation as “a presentation of fact either by words or by conduct made to induce someone to act, especially to enter into a contract.”
Representations and warranties are really assurances by the seller that the purchasing party can rely on as factual. When we look at traditional asset purchase or stock purchase agreements or even other contracts that we may have in our lives, when we look at what representations and warranties are, again, there are assertions of fact that are intended to be true at present — that is the representation part of representations and warranties.
Warranties kind of go to the future, and say that we are telling you, as the buyer, that with respect to these items, these things are true and will continue to be true. And what we often see in representations and warranties is things such as employment status, that if the company has employees that there’s no current complaints. There's usually reps and warranties about litigation and whether or not there is any material exposure.
We have talked a lot about contracts today, Jeff, and so again one of the representations and warranties is that the schedule that’s part of that particular representation and warranty that states that all material contracts are attached to the agreement, or that the referenced and the buyer has had access to those contracts to review in their own case.
Every transaction is a bit nuanced. Depending on who is drafting the original drafts of the purchase agreement, if it’s the buyer, then you can expect that the representations and warranties will be slanted more in favor of the buyer. That’s just who drafted determines what the provisions say.
And so it’s important again because a lot of language in various agreements is absolutely boilerplate. Every transaction is a bit nuanced. Depending on who is drafting the original drafts of the purchase agreement, if it’s the buyer, then you can expect that the representations and warranties will be slanted more in favor of the buyer. That’s just who drafted determines what the provisions say.
So again, it is important that a lawyer review how these are drafted and to ensure that they are constrained and limited as much as possible. For example, oftentimes the draft from the buyer will make very clear statements that are just absolute. For example, seller represents and warrants that all contracts that the seller has entered into are attached as schedule 1.3 or whatever the schedule number may be.
The problem is that oftentimes, especially in organizations where it is not just a very small group of employees that are knowledge-based. For example in this transaction, it was the principal, and she was the main person that was responsible for having knowledge.
Oftentimes, what we as lawyers would do is put in qualifiers to make it clear that it is to the knowledge of seller, and the knowledge will be defined to be the particular, actual knowledge of a particular person or a control group of people. And so again what is trying to be done here is that while these are reps and warranties, our assurances and statements to the buyer that certain things are true. I want to make sure that when somebody makes those statements that they actually have knowledge.
And so you can think of situations where, you know, if GE were being sold, for example, you would want to make sure that there are only certain people that might have that knowledge because literally receptionists in one of their branches in Hong Kong could have received a notice of a lawsuit that is material, and for whatever reason, that is still sitting on that reception desk in Hong Kong. So you want to make it actual knowledge.
Jeff: There is a kind of a colloquial expression that I have heard bantered around now and again, “once and done” and sometimes we use that expression, we take and twist it a little bit, we may call it “one and done.” But “once and done,” what does that mean when you are talking about a business sale or perhaps in your particular case in this particular deal, what does that mean to us and why is that important?
Dan: You know from a business perspective, the “once and done” is that all of the facts, all of the tire kicking, all of the request for information should be done all at once. And once that process is complete, then the contracts will be fully fleshed out, the definitive purchase agreement.
The reason for that is that if you are doing this piecemeal and repeatedly coming back with a request to the seller for more information, is that 1) the price and terms may change. But to me, the importance of casting a wide net and getting as much information as possible like we do when we enter any personal transaction makes it much easier in terms of the time spent, the resources required by experts and your advisers to review contracts, to review final terms and to opine on things.
If you have a transaction that is constantly shifting, that’s going to be costly and is also frustrating to both the seller and the buyer. And not an ideal way to approach.
Jeff: I would imagine so, particularly if you are a buyer, and you are interested in a business, and you really wanted to take and move things forward, and move things forward as quickly as you possibly can, and after all I think both sides want that very much. But it would seem that the buyer comes in at a slight disadvantage because the seller holds all the cards from the very beginning.
You talk about casting a wide net, how does a buyer do that? What would you suggest, Dan? What is maybe a step or a couple of steps that they can take in order to ensure that they are able to, as you say, obtain as much information as they can and make sure that everything is out on the table, so to speak. What is a good tip or rule of thumb for a buyer to remember in order to take this “once and done” approach?
Dan: I think that the best first step is to, again, engage with advisers from the buyer's side and to develop or have advisers provide kind of a template, a due diligence checklist.
I can give you a story many years ago: I just started at a client, and my first order of business was to put together a due diligence request to a seller and got the business folks’ input, sent it out to the potential seller, and that was my first week with this client. We sat down to dinner on a Friday afternoon with my family — my two young boys and my wife. We got an email and the subject line was "Ouch." So I opened that email, and the email was a long exchange between one of the partners of the seller and my client's CEO. The sellers were not happy with the fact that we had sent them a pretty expansive due diligence request that we’ve used in other deals that listed things by organizational documents, good standing of the company, human resources, IT, contracts, litigation, etc.
And so I was told that I had to put that down to one page, and we did so. Then we visited the potential seller, and it was immediately apparent why they had balked at that request.
My advice on both seller and buyer side is to put everything that you might want to know about the seller into the initial due diligence checklist and request. In the worst case, the responses to much of it would be not applicable, none, nothing responsive.
But as you said, the buyer on the transactional side is always at a disadvantage because the seller knows the business. He knows where the issues are, he knows the blemishes that might exist on the business, and it’s not required as part of the transaction to fully disclose without being requested. At the same time, he should give enough information to make the deal.
The buyer, if they are doing it right, should send a due diligence list and figure out whether it is going to be an electronic database and due diligence room or if it is going to be in person. Then start that process, in addition to documentation, includes interviews with the main management of the seller, includes perhaps interviews with major clients of the seller. But it is again cast in this broader net and being more thorough rather than the one-page due diligence list that I mentioned in a prior life is going to get as much information as possible.
The other benefit of having that approach is when the final definitive agreement is drafted with all the schedule showing various disclosures and reps and warranties. Again, the buyer may have recoursed on the line if it turns out that the seller, despite the assurances and despite the request from the buyer for a broad information, that the seller did not fully disclose everything that was relevant to the transaction that was requested.
Jeff: Dan Cotter, this has been a great conversation we’ve had today. It has been very insightful, just as we are kind of winding things down a little on this particular discussion.
Anything else that might pop into your mind when you are talking to a roomful of business owners or even those folks who may be looking for a business to purchase at one time or another, whether that is in the near term or in the distant future, at some point when they are ready. What kind of advice or just a couple of real key pieces of information could you leave us with today? Some takeaways as far as preparing properly or being ready to engage in a conversation with a business owner about his or her business for sale in order for things to move as swiftly and as successfully as possible toward a deal that is going to benefit both?
Dan: I think that from a seller's perspective, one is that the transaction itself is like selling a house. Oftentimes it is a business that the seller created from scratch and has built into something that is a fantastic organization.
One thing to keep in mind is that the process can become very personal, and it is very difficult to separate that but I would advise that.
Secondly, from the seller's perspective, when the seller is ready to contemplate selling and an exit strategy, it’s important to have good advisers in terms of valuation, in terms of the market for whatever line of business your organization is in. People that have a wealth of experience in brokering transactions, they understand where the market is for various lines. So I think it is important for a seller to reach out to somebody that is in that space and get some advice.
On selling a service-based business: You’re not selling inventory, you’re not selling property plant and equipment, all you are selling are relationships and contracts and agreements you have in place with your customers. So you need to have a pretty good idea of the range of potential value that your organization presents.
As the deal starts, as we talked about already, I think for both sides, it is important to have those advisers involved in the discussions and negotiations as much as possible. Put into understanding that the business principles are going to hammer out a lot of details. And it is not cost-effective to have your full body of advisers in every meeting and in every conversation, but if you are serious, I think having advisers in place and thinking that through is a very good idea.
Finally, if you are in the service industry, I think getting the sense of what valuation methodologies are opted for your business. You’re not selling inventory, you’re not selling property plant and equipment, all you are selling are relationships and contracts and agreements you have in place with your customers. So you need to have a pretty good idea of the range of potential value that your organization presents.
Jeff: Dan Cotter, we’ve run out of time on this edition of the program. I want to thank you again for your participation in the program today.
Dan: Well, thank you.
Jeff: Dan Cotter is an attorney and partner at Butler Rubin Saltarelli & Boyd in Chicago. Done Deal is brought to you by Morgan & Westfield.
We try to bring you stories from real business owners and from those third-party organizations and representatives that they’re associated with to try to give you some insight as to how things went down with the sale of those businesses, some of the key challenges that were faced, how they were overcome, and what you should do in the future in order to work toward a successful deal on your part, whether you are the owner of a business now or looking to buy one in the future.
We hope that you join us again on the future edition of Done Deal. My name is Jeff Allen. Until then. Thank you.
When I negotiate every dollar of benefit that I negotiate for myself is a dollar out of your pocket and vice versa, there's no value created. When we're negotiating between two companies to provide a product, we can negotiate many items beyond price. … We can negotiate those issues and develop a contract where we actually create value.
And when we sit down and we work to become a good customer to a supplier, and we sit down and we have a rational, thoughtful conversation about who should do what to minimize the total cost of the supply chain, we can create a ton of value for our collective supply chain and how we serve our collective customers.
And what I found is that people get comfortable with their existing supplier and they do not like having a difficult conversation periodically that we're going to be putting it out to bid. And in fact they're concerned that they could disrupt their supply chain if they go down that path. And so there's a certain level of fear of change and of unknown that kind of prevents people from taking a deeper dive.
The idea here truly is that you try to build a customer base that's not specific to a particular industry, so that you have more of a cushion to any events that hit particular industries very hard.
If, for whatever reason, you can't clean up legal issues before you put the company up for sale, at least be open and upfront about it. Disclose all these issues right away. Have the paperwork ready. Very few issues truly will derail a deal as long as you're open honest about them.
Buyers love recurring revenue streams. And when it comes to valuation, I can tell you an appraiser will put higher value on a recurring revenue stream typically than on non-recurring.
You shouldn't buy a five-bedroom house in a three-bedroom neighborhood and expect to be able to sell it in 10, 15 or 20 years. And the same thing for entering into a franchise; you need to really think about the exit strategy, what type of management model you have, and how you're going to get out of that.
With the turn-key aspect of a franchise, not only can you plug and play, if you will, but you can also validate with other people.
They'll (franchisor) give you the system and encourage you in every way, shape and form to duplicate it, but you have to do the duplication of that, which means going out and getting your own local customers.
Marina: Thank you Jeff, I'm happy to be here.
Jeff: We appreciate you taking the time and sharing your expertise in a very, very important topic. Today we're talking about ways to save potentially money and some real headaches that can be associated with construction projects where the need is to go out and you need to find a contractor. And a company has to make sure that the contractor is licensed. We've all heard that, but what I'm kind of wondering is we've heard this drum beat for so many years. Is this really a serious problem among businesses today, Marina, from where you sit? Is this still something that is a critical problem in something that many companies end up making a poor decision about?
Marina: Absolutely Jeff, and I'm so glad to be talking about this on your show because I'm often am asked to come into a situation after it's already gone wrong. And what I would like to talk about today is what to do to have things go smoothly. The first thing that companies should be doing is to search on the State's website to see if the contractor is licensed and that's the cslb.ca.gov site and to check to see if the license is active, if there are proper insurances in place. Because on the CSLB website you could actually check to see if they have the necessary bond. You could see if there are personnel that have been disassociated with the company. Those are sometimes red flags to look for. And if you can see if they've had any history of suspensions. These are all red flags. So when hiring a contractor you want to make sure that the contractor is licensed not just because they tell you they are but you've checked on it.
Jeff: I think that's really important because every contractor it seems, they go to great lengths to make sure that you understand that they're licensed or should be because they put that information on their business card. They may put it on an estimate, it'll be on their trucks or what have you. But that doesn't necessarily mean that the license is current, active, or hasn't been suspended for some reason. And so you mention again and here's the website. It's worth repeating. It's www.cslb.ca.gov. That's for those companies that are operating and doing business in the state of California. If you're listening from another state across the country you can check with your own contractor's state licensing board. I'm sure that you’ll have one in your state as well. Or contact an attorney to help you with that. Let me ask you this Marina, can you explain to me what a bond is? A lot of people may not know exactly what it means to be bonded as a contractor? What does that mean?
Marina: Sure. That's a very limited insurance policy. Currently the minimum that they ask for is $12,500. To be clear, a lot of property owners think that, "My contractor is insured, so if something goes wrong I'm covered." That's not necessarily true. There is no such thing as construction insurance that covers the actual work if the work has been done defectively. The bonds that the CSLB requires is limited in certain situations like if the contractor abandons the project or if there's any fraud in the contracting or the deal, that's when that $12,500 comes in, and you don't even often get the whole amount because the cost of an attorney representing the contractor's bond is deducted from this amount. It's not that much of a protection but it is there. And sometimes when a contractor abandons a project you can seek the bond and the bond can pay you whatever amount that is calculated at that point.
But there are insurance policies that do cover some problems during construction. When I say that the work itself isn't covered, that's correct because there are no insurances that would cover the actual defective work. But to give you an example they would cover personal injury or property damage caused by the contractor's work. To give you an example of a situation like this: if a contractor's doing work and there's a hole in the ground and that hole is not covered, and somebody walks, trips, and falls into that hole and gets injured, that insurance policy would cover that injury. On the construction side let's say that it's a roofing contractor and the roofing material, the waterproofing has not been done properly and water gets into the house or building and damages the ceiling and dry wall, it damages the hardwood floors, whatever else. Everything other than the roof itself would be covered by that insurance. But re-doing the roof itself which is the defective work would not be covered by insurance.
These are all red flags. So when hiring a contractor you want to make sure that the contractor is licensed not just because they tell you they are but you've checked on it.
Jeff: Marina, is it common for contractors to provide their own company guarantees for quality workmanship so that if in case something were to go wrong down the line that, that sort of damage or that sort of faulty construction would in fact be covered by the contractor down the line?
Marina: I think, Jeff, you raise a good point that we do need to talk about what the agreement is between property owner and contractor.
Jeff: Very good. And that's a pretty long conversation I know. So probably a great segue into it then Marina, let's talk about that a little bit. What should that agreement include?
Marina: First of all there should be a written agreement. If you're doing a big enough project these agreements are often drafted by the contractors or their lawyers so you can imagine that they would be one-sided. You would want to as a property owner have your own lawyer look at these written contracts. But the things to look out for in those written contracts are what you were talking about which are some warranties. There are warranties for new construction that contractors can give. Those warranties are typically about for one year. But in the contract you can talk about the budget, you can talk about the schedule, because these are things that the contractors require to put in the contract. And you want to have the plans and specifications ready when you do enter into a contract because that is what considers your scope of work.
If you bring in a contractor and say, "Listen, I want to do an expansion on a building. I want to add 5,000 square feet to this building over this parking area. And the contractor say, "Oh sure, I can do that for $500,000." That's not necessarily the deal that you want to get into. What you want to do is you want to have an architect, structural engineer, mechanical engineer, you want to have plans that have gone through plan check, in whatever city you're at gotten approval then gotten permits. And then you have the approved set of plans and specifications that you give to the contractor and say, "How much to build this?" That forms the basis of your scope of work. Once the contract has a scope of work and pricing for it then your contractor will have a hard time increasing that price later on, because if the scope doesn't change he's supposed to finish the project for the price that he gave. Sometimes the scope does change because the owner changes their mind or some unforeseen conditions arise and that's very, very common in construction that there are change orders. But when you are entering into a contract you want to have your approved set of plans and specifications, and you want the contractor to tell you, "This is the line item budget to do this construction." The line item budget should have a contingency in there because in everything in life you think that you're going to be done with a certain price and it always goes up. You want to have a little cushion.
So you have the contingency in there, and then you ask the contractor also to give you a schedule. A contractor calls this a critical path schedule where they show you how each trade will start and finish their work, and it makes the contractors also plan ahead. So then you know when you're going to finish and you can hold the contractor to that schedule and say, "Where are we with the schedule?" To have a good set of contract and construction plan in the beginning is one of the best ways to avoid problems later.
What you want to do is you want to have an architect, structural engineer, mechanical engineer, you want to have plans that have gone through plan check, in whatever city you're at gotten approval then gotten permits.
Jeff: When you hear stories often times, Marina, about claims by subcontractors and suppliers that they don't get paid on a timely basis. That can hold up a project also. How can a business owner protect him or herself against claims like these that create serious delays and needless disputes that nobody wants to be a part of?
Marina: This is a serious problem because when material suppliers and subcontractors don't get paid they have the right to put mechanic's liens on the property. And the property owner will be scratching his head thinking, "I paid the general contractor. How did I end up with this lien on my property?" There are ways to avoid this and there's different paths to take to get to a point where you're feeling secure you're not going to get these claims. One option is on larger projects, to use a fund control company because sometimes these constructions for business properties require a construction loan from a bank and oftentimes the bank will require you to use a fund control company. What a fund control company does is that they take the budget that you receive from your contracts, the line item budget.
And there's also something called the schedule of values. The schedule of values is the amount for each trade. Let's say a trade would be plumbing, electrical, framing, things like that. They take the schedule of values and they are basically holding the purse strings, they're holding the money. Whenever the contractor starts the project and they get to a certain point like in 30 days they draft what's called the voucher for payment. And in that voucher it's an application to the fund control companies saying in these trades we've completed 15 percent, 20 percent, whatever they think that their percentage of completion is, and then they send it to the fund control company. Now, what the fund control company is supposed to do, and I say supposed to because sometimes this doesn't happen and I've seen it afterwards when I have to get involved. But what they're supposed to do is send somebody out there to their project who understands the plans, who understands the schedule of values, who can review the actual work and make a determination whether the percentage that the contractor says they've completed they've actually completed. Once that's done payment is issued. So in that way you're not pre-paying or overpaying the contractor when they haven't done their work. And the fund control company can make sure that material suppliers and subcontractors are also paid and so they don't have any complaints. That does take some sort of an expense to go through this fund control company but oftentimes the construction lender will require this.
Another way is to ask the contractor to buy what's called a payment and performance bond. This is an insurance policy that basically secures performance and payment. And when I say performance what I mean is that sometimes contractor find that they cannot continue on a project. It's called an economic breach because what they do is they commit to a certain number to finish the project and then they realize that, "I can't do it within this budget, I'm going to lose money." So they decide to abandon a project. This happens more often than people can imagine. Once that happens, if there is a payment and performance bond in place the insurance company will pay for completing the project. The owner would have to pay whatever their contract price is. But if they end up having to pay more than their contract price the insurance policy pays for the excess. The payment part of that bond covers payments to subcontractors. If the general contractor does not pay the subcontractors or the material suppliers then this insurance policy will pay these subs and material suppliers so that the owner doesn't have to pay twice or risk having a mechanic's lien. These are two methods for larger projects.
The cheapest method to make sure that your material suppliers and subcontractors don't have claims against you for non-payment even though you've paid the general contractor is to write joint checks. In order to do that you'll have to ask your general contractor to give you everybody's names and their invoices so that you know who's working on your project, who's giving you materials to build the project with, and how much they're charging, so that when you want to pay for these subcontractors and material suppliers, you're writing a joint check with the general contractor and them so that neither one can cash it without the other's approval, that's kind of a way to protect yourself from the general contractor not paying the subcontractors. With these three methods you can make sure nothing is full-proof but you can do a lot to make sure that there's not material supplier or subcontractor who hasn't been paid who will come after the owner and record a mechanic's lien on their property.
Jeff: Outstanding words of advice and there were three methods we talked about there and I'm going to give Marina's contact information at the end of the program. So that if you have any questions about these particular methods to help ensure that these guys get paid on the project and it keeps moving forward. Marina will be able to provide with that information and answer any other questions that you might have, I'm sure. I'm Jeff Allen and I'll be back with business and construction attorney Marina Manoukian when Deal Talk continues in just a moment.
The cheapest method to make sure that your material suppliers and subcontractors don't have claims against you for non-payment even though you've paid the general contractor is to write joint checks.
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Jeff: Welcome back to Deal Talk where we are becoming the Internet's go-to resource to help business owners understand what it takes to sell their company successfully. You can find a wealth of resources along with all Deal Talk episodes and their transcripts simply by visiting morganandwestfield.com. I'm Jeff Allen with my guest Marina Manoukian, senior counsel specializing in litigation, business, and construction law at ADLI Law Group with offices in the LA area.
We're continuing our discussion now about how you as a business owner can avoid the stress, unnecessary delays, legal and financial risks that can sometimes be associated with contractors on construction projects. Marina, to kind of continue the conversation now, who do I talk with? If I'm a business owner and I know that I'm working with a general and I need to make sure that I communicate and keep the communication open with them at all times, can I talk with the general contractor? Can I talk with the subs? If a guy comes in, in a restroom we have in our lobby. I’m not really happy with the way that they've laid the tile in there. Can I talk to the subcontractor? Who should I be interfacing with?
Marina: It's always best to keep the lines of communication open. The general contractor is usually the point of contact for the owner. But again, on larger projects and may be in the owner's best interest to hire its own project manager so that there is an owner representative who is knowledgeable in construction to deal with the general contractor, and the subcontractors, and the material suppliers.
Jeff: Typically, is this something that we see with the larger projects, with larger companies on bigger projects?
Marina: Yes, definitely, because the owners are either too busy, and most of the time property owners are not that knowledgeable in construction unless they've done it many times. To have your own project manager who's watching out only for the interest of the owner is extremely beneficial to stave off any litigation later. With keeping up with the schedule somebody has to be on top of a general contractor because the schedule is one of the biggest areas of contention when the construction doesn't go as planned. And you want to make sure that you're happy with whatever they're doing because, for example, if they've laid the tile and on top of that they're going to be putting cabinets. If you're not happy with the tile you don't want them to be going onto the cabinets. You want to keep the lines of communication open with the general contractor or get your own project manager.
To have your own project manager who's watching out only for the interest of the owner is extremely beneficial to stave off any litigation later. With keeping up with the schedule somebody has to be on top of a general contractor because the schedule is one of the biggest areas of contention when the construction doesn't go as planned.
Jeff: Let's say we move down the line and we've had a few bumps in the road but things for the most part have gone pretty nicely, and we're just about to the point when we are going to occupy our new building. It's passed inspection. But once we get beyond that I guess I'm a little bit concerned as the business owner that maybe things may not necessarily be quite right and I'm worried about defects and all of a sudden I've got my business partner Bob, he's upstairs in the break room at our new building. He has a doughnut and ends up falling through the floor or something like that, I don't know. But let's just say ... It's a funny visual we can put in people's heads at the moment. But what if something happens down the line and it passes inspection, things seem to be great, and all of a sudden we have this happen.
Marina: I have to warn people, because every construction does have to go through an inspection process with that city. They do inspection of the rough meaning the electrical or plumbing works that hasn't been covered by dry wall. They look at the framing that hasn't been covered. They pass inspection and then you go through the next phase and they come and do an inspection of the finished product. And most people think, well, it passed inspection. This project will not have any defects. Well, Jeff, if that was the case then I wouldn't have a job defending contractors on defect claims or representing owners to go after defect claims. Defect claims exist regardless of whether properties have passed through inspection because these city inspectors they're looking for certain code compliance but not necessarily defects that might be just industry standard defects. You haven't done this. You haven't water-proofed properly so now water is seeping through the shower to the bottom floor, things like that.
First, let's go back to when the project it’s almost complete. At that point when it's almost complete it's best to never pay the last payment to the contractor unless you've done a walkthrough and are happy with the product that you're getting. Because upon the last walkthrough you can go through a punch list, meaning a list of little things that you want fixed before the contractor completely leaves the project. Because to be clear, if you paid their last payment that contractor's gone. I'm not trying to discourage any contractors but it just makes sense. They've been paid, they think they're done, they're not going to come back too many times. Some of them are very honorable and they do come back and complete punch list items but you want to be holding that back so that you're satisfied before giving it to them. So you go through the whole project and whatever you have a problem with you write a list meaning there aren't enough electrical outlets here, this door opens the wrong direction, whatever you see. This window doesn't seem right, it's not level. You make a list, you give it to the contractor, and you make sure that they do all of that before you release the last money. And one thing to go back to as far as making sure that contractors don't have claims against the owner afterwards.
Every time the money is released to the general contractor, subcontractor, or material supplier there should be a form completed by them called a lien release. It's a conditional or unconditional release upon partial or final payment. These are forms that can be easily found on the Internet. If anybody calls me I'll be happy to send it to them. You have the contractor sign for the amount of money that they have received. So you have this cushion where they cannot come after you for that money. But at the end when they've gone through the punch list item, corrected everything, then you give them the final payment, and you get an unconditional release upon final payment. So that takes care of it. They cannot come after you after that.
Later on, if you do discover defects, as I said that there's the warranties that you can call on so don't sit on them. Certainly don't sit on the complaints over a year because when you call they'll say, "I'm sorry, your warranty is up." Don't sit on them, call them. There is a difference between a warranty and whether you've lost your legal rights to make a claim. The warranty is whatever the contractor decides to give you, meaning 12 months, maybe 36 months on certain components. Your deadline to file a lawsuit is called the statute of limitations. And for defects that are physical and it's based on the contractor breaching their contract because they didn't give you work without defects because it's obvious that you see. It's a four year deadline to file. But most people say, "No, I have 10 years." So the 10 year deadline to file is only for latent defects where latent means not obvious, hidden. So something behind the wall, something in the foundation, something that when you're sitting or walking through the building you cannot see. Those are the types of defects that you're allowed to bring in within the 10 year deadline.
So these are things you'll have to deal with afterwards, but the best way to avoid it is to have your own walkthrough, make sure everything is the way that you wanted. You won't be able to catch any latent defects, hidden defects, but at least you'll catch the ones that are visible and hopefully move on and have a defect-free project.
Jeff: Please be advised that these are California statutes of limitations that we've been talking about here associated with those warranties and about making sure that you have the time to go in and file a claim in the state court against the contractor, again in California. But in your area, the statute of limitations may be different so please check with an attorney in your state or in your city about the laws that apply to you where you live and where you do business. I think that's really important to mention.
Marina, this has really been a fantastic conversation and I think we could probably extend this longer if we wanted to. And I know that there are more items involving business and construction law that we could probably talk about another time. So we would like to have you back on again. However, for this segment we have run out of time. Just real quickly, if you could leave us with some final thoughts about some things that you just think that people absolutely need to remember when they're considering a new construction project for their business what would those things be?
Marina: To be honest, Jeff, not to promote my work, if they can get an attorney involved in the beginning they can actually avoid litigation at the end. That would be my advice, for an attorney to be in on it in the contract drafting and approval, and also for advice throughout to avoid the litigation part it.
I'm not trying to discourage any contractors but it just makes sense. They've been paid, they think they're done, they're not going to come back too many times. Some of them are very honorable and they do come back and complete punch list items but you want to be holding that back so that you're satisfied before giving it to them.
Jeff: Marina, I know that no doubt there are a number of listeners to Deal Talk in Southern California that would probably like to speak with you perhaps if they've got a project that they are looking at and they would like to get your counsel, seek your advice, how can they reach you?
Marina: Absolutely. The firm name is ADLI Law Group. My telephone number is 213-623-6546 and the website is adlilaw.com. In either way they could reach out to us and I would be happy to help anybody.
Jeff: Marina Manoukian, I thank you so much. I enjoyed the dialogue and hopefully we can have you back on again to continue our conversation and maybe go to some other areas or some other topics with you as well. Thank you again so much.
Marina: Thank you for having me.
Jeff: Marina Manoukian, senior counselor at ADLI Law Group PC has been my guest.
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Jeff: We appreciate having you. Jennifer, the idea of crowd funding, it seems that we really started to hear more about crowd funding from the very beginning at about the time of the financial collapse in 2008. It seems like maybe this was an idea that may have been born slightly ahead of that, but that started to really gain some traction as an option for companies to find a way to finance at least part or maybe even in some cases all of their business when maybe the traditional means of funding their business may have dried up a little bit after that financial collapse that we saw in 2008. Is that correct or has crowdfunding been around for a lot longer than maybe we give it credit for?
Jennifer: I think that's mostly correct but there is a bit of a history to understand in terms of how we got to today's notion of crowd funding. And I think if you look back just a little past 2008, maybe several years before that, with sort of the advent of the Internet being a constant source of communication between companies and the crowd, or between causes and the crowd and they're being sort of this 24-hour news cycle. It became quite popular to raise money online for various humanitarian causes. So the Red Cross and other international relief organizations turned to the Internet as a means to reach people to make donations for crisis-oriented events. That sort of merged forward with this notion that individuals could raise money, that companies could raise money for their projects, that people who wanted to make films could raise money, people who have medical problems could raise money. Websites like Kickstarter and IndieGoGo were founded on the notion that if humanitarian companies could do this why can't individuals. And organized companies do this for the sake of reaching people that have an interest or passion in connecting with those people and getting funds from those people.
IndieGoGo and Kickstarter were set in place really before the recession, but they were an outgrowth of this notion that the Internet was this perfect way to reach people with news and information and have them become involved monetarily with these causes, or with these crises, or what became products, films, and other passion products of individuals and companies. The history here is that the Internet provided a terrific interface for people who needed money, with people who are willing to give money if they could form a connection around the cause, or the passion, or the common interest. That's sort of the long history of how we get to the JOBS Act.
But to your point, certainly the recession brought a lot of typical and customary sources of capital to a halt. Banks stopped lending. Most venture capital fund and private equity funds rolled up shop for a while and weren’t making traditional investments, certainly not at the pace in prior years. There are a lot of failures in technology and other industries. So investors started to hold on to their pocketbooks in a way that we hadn't seen in a long time. At the same time the Internet was out there and companies were raising money. Companies that were producing movies, creating new consumer products, launching restaurants, and also individuals who wanted to forstore foreclosure, or raise money for medical purposes, etc. People were turning to the Internet to raise money and have people participate in their project. However, it was not legal then and it just recently became legal to have these people take the form of investments to make actual equity investments in the company. Until recently IndieGoGo and Kickstarter, I'm picking on them because they're the most popular and widely used platforms were able to take pledge-based donations or pledges or donations.
The history here is that the Internet provided a terrific interface for people who needed money, with people who are willing to give money if they could form a connection around the cause, or the passion, or the common interest.
Jeff: In other words pledge is really from anyone. We're not talking institutional investors here but we're talking about the guy or lady next door, right?
Jennifer: That's right. And that's sort of the beauty and the magic of crowdfunding is that someone who wants to raise money for a movie, or a new consumer product, or open a new restaurant can find some way to appeal to someone who maybe can only donate $10, or $5, or $75, or $100. But over the course of hundreds of donations like that companies can raise substantial amounts of money. But yes, it's true. There was no particular disclosure requirements. People were giving money for the sake of helping companies and for getting back some kind of perk. So these perk-based campaigns for example, if you're raising money to produce a movie, if you pledge $10 maybe you get a hat. If you pledge $50 you get a t-shirt. If you pledge $100 you can come to the movie set. If you pledge $1000 you get a copy of the script signed by all the actors. They were ways to create incentives for people to make pledges. And this was all fine in terms of the securities laws because no one was actually investing, no one was anticipating sharing in the profits of the venture. And conversely the companies didn't have to make any particular representations, and have any particular compliance requirements. The bottom line was the company had to try in good faith to accomplish what they promised the pledgers they were trying to accomplish. Make a movie, produce a product, open a restaurant, and so forth.
Jeff: Let's broaden the base here. Crowdfunding as a source for funds for privately held businesses. You were getting ready to, before I kind of walked on you just a little bit there, Jennifer, for clarification. You were getting ready to talk about some changes that have come about for the purpose of equity investing now as opposed to just kind of a one-off contribution to a company for the purpose of helping it grow or get up off the ground. Things have changed a little bit, is that correct?
Jennifer: Oh yeah, they've changed radically and substantially I would say. The history as I said is sort of humanitarian relief, and then companies and individuals who wanted to get money from the crowd for projects, or new companies, etc. And this was sort of during the recession. And then a movement started amongst people who were hosting the websites, amongst the individuals in the crowd who said, "If we can give money for the purpose of getting a t-shirt or some other gift, why can't we invest money and actually participate in the profits?” Meanwhile, in 2012 the JOBS Act is adopted. The JOBS Act provides many changes to the securities laws. But most importantly it opens up the access point between companies that want to raise money, and people in the crowd who are willing to invest money and take a risk, but who want to participate in the profits. And this is known as equity or securities based crowdfunding.
And so the first generation of that under the JOBS Act was changing a very, very old rule that the FTC and Congress have laid down decades ago that if you're going to have a private offering, if you're going to offer securities privately, if you're a private company and you're going to work with small groups of investors, that offering in fact had to be private and you could not have any public advertising or what's known as general solicitation. So in very traditional venture capital financing, the sort of closed loop capital environments, investors knew emerging companies, emerging companies knew where to go to meet investors, etc. But there were a lot of entrepreneurs who couldn't penetrate that environment. And as we said, in 2008, 2009, 2010, those environments were shut down anyway. The FCC said, "If raising money privately, having existing relationships with investors is not working, we need to open up the capital markets we need to be responsive to what Congress has asked us to do under the JOBS Act." Under the JOBS Act this really sort of ancient rule about no general solicitation, no public advertising, you can only take money from people you already know, that was eliminated. And that was known as the elimination of the ban on general solicitation.
What does that mean? That means that you can go beyond people you know in your direct circles. You can go beyond the traditional sources of capital, and you can open up your offering to the general public by means of advertising by email, on the Internet, and so forth. However, that first stage, that first step of the JOBS Act, which was huge frankly for the securities regulatory commissions at the state level and also obviously for the FCC, you could go to the crowd and you could offer your investment and your company but you could still only take money from high net worth individuals or credited investors. All these years when you were doing private offerings with French capital firms and high net worth individuals, and everybody was sort of in that club of ready investors, they were all credited. And if you were a private company and you had a relationship with an investor and the investor was accredited you could take their funds. And the investor could tell you on their own, they could self-certify as being accredited. There was this ecosystem of companies who could find high net worth individuals who were accredited. The accredited investors could say, "Yes, we're accredited." And the transaction could move forward. Because of the JOBS Act, and because the FCC reacted to the JOBS Act, you could advertise on the Internet. As I said, the ban on general solicitation was gone but you could still only take money from accredited investors. The trick here and what the FCC did was they said, "Okay, you can advertise to the public. You can find accredited investors, but the way you determine whether or not they're accredited is going to be more challenging, it's going to be more difficult.”
If it's private you can self-certify as accredited. If you find investors over the Internet and you want to verify that they're accredited there has to be some third-party substantiation or documentation. People have to submit tax returns or investment statements, or their lawyer, or their accountant or somebody has to write a letter verifying that they're accredited investors. What are credited investors? They're people with over a million dollars of net worth, or they're people with substantially high annual incomes of either $200,000 if they're independent or $300,000 if they're married. Congress said, "Go to the crowd and find these people. Find the accredited investors. The FCC said you can do that but we're going to make it a little harder for you to verify that they are in fact accredited." That was the first part of the JOBS Act. It created a new exemption under Section 506-C Regulation D which is a mouthful. But basically the first stage was to allow companies to reach the crowd but only to reach investors who are otherwise qualified to invest in private companies. That was sort of the first wave of it.
The second wave which just recently was implemented by the FCC is under Title 3 of the JOBS Act which allows companies to go to the crowd, and so to your point, to allow anyone, sophisticated or unsophisticated, wealthy or not wealthy, to invest in private companies. This is a general equity crowdfunding rule. There are some limits but basically it has proverbially opened the floodgates for everybody in the crowd to become an investor in private companies, and for private companies to reach virtually everyone they can via public means to appeal to these people to become equity investors, stakeholders, profit holders in their company. We can talk more about what those regulations entail, but you can see it's been sort of a steady march forward and there have been incremental changes. But given where we were and given where we are now it's quite substantial, the changes.
If you're going to offer securities privately, if you're a private company and you're going to work with small groups of investors, that offering in fact had to be private and you could not have any public advertising or what's known as general solicitation.
Jeff: But from where you sit as an attorney, and really as someone who, I'm sure you're an investor as well and probably have a 401K set-up there through the firm that you're with. But as someone who works a lot with business owners is this a good thing, do you think?
Jennifer: I think it depends on which side of the table you're on. I think the regulations and the FCC mandate to protect investors is really where the regulations were geared to. There's a lot of wording in the adopting release. There's been a lot of wording in legislative history and so forth to protect investors. People in the crowd are going to be seeing these company offerings, is there going to be fraud, and are they going to be taken advantage of, and how do we protect investors? That is the FCC's focus and that is more or less their mandate and understood. But your question is really I think in some ways the more interesting question.
If I represent the company or companies out there trying to raise money, of course they want funds, of course they need capital, of course they have to have money to survive, operate, and grow. However, they really have to ask themselves, and I tell my entrepreneur clients this, "Do you want to have in your company hundreds of shareholders who have never invested in a private company, who don't know what to expect, who could be nervous and demand liquidity at a time when you can't offer it, and who have ultimately voting rights in your company, and who also have quite a buffet of statutory and contractual rights to hold you accountable for what happens inside of your company?" That by itself is not a bad thing, shareholders should have rights. But think about having hundreds of strangers, people you don't know, don't know what their qualifications are, don't know what their level of sophistication is, potentially involved in your company, potentially having to manage them to a process, etc.
I think for entrepreneurs there's a real question of, first of all, could you raise the money. And second of all do you want to have all of these shareholders to manage. Even having a company where the shareholders are sophisticated, or venture capital, or angel investors, or people that have a background of investing in startup companies. It's tough to negotiate and keep your shareholders happy. It's just the reality of being an entrepreneur. I think it's that much more risky when you're dealing with investors you've never met, you have no relationship with, and you don't know what their level of sophistication is. You have to be willing to live in a new environment where you're bringing with you through your corporate life lots and lots of stakeholders who may or may not be a good fit for your company or for the ups and downs that your company is going to experience. A few of the things we don't know, we don't know with very many examples, there might be a few but very many, what happens to companies that are crowdfunded and have 300 or 400 shareholders. Maybe they've raised $750,000 or maybe they've raised a full million that they're permitted to raise under the rules. Will sophisticated, institutional investors invest in a company that already has hundreds of shareholders? Investors are smart, they're savvy, they want to make money, they're looking for exceptional opportunities, but their risk tolerance only goes so far.
And it's very risky to invest in a company where there are hundreds of other shareholders that you don't know, can't control, don't know what they're going to react to, don't know how they're going to behave. So it's another layer of risk for institutional investors as to whether or not they're going to want to co-invest with the crowd. And that's just an unknown right now so unknown if it's going to work. There are some commentators out there saying, "It's going to go the other way. Investors are going to put in the first half a million and then that's going to give the crowd confidence to go in and put a million on top of that. In other words as long as someone with sophistication, knowledge, and experience has invested why wouldn't I?" The thought there is that companies might be able to leverage early rounds of capital through angel investors and other sophisticated investors, and then go out to the crowd to raise money on top of that.
There are a lot of unknowns there. I think it creates some risks which can probably be managed but nonetheless risks new to entrepreneurs and growing companies. When you invite into your capitalization table potentially hundreds of investors who frankly have never done this before. There are some unknowns there.
Jeff: Interesting point, very risky indeed. There are risks with anything that is new and different, and crowdfunding has been around now for a few years and is gaining traction, and it's gaining investors quite honestly from coast to coast. My name is Jeff Allen and we're going to talk more about this idea of crowdfunding. Is this something that you could benefit from with respect to your business and raising capital? We're going to continue our discussion with Jennifer Post from Raines Feldman LLP when Deal Talk continues in a moment.
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Jeff: Welcome back to Deal Talk where we are becoming the Internet's go-to resource to help business owners understand what it takes to sell their company successfully. You can find a wealth of resources along with all Deal Talk episodes and their transcripts simply by visiting morganandwestfield.com. I'm Jeff Allen with my guest Jennifer Post, partner at the law firm Raines Feldman LLP in Los Angeles talking about crowdfunding as a source of funds for your business.
And it doesn't really matter what stage you are in, in terms of business ownership or how old your company is for that matter, how long you've been in business, crowdfunding is something that is relatively new, it's relatively different to consider. But let's say for example that you've got somebody out there, they've already got a Small Business Administration loan. They're working to pay that off. They've been in business for five, ten years and they're looking for a means to raise capital for any variety of needs. Maybe it's to buy additional equipment, supplies, to expand their business, maybe to open up a new shop someplace. Is crowdfunding really something that they should seriously look into, do you think?
Jennifer: I think crowdfunding potentially can work for a lot of different kinds of companies, but I don't know that it's a solution for all companies. I think companies that are likely to succeed in crowdfunding are companies that have some sort of wide appeal to their product or service, sort of a "sexy industry", some sort of brand new technology, something all consumers can relate to. Perhaps it's a film or creative production that has popular talent associated with it, something that appeals to a lot of people in a broad range of cities, lifestyles, etc. in the country. Companies that have some sort of sex appeal to them if you will are probably going to do well in the crowd.
Other types of companies that are going to do well in the crowd I think are companies that are regionally based. For example I'm in Los Angeles. I like restaurants. I'm not going to invest in a company that's starting a new restaurant chain in New York because it's not in my backyard. But I will be motivated to work with companies, or take a stake in companies that are in my neighborhood, in my region, or in my city. I think companies that are looking to build a brand, or don't have a presence or a connection with the local community I think will also do well. And companies that can find a way to use crowdfunding to find the pockets of investors who will understand them I think will also do well. Posting a crowdfunding campaign and expecting to reach millions and millions of people, and hoping that someone out there understands your business may not be the most strategic way to crowdfund. But if you can find specialized crowdfunding portals, or access, or avenues where people can help you develop and cultivate an audience of people who understand your industry, or understand your technology, or understand your brand then you're more likely to find people who will actually invest. If you're a machinery company and you're involved in aviation, all the better for you if you can find a crowdfunding platform that seems to attract people who have worked in industry, people who have worked in manufacturing, people who have worked in the aviation industry.
I think we're going to see a development probably by necessity of crowdfunding portals and intermediaries, consultants, and advisers who will help these portals and these companies cultivate sort of, if you will, the equivalent of a direct marketing campaign to investors who will appreciate the company, their status, their industry, etc. Otherwise we're falling back to who's interesting, who's sexy, who's got wide appeal, or conversely who's in my neighborhood, who's in my community, who's in my state that I'm interested in supporting?
You have to be willing to live in a new environment where you're bringing with you through your corporate life lots and lots of stakeholders who may or may not be a good fit for your company or for the ups and downs that your company is going to experience.
Jeff: What do we not know yet about crowdfunding that you may have a concern about in terms of risks potentially, not just risks to a company for embarking, going down that road. Whether or not you've got a sexy product or not it really depends and it's kind of in the eyes of the beholder. Really, what is there that you are concerned about as an attorney from a legal standpoint that we just don't know yet enough about crowdfunding and its safety as far as a resource for companies that want to go that way?
Jennifer: We've discussed in the first half it’s not only risk for the companies in developing large populations of shareholders that can be a burden from an administrative point of view, it can be a burden from the point of view executing on transactions. And also there's some exposure there frankly to shareholders who don't feel that there's enough liquidity. Or frankly if there's no success, people I think don't really expect to lose money. I just think that that's going to be a new reality for a lot of investors. On the other side of the table for the investors I think there will be a lot of disappointment. I think there will be a lot of complaints filed with the FCC and also with state regulatory commissions, people who feel in hindsight that they didn't get a good deal, that they lost money unnecessarily, or there must have been a problem with the company or the management that wasn't disclosed.
On the investor side I think there's going to be some amount of frustration. What happens with that frustration I think is the big risk. There's been a lot of discussion by commentators and others as to whether or not this is going to be a breeding ground for class action lawsuits. Hundreds and thousands, maybe millions of investors coming together to sue the websites that host these offerings, or the companies that offer securities. There certainly is always a risk of fraud. But I think the biggest risk in the market right now, unfortunately, is that there is this legal track developing for offering securities. The securities offerings to the crowd needs to be conducted on registered Internet sites, or they're known as intermediaries or funding portals. These are websites that register with the FCC, will be regulated by the FCC, are mandated to provide certain types of information to the crowd. However, the Internet's a big place. Lots of people get email, lots of people get spam, lots of people get solicitations from all sorts of websites. I think there could be, at least for some period of time, an unregulated crowdfunding market that could develop. So investors could be fooled in other words into investing in companies that are not offering securities through these regulated crowdfunding portals. That is certainly a risk. It's really hard to know if that's going to happen, but I think that risk is out there because there's a lot of misinformation, misunderstanding, and lack of clarity around how someone in the crowd can invest in a small company. The regulations are still developing. I think that that will be a continuing risk.
The other risk I see for investors, and this happens even in well-funded, well capitalized companies, is that investors want liquidity. If you're a company with a few hundred shareholders, shareholders want to sell their stock. We live in a world where people buy things and then they're not useful anymore and they want to sell them. So people will want to sell their stock to their friends and family. They may just want to get rid of it. People frankly move, they die, they become incapacitated. What happens among the ranks of shareholders in terms of how they want to handle their stock as property is a risk we don't have any answers to. Will there be a secondary market where people start trading in these crowdfunded companies even though they're either not supposed to or the regulations restrict that? Again, another unknown, it's a risk for the shareholders and it's also a risk for the companies.
A lot of unknowns really about how the rules are going to be implemented. Whether they'll be sort of a shadow market. Even if people successfully invest in crowdfunded companies what are they going to do with that stock and how long are they going to be willing to hold on to it before they start taking action which are contrary to the regulations.
Jeff: Because we're running out of time I'd like to go ahead and just break now and tell you that we might have a need to have you back on the program for a follow-up edition of our show just to once again explain maybe even in greater detail some of the key concepts here that we talked about today. And provide us with the an update as news comes down about any changes, further changes in the law and regulations, and legislation concerning crowdfunding. We hope that you'll do that at some point in the future.
Jennifer: Sure, I'd be happy to. These are very complicated regulations. Things are changing rapidly. There's a lot of material to talk about.
That is certainly a risk. It's really hard to know if that's going to happen, but I think that risk is out there because there's a lot of misinformation, misunderstanding, and lack of clarity around how someone in the crowd can invest in a small company.
Jeff: I'd like to find out too also Jennifer how people can get in touch with you if they have any questions about this subject that we're talking about today or if they want to talk to you too about any number of other business related matters concerning their companies, how can they reach you?
Jennifer: I'm a partner at Raines Feldman. We have offices in Beverly Hills and also Orange County. Our website is www.raineslaw.com. There's always the telephone. I'm at 310-440-4100. I'm happy to speak with people about their questions and comments on this or other topics that are important to them.
Jeff: Jennifer Post, again, I thank you so much for participating with us today on Deal Talk and we look forward to having you back on again.
Jennifer: Great, thanks so much for having me.
Jeff: Business law attorney Jennifer Post, partner at Raines Feldman LLP has been my guest today. We hope you enjoyed the discussion.
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Jeff: As a business owner, I know that the buyer's going to be conducting all their own due diligence. Why is it important for me as the seller to do the same thing?
Michael: A business owner who wants to sell their business needs to get all the due diligence in order to appeal to the buyer themselves. When you do due diligence you want to impress the buyer and make sure that everything's in order and organized. And it actually helps in order to expedite the transaction by putting things such as general corporate matters, employment matters, contracts, obtaining all these and ascertaining what they are, and organizing them to make you more appealing to the buyer and impressing them, quite frankly.
Jeff: Due diligence is something that we have talked about on Deal Talk in the past but business owners may not necessarily have an understanding of the time and the effort that's required here. It's not something that you can just sit down over a cup of coffee and work out with a couple of your key managers over a period of hours. When a business owners knows, Michael Schachter, that he or she wants to sell their company, when should they start the process of conducting that important due diligence?
Michael: When the business owner makes the decision to sell a company I think the sooner the better, start the due diligence process, quite frankly. It also depends on how long the business has been around. There are some companies that I’ve represented have been around 20 to 30 years. And in that instance there's a number of documents and more information than in a company that's been around for a year. So I think it depends on how long the company's been around. But more importantly I think it's important to just get the process started sooner than later. Most of the companies when they make the conscious decision to sell, I think that's when they should start organizing their documents into certain categories such as corporate matters, employment matters, contracts, just to get them in order. Sometimes, depending on how long the company's been around like I said, if the company has been around for a year they might wait until they have a letter of intent in process because in the letter of intent the buyer's going to ask for due diligence at that point. But if you started sooner before the LOI then you put yourself in a better position. So my answer is the sooner the better.
When the business owner makes the decision to sell a company I think the sooner the better, start the due diligence process, quite frankly.
Jeff: Let me ask you, is there anything that an owner of a business who is a conscientious owner, they have it maybe in their exit strategy at some point to sell their business. Would it be to their advantage to from time to time conduct their own internal audits of the systems and processes that they have in place and particularly of the numbers of the books so that at some point down the line when they are ready to sell that it may actually shorten up the due diligence process?
Michael: Absolutely, and it makes total sense. For my clients what I do for the most part, I represent some start-up clients and what we do is we start a Dropbox file or a box file. And we start keeping track of all the documents as soon as they're incorporated. The key with due diligence is organization and making sure you document everything that is happening in the life of the company. It gets tedious but I do think that it's a good practice to organize and keep track of all the documents that you have outstanding in one place that makes sense. So for example like I said for startup companies I'll incorporate the business for example. And then I'll make a box file and call it corporate matters, and then I'll keep track of all the signed documents and filed documents in that one file, even though they just incorporated. For the most part, most companies not withstanding the fact that they just incorporated are looking for an exit at some point down the road whether it’s five years, ten years. But the sooner you keep track of these documents the easier it's going to be when you actually have a transaction pending.
Jeff: Michael Schachter is a business, corporate, and real estate transactional attorney at the firm Pearson and Schachter in Walnut Creek, California. My name is Jeff Allen. You're listening to Deal Talk. From your experience, Michael, what are the most common areas of concern for most companies when it comes to conducting their due diligence? What area do sellers really need to focus on or clean up during the process?
Michael: Good question, Jeff. So I would say when the buyer's looking at the seller's company, what they're doing is investigating and making sure everything makes sense. The buyer's looking for inconsistencies, unsigned documents. But the buyer wants to make sure is that they're getting what they're paying for. So as the seller you want to make sure that if you issued any stock to individuals you want to make sure that that's documented correctly. Moreover if people had left the company you want to make sure that you have the separation or release agreement with them and appease the buyer to make sure that there's no issues outstanding. You also want to look at the contracts that you have, existing leases, contracts with third parties, with customers, and make sure that you have the right to actually assign or terminate the contract upon the change of control which either stock purchase or an asset purchase. So you want to make sure that those items are documented correctly. Furthermore, you want to make sure in the agreements themselves that you're allowed to actually disclose the actual contract to third parties and not breach any particular provisions in the agreements. I would say documenting everything correctly such as equity interest especially because the last thing you want is to sell the company and then have some random shareholder that wasn't documented correctly come after the buyer later. You want to make sure that the agreements allow you to actually give the document and the agreement to the buyer without breaching it. And you want to make sure that you can actually assign or terminate those agreements before the deal closes. Those are the types of items that I see that happens a lot that cause some last minutes these.
So I would say when the buyer's looking at the seller's company, what they're doing is investigating and making sure everything makes sense. The buyer's looking for inconsistencies, unsigned documents. But the buyer wants to make sure is that they're getting what they're paying for.
Jeff: Let's camp out there for just a minute. You're talking about the contracts and agreements with vendors, clients, staff, etc. How often do you see, Michael, that oftentimes these contracts don't take into consideration proper language in order to allow for a seamless transfer to a new owner. Is it pretty common where these contracts are written up and drawn up between the two parties of interest without allowing for any kind of changes down the line between one party and another, particularly in this particular case when you're talking about a transfer of ownership?
Michael: It depends how the deal is structured. If it's a stock purchase then arguably the seller will remain as the seller's entity. If you have an asset purchase then that kind of creates a different kind of situation because the seller will be a new entity and that would trigger the assignment provisions in these contracts. Most contracts you need to look at the assignment provision and all these deals, and all these contracts. Most of them if not all say that if you have an assignment which means to transfer the contract to a third party, a different third party, then you need to get written consent of the third party. The tricky part is like I said in the stock purchase agreement you're actually transferring the contract to a third party where you're going to remain as the party of the contract even though there's different owners. So in that situation you need to look closely as the assignment provision, make sure they don't have any change of control provision where they say, if you sell 51 percent or more of the controlling interest then that is deemed an assignment. So to go to your point about being proactive about the due diligence process, I think it's a good exercise to look at these assignment provisions and ascertain even before you structure the deal about how many contracts are actually signable without the consent of the third party. If you're a construction company for example and you have a hundred contracts with third parties that require the consent then that might be an issue for the seller themselves and the buyer, and you might want to structure the deal differently.
Jeff: It really does sound like something that could if it's not addressed properly - and sometimes that means getting way out in front - it could really put a hitch in a deal when you consider how valuable that some third party vendors, for example, might be toward the operation of a company or towards the processes that it has if it's a manufacturer, for example. If it's a supplier and the supplier has some questions about any new deal with any new ownership coming in. What about lease agreements for buildings, equipment, anything like that, anything important that we should remember as sellers of a company here with regard to these particular items?
Michael: Absolutely. For the most part, the major contract for sellers is the commercial lease where they have the premises. And a lot of times these leases take a lot of lead time from the landlord in order to get consent. The first thing you need to do is ascertain whether or not you need consent from the landlord. And that's dependent upon how the deal is structured. If you have a stock purchase, for example, the seller will remain as a tenant in the deal. You need to look at the assignment clause and make sure that it says that if you don't have a change of control that's not deemed an assignment. If the explicit language in the assignment clause that says a chance of control such as selling 51 percent or more is deemed an assignment then you're going to have to get landlord consent. So it's imperative that you look at these provisions and make sure that you do not transfer the lease without the landlord's consent. And these things, depending on how reasonable the landlord is, could take time, and time is of the essence in all these transactions.
I think it's a good exercise to look at these assignment provisions and ascertain even before you structure the deal about how many contracts are actually signable without the consent of the third party.
Jeff: Michael, you know what this does right now, you're talking about things that I'm just thinking, wow, there's so much to remember. This is why it really is imperative to be working with an attorney to help make sure that there's nothing, there's no stone that is left unturned.
Michael: Correct. And a lot of people, the attorney’s role in this transaction is really dependent upon their client and the buyer. Some buyers scrutinize things more than other buyers. And the attorney's role is really to ascertain what the issues could be with this due diligence and help the client get organized and actually expedite the process. It might cost more money to pay an attorney to do these things. But in the long road it expedites the transaction and it could save you a lot of money later if there's litigation regarding certain disclosures.
Jeff: We're going to come back in just a moment, Michael, after we take a short break and we're going to talk about small companies versus large companies and their use of an attorney to help them with their due diligence. Due diligence, why it's important, but why you need to get an early start on it. I think that's the most important thing that we're trying to take out of this discussion here. And we're having our guest today, Michael Schachter, on the program to elaborate on all of the reasons why it's so critical that you need to get an early start. My name is Jeff Allen and I'll be back with attorney Michael Schachter when Deal Talk continues in just a moment.
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Jeff: Welcome back to Deal Talk where we are becoming the Internet's go-to resource to help business owners understand what it takes to sell their company successfully. You can find a wealth of resources along with all Deal Talk episodes and their transcripts simply by visiting morganandwestfield.com. I'm Jeff Allen with my guest Michael Schachter, a business and corporate attorney at Pearson and Schachter Law Firm in Walnut Creek, California where he's also co-founder and co-owner, and we have questions from a seller's point of view on the subject of due diligence and all that that entails.
Michael, let's go ahead and we'll get right back into it here. I've got a small company without a lot of assets. I've got a business here that really I could run from home if I wanted to. Can't I simply conduct due diligence on my own without the aid of an attorney?
Michael: Jeff, I wouldn't advise doing that, not withstanding the fact that it's a small company. There's still a lot of issues that could arise when you're a seller of a company. Everything seems fine until something goes wrong. So it's not to say that something would go wrong if you did it on your own but I wouldn't advise doing it. The attorney's role in these transactions especially on the due diligence is to ascertain what is potentially wrong. Every company is going to have skeletons in their closet. Other than getting the money from the transaction when you sell, the disclosures to the buyer are the second most important thing. So in every transaction you're going to have representations in warranties in these agreements, and they're going to ask you everything about the company, even if you're a small company or large. And the extent of the reps and warranties in these agreements will depend on what type of industry you're in and how long you've been around. But pretty much most if not all of them are customary. And in addition to these reps and warranties the seller needs to disclose certain items that are not true in these representations and warranties. And without an attorney's guidance you'd be lost. A lot of these representations or warranties are very intricate and they ask things that you might not understand. And then rather than guessing and getting in trouble later by not disclosing things it'll be much advisable to seek an attorney to help you get through this process and figure out what could potentially be the issues moving forward.
It might cost more money to pay an attorney to do these things. But in the long road it expedites the transaction and it could save you a lot of money later if there's litigation regarding certain disclosures.
Jeff: And that's where I want to talk to you a little bit more. You touched on some things before we went to the break. You were talking about how involved an attorney could get in the process. From where you sit, Michael, you’ve probably had a chance to be involved in many different levels and to many different extents. But let's just talk about maybe the common garden variety if there is such a thing, a due diligence process where a company gives you a call, and from the time they give you that first phone call to the point where you've agreed to work with them. Tell us a little bit about how you work with the business owner in the process.
Michael: Right, good question, Jeff. When I represent sellers of the company for the first time this is just assuming that I haven't represented them before. What I do as the seller's attorney is I give them a due diligence request list which is pretty extensive. And I actually do my own investigation of the company themselves so I can ascertain what potentially could be an issue when you disclose it to the buyer and in due diligence. And one of the items that that I'll ask for is the capitalization table which is the ownership table of the owners of the corporation, for example, or LLC. And we want to make sure that every issue once we have given to these particular shareholders and members of the LLC is documented correctly. And I will go through this due diligence request list with my client and do my own investigation of that message as if I was the buyer's attorney so I can ascertain what issues could arise and try to clean them up at this point. And a lot of the clients really appreciate that because these are the same questions that the buyer's attorney asked them when the deal is in progress and it actually expedite the transaction.
Jeff: And so they kind of know what's coming and because they know what's coming they can respond and react with confidence and provide them with the information that the buyer is looking for. This is all obviously a very involved process and I'm really appreciative of what my attorney is able to do for me in terms of get me prepared for the workload that's kind of involved. Then there is going to be some work involved. I've got a business to run but because I am serious about selling my company and I want to do what's right I'm going to take that list that you provide me and I'm going to get to work on it. But who else can help me out there? Who else can I involve in the due diligence process, Michael?
Michael: Good question, Jeff. A lot of times the due diligence process actually inundates the business owner, and it becomes like a full-time job. And it's kind of frustrating for the business owner because they need to run their business but at the same time they're intrigued and fascinated by the exit. So there's a challenge there. So what helps is try to figure out from the owner of the company who the people are in the company to ask certain questions like if there's financial questions you ask the CFO. If there's operational issues you ask the COO. So you figure out who these people are and you actually figure out which questions are directed at who because you'd be amazed how many times you could ask the question and some of these people wouldn't know the answer. And you can actually expedite it and figure out who to ask the question to. So it's an intriguing process. But what you need to be careful about is how many people you tell in the company about this transaction because it should be on a need to know basis. Because the last thing you want to do is have every employee involved with the company know about the transaction and they might get worried about whether or not they're going to be staying on after the deal closes. It's an interesting dynamic and the people who will give you the best answers are the actual owners of the company themselves and the officers and directors. So you would seek their guidance to ascertain who to ask these questions to.
So what helps is try to figure out from the owner of the company who the people are in the company to ask certain questions like if there's financial questions you ask the CFO.
Jeff: What about people like my CPA for example?
Michael: The CPA, I would put them on the same level as the attorney. The CPA would probably know as soon as the attorney knows about whether or not if they have a potential buyer for the company. The CPA's going to be involved with all the financial issues that arise and the tax matters. What I do is once we get the first draft of the definitive agreement such as the stock purchase agreement or asset purchase agreement I will actually have the CPA review the agreement simultaneously with me. So I know these answers to a lot of the representations and warranties regarding tax matters and financials. And the CPA will ascertain and figure out what they need to provide to the buyer as well. So we work hand in hand for the most part.
Jeff: If I don't necessarily have a buyer interested or trying to get more information about my company yet and I'm kind of taking the process, the bull by the horns, and moving forward with my plans to put my company up for sale and to list it, when might be a good time for me to get a business broker involved if I don't already have someone approaching me?
Michael: Right. I think you need to make a conscious decision that you're ready to sell. And at that point I think it's a good point to ascertain and find a business broker for you. It's similar to the analogy you gave when you're selling your house, at some point you realize that it's the right time to sell it and I think the business owner will have the same inclination with their own business. And at that point it would be good to seek out a third party business advisor, business broker. And they help out with the due diligence as well. And for the most part they only get paid if the deal closes, so I think it will be a good partner for any business owner to try to seek one out when they make a conscious decision to sell the company.
Right. I think you need to make a conscious decision that you're ready to sell.
Jeff: You mentioned that they help out with the due diligence process. Can you point to any examples of how they would be helpful in that process?
Michael: In my experience I've actually given due diligence request with some work with business brokers and the client together to put together these items that I've requested in the due diligence request list. And honestly, quite frankly it's cheaper for the business owner to use the business brokers, someone who's experienced. They can't give legal advice obviously but they can help organize these items to make my job easier.
Jeff: Understood. Michael, we are running short of time here. If there are maybe a couple of key take aways, if you're riding up an elevator for example to the top of a metropolitan high rise, and you're off to a meeting there, and you've only got about 30 seconds left what would you tell the person you're riding with about selling their business and what they need to be mindful of as they get ready to embark and go down that road?
Michael: I would say the most important thing is to keep organized and document everything that's happened in the life of the company. Every company is going to have skeletons in their closet, and whether or not that's a big issue or not isn't up to the client themselves but should be judged by an attorney. That's why it's important to get an attorney involved with the process and help expedite the transaction with the buyer. I think the attorney's role in this process is imperative and should be sought as soon as the business owner makes a conscious decision to sell the business.
Jeff: Very, very good. Michael Schachter, this has been a great conversation. I really do appreciate your time and I know that you're busy there and you've got to get back to matters at hand. But if there is anyone in our listening audience to Deal Talk and they may be in your area at Walnut Creek in Northern California. They'd like to contact you, get your advice, maybe discuss the possibility of having you assist them with their due diligence needs and as they're may be preparing to sell their business. Or if they have any other business-related questions for you, perhaps would like to seek your counsel. How can they reach you?
Michael: Sure, thank you Jeff. You can reach me at 925-954-7248. I give free consultations and I'm happy to discuss with any business owner any potential questions they have. You can also reach me via email at email@example.com
I would say the most important thing is to keep organized and document everything that's happened in the life of the company.
Jeff: pearsonschachterlaw.com, and again that phone number if you would just repeat that for us.
Michael: Sure, 925-954-7248.
Jeff: Again, Michael Schachter, I appreciate all the time. Thank you so much for joining us on Deal Talk. Hopefully we can have you back on again.
Michael: Thank you Jeff, my pleasure. It's been fun.
Jeff: Michael, Schachter, business corporate and real estate transactional attorney has been my guest today. We hope you enjoyed the discussion.
To listen to more Deal Talk, visit morganandwestfield.com and click on the podcast link at the top of the site. And if you consult- or work with business owners prior to, during, or after the transaction process, you'd like to join us as a future guest to share your expertise contact me directly at 888-693-7834, ext. 190, or email me at firstname.lastname@example.org. Deal Talk is presented by Morgan & Westfield, the nationwide leader in business sales and appraisals. Find out how Morgan & Westfield can help you at morganandestfield.com. For everyone at Deal Talk, I'm Jeff Allen, thank you for listening.
Jeff: Thank you. We're excited to have you. Let's start by talking about some of the most common legal mistakes that sellers of businesses may make. And what advice can you offer to help them avoid really what are nothing more than pitfalls?
Jamie: Okay, Jeff, that's a common, good question I hear a lot of times and what I see is a lot of times when people are buying or selling a business, obviously we all want to make money and everyone wants to be cognizant of saving money and really watching the dollar because obviously you're spending money buying a business, you don't want to spend too much. And I see that as the first pitfall because the most really important thing you need to do is you need to really make sure that the deal's being done correctly. Because you might think you're saving a couple of dollars here, but in the end you're going to spend a lot more on legal fees and possibly court resolving everything. Because there's an old saying, "One partner's fine, two partners is too many." You have to be aware of that. Anytime when we deal with bringing on partners. There's ego, there's personalities, and it's money. And anytime money's involved there's a lot of problems that can ensue. So you want to make sure that everything is done correctly. Going back to where I first started with, it's really important to get a lawyer on board. Obviously I'm a lawyer so I say that but I'm telling you I've been down this road before, that is money well spent. Because you want a lawyer to make sure that things are done correctly, the documents are created correctly, basically it insulates you from the buyer or seller also because now you have someone who's doing negotiations for you. In anything, do you ever notice, Jeff, when you go to buy a car or you go to sell your house it's always difficult because you're emotionally involved. You're saying, "Why should I pay an extra $5,000, it's not fair." By bringing in a lawyer or even a realtor, someone who's basically able to look at it from 30 feet above, they're able to basically give you the right direction because they're not emotionally involved, and that's really what a good lawyer is. We try to keep the emotion out of it. We're looking at what your best interests are, not your emotional interest. So I think it's really important to have the lawyer to make sure that certain things are done correctly.
Just quickly because I'll let you get into the next question. Certain things that I see a lot of pitfalls are, people buy companies and they end up taking on the liabilities. That's a really common one. If you correctly draft the document you make it very clear that you are not taking any liabilities. Indemnification clauses, that's another one where for instance if you were to basically, you sell the company and on the flip side someone gets injured in the store and they can't turn around and sue you because you formerly had the company. So very specific things can be done by the lawyer to make sure that both sides are protected.
Obviously we all want to make money and everyone wants to be cognizant of saving money and really watching the dollar because obviously you're spending money buying a business.
Jeff: We know that the bottoms of the documentation ... throughout the documentation, it doesn't really matter, it's full of a lot of legalese. There's so much to read. And whether you're selling a business or you're selling your home, or whatever the case may be, a business owner being very busy as he or she typically is, they go through this stuff and their head is spinning. And the fact of the matter is that language is there really to protect both sides but it's very detailed and it is written with attorneys in mind, or at least that's the way I would think, Jamie, that people should look at it. So if you see that stuff, and you know that you don't have the time to go through it, that's a perfect reason right there for getting a lawyer involved.
Jamie: Yeah, you hit it right in the head. Most of this language is very legally written. It's confusing. I will be honest with you, I'm always honest, but when I first started as a lawyer I couldn't understand it. I've been a lawyer now 11 years, eventually by seeing so many contracts and doing this I am very familiar with this. I've seen every single clause. I know how it works, how it can work backward and forward, and really the pitfall is kind of similar to what you said of how sort of language can go against someone. For instance deposit language, in most business you have to put up a deposit to buy a house or a commercial business. I deal with a lot of sales and commercial businesses. That's very popular now in South Florida because there's a lot of money people can make. You buy the property for low value with the business sometimes included, sometimes not. And then you either sell off the property years later or you just run the business. It's a very popular thing. But even something like that it gets very tricky sometimes with the deposit because the seller wants to say that the money is non-refundable but as the buyer you want to protect yourself. For instance the appraisal doesn't come through, or if something happens you don't want that money to become tied up because for a lot of people that deposit money is a main source of revenue that they have or the money they put aside. So as a lawyer I really try to protect the client both ways, because sometimes it's not worth putting it on the line. Bad things happen, that's what litigation's about, litigation is not fun. So as a lawyer I don't want to see you when you're already in litigation, I want to avoid the litigation, and I think that's a good thing to tell clients when they first come in because a lot of people have never been involved in law suits. But law suits are not fun. They keep you stuck in the past. You're looking at that person who you just wanted to get away with. And we have a saying in our office, is a law suit’s like wrestling with a pig, and the problem is the pig loves to get dirty. And that's kind of what it's like. You're dealing with someone who's litigious and you're stuck with it.
Jeff: And in some states that sort of thing can be probably worse than others. And I happen to be in Southern California right now. California's a very litigious state as you know. And Jaime, I know that things are probably much the same way in your part of the country in Florida. So we know then it's best to have a legal representation there, the help of a business attorney to make sure that you have all of your documentation, everything is tightened up as much as possible. And they are also there to be able to assist you to make certain that any risk of getting into some legal liability related issues, legal problems during the sales process is mitigated as well so they can help you avoid certain issues during the sales process. Let's go back though, Jamie Sasson, and let's talk about some of the documentation specifically that one needs to make sure that they're current on or that needs to be prepared before I can list my business for sale.
Jamie: Okay, so from the seller's standpoint, Jeff?
So as a lawyer I really try to protect the client both ways, because sometimes it's not worth putting it on the line. Bad things happen, that's what litigation's about, litigation is not fun.
Jamie: Okay. It's very important when selling your business, in 100 percent of these cases, these sales, the buyer's going to want to do his due diligence. And that's really what it comes down to. The buyer's going to be going through all your documents and he's going to be making sure that the numbers match. That's a very common law suit where you will see where they ... they say cooking the books. As a seller you never want to be in that position because if you give ... Your taxes you got to hand over, so the taxes are the taxes. But the problem is a lot of businesses which we know can play a little funny with the numbers, with IRS. The accountant, "Show this is a loss. Do this, do that." What happens is you think as a seller of a business, "My accountant says it's okay. He's saying this is how much the business is making." And now on the vice versa sometimes you're saying that you are making more for start-up reasons. So it's very important, you don't want to end up with, you do the deal, they do due diligence, and then the buyer comes back afterwards and basically claims that you cooked the books, or you didn't give the right figures. Because what happens is that that can open up even more things. Because not only you could end up in a lawsuit where the buyer is trying to rescind the agreement, but I've had many cases I've won currently right now where I'm representing a buyer of a school, a daycare. She bought the business. She hired a broker actually and the broker basically went along with everything so we brought in the broker which rarely you don't see. But long story short it turned out that the seller intentionally cooked the books. So not only am I suing to rescind the deal but I'm suing for fraud and for conversion. And other types of more serious type of claims where if I can be successful in that I would get triple the damages in some instances. You want to do things by the book. Being truthful and doing things the right way will always lead to better things. Because you might think, "I'm getting a little bit more here, puffing it a little bit here,” but it usually comes to bite you where the sun doesn't shine. So you got to be very careful there.
Jeff: Pay me know or pay up big time later, and it's a really interesting example that you use with regard to a day care facility. And people, myself included don't tend to think of a day care facility as being among those types of businesses which could be involved in something like that, but it just goes to show businesses of any size and any industry can place themselves at risk of real significant damage. And look at the people that you're hurting along down the line as well on both sides of the ball there. Jamie Sasson is managing partner at Ticktin Law Group. You're listening to Deal Talk. My name is Jeff Allen. I'm so glad you could tune in. We're talking about keeping things legal, what you need to remember on the path of selling your business and what you need to be mindful of. Let's say hypothetically I'm ready to sell my business. I'm preparing to do that and I'm considering using standardized legal forms which are pretty much readily available now online as you know, Jamie. And I want to do this because I want to save on fees. What advice do you have? Is that something I can do? Is that reasonable, or no?
Jamie: Great question Jeff, and I get asked this a lot. Because it goes back to my first thing we spoke about it, saving a couple of bucks here, is it worth it there? I very strongly suggest people do not do that. I see that so many times leads to problems later on. You see it more on the real estate side where people buy ... They'll try to draft up a quick claim deed and I know we're not talking about it today so I'm going to lead this by ... It's a similar example though. I try to draft my will myself or I try to draft a quick claim deed. That usually leads to problems because you can use a form and same thing with business contracts. Let's say I'm selling my business and I just want to draft up a contract. And I'm using the standard form. And that's the problem, the word standard. Because most of these forms, we could all find them, and I use them myself sometimes but I use it as a template to basically expound upon, and that's the problem. By using a standard form, number one, they're usually not tailored to the individual states. For instance if you'd see one online it might be from California but I'm in Florida. Some states have very different laws. That's one of the big problems. But let's assume you're using a form you found that says, "For Florida Residents Only." The problem is each deal is very specific. There's no deals that are exactly alike. What you really need is a lawyer to basically fine tune that contract for your specific needs, and that's really what I see a lot of times is the client will use a form that they found and it has language that to their blind eye, to their not legal mind, it looks fine. Oh yeah, that looks like it'll protect me. But when you really read it it doesn't protect them because it needed very specific language regarding this specific deal. I hope that explains how I feel about it. And it's not tremendously expensive. There's a misnomer out there that to hire a lawyer to do these kind of deals. Let's just use the example I said, someone buying a day care center, it's not that expensive to have all this stuff done. It could be a thousand, it could be two thousand, it depends. Where people a lot of times see that there's these huge bills is there's some very affluent law firms and a lot in California where you live where they have to pay expensive leases. What happens is if you have a very big corporation and you need to do all the paperwork, yes, that can get into $50,000, $100,000. We're just talking about a normal person wants to buy a restaurant, somebody wants to buy a bar, it's not that difficult to put together a pretty strong shareholder agreement, contracts, and basically do those things.
Being truthful and doing things the right way will always lead to better things.
Jeff: Something that's simple but at the same time it's necessary. Make sure that you're going through an attorney to make sure that your forms or the documentation that you're using is custom tailored to your own particular business.
Jamie: You got it, but I wouldn't say it's simple because that's the mis...
Jeff: That's why people go and use standardized forms, because they think that by using standardized forms, because they think it's simple that's why they would do that.
Jeff: Okay, good. So we want to make sure that people understand. It's not as easy as you think it is so please consult your attorney before you attempt to go to their sites.
Jamie: I'm sorry, I'm talking over. I got a lot of people who use LegalZoom and those things and I've seen a couple of times where people made really fatal errors by using the wrong documents, really bad stuff where they're on the hook for attorney's fees. So people have to be really careful. It's a really important issue that you brought up, and you'll see that's why a lot of these companies like legalzoom.com, they went away from this offering to give documents. The big thing now is you could talk to a live attorney because they're getting the same complaints. People are using their forums and they're getting screwed. That's my point there. You want a lawyer to make sure that things are done correctly.
People are using their forums and they're getting screwed. That's my point there. You want a lawyer to make sure that things are done correctly.
Jeff: No, it's an excellent point and it's a great point to lead out on the first segment of the program, Jamie. When we come back we're going to continue our chat with Jamie Sasson, he's managing partner at the Ticktin Law Group in Florida. We're talking about the importance of keeping things legal so that the deal does not fall through at the end of the day. As you're getting ready to cross that finish line the last thing you want is for the wheels to fall off. So keep it right here. My name is Jeff Allen. We'll both be back when Deal Talk resumes after this.
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Jeff: Welcome back to Deal Talk. I'm Jeff Allen joined by Jamie Sasson, attorney and managing partner at the Ticktin Law Group PA and he's got several offices there in Florida. Jamie, you've got probably about 12 locations throughout the state there, is that right?
Jamie: Yeah, we have about 12 locations. Our principal main office is in Deerfield Beach which is pretty close to Fort Lauderdale, about 10 minutes away.
Jeff: Let's go ahead and let's pick it up, another hypothetical. I can just be anyone here but let's say I'm selling my business this year, or maybe over the next 12 months to be more clear. I don't have any documentation for my employees per se. Maybe I've got just a small group. I've got maybe half a dozen people, I've been working with them for years. Is it too late to properly document their employment, Jamie, with only 12 months left to go before I'm ready to go ahead and get out?
Jamie: No, I think that's totally acceptable. A lot of employers do that right before ... Because it's the normal daily grind. We're all working and usually businesses a lot of times are service industries, and you're running a pizzeria, you're doing this, you're doing that. You're not keeping your eye on the ball, which I do suggest you do have an important for any business have some type of control or some type of managing kind of person to do that because there's only so much one person can do and sometimes it's better to have someone working on the sales and the other person worrying about the books. In business we try to do too much. That's probably acceptable. I see it all the time where you can put together your books, what the employees are making. I see very common where employees, you’re supposed to keep their hours and have that all recorded. A lot of times that's not done correctly and that's another thing you can after the facts put that stuff together. It's important to keep the records of that.
Which I do suggest you do have an important for any business have some type of control or some type of managing kind of person to do that because there's only so much one person can do and sometimes it's better to have someone working on the sales and the other person worrying about the books.
Jeff: I'm just wondering, is it a legitimate concern that people have, business owners have, about the possibility of their employees leaving should the employees find out that the company's up for sale. I can imagine that this would be a problem. And if it is, is there a way to ensure in any way that the employees stay on after I sell my business so that in fact the sale goes through? I don't want people to bail and then all of a sudden the new buyer comes in and he doesn't have anybody to work with.
Jamie: Right. That's a pretty tricky one that a lot of people deal with. Unfortunately, we abolished slavery in the late 1800's so we can't pretend. I'm saying that joking around but we can't force people to work. I'll just give an example of our law firm. We try to be very transparent with our employees. We got about 80 employees. And different businesses have different philosophies about that. Some businesses don't talk to their employees about how much the business is making, or what the profits are, or the state of the business. At our law firm, we think it's important that the employees do know what's going on and they feel like ... because they spend more time here than with their own families. That's what a business is, you spend the majority of your lives, especially in the United States of America compared to other countries, working. So it's very important that they feel part of the team. That's always a judgment call by the actual individual business owner, how transparent he likes to be. Some people are more to themselves, some people are more out there.
For me, I think it's better to be more in the open. So taking my approach, which I think is the best approach to deal with that situation, Jeff, which you just spoke about, I think if you are truthful to your employees and say, "Hey, this is going to be happening. I really like you here. I really like you to stay on board with this new owner and work the transition." But if you're going to just not say anything to your employees and all of a sudden get up in a meeting and say, "By the way, we brought in Darth Vader" or any type of person you could imagine, they're going to freak. It's like anything. I think if you can deal with it honestly and truthfully with the employees and basically tell them you're still going to be around. You've talked to the new owners and they know about it, people want to feel respected. I find in business, because I do obviously manage about 25 attorneys and a staff about 50, no one likes to feel like they're under your thumb. That's the one complaint I hear. And as a management and running a business, people want to feel appreciated. People take less money just to feel appreciated. I think that's very important. It's the same type of thing here. If you're honest with your employees and you let them know what's going on they're going to feel appreciated. And they'll go to this other place that you suggested and they look up to you, they're going to do what you suggest.
Jeff: And the thing is I know that this sounds very elementary to a lot of people who may be listening to this program right now. But the fact of the matter is there have been studies, there's been a lot of research conducted particularly over the last 10-15 years on this kind of psychology. Whereas if you treat your employees with respect and you let them know that they're contributing to the success of your business, you show them that in so many ways that they're going to stick around. And so your point about being transparent I think is really, really important. And that also too might extend, and I'll let you go ahead and take over here on this point too, customers too. One of the things that we know that all buyers of businesses really like, they find really attractive, is that built-in customer base. They look for loyalty, they look obviously for cash flow and revenues, but they like to be able to step in to a business, take over, and know that they've got some loyal customers that have been doing business there for years and they'd like to think that they're going to be able to retain those customers too. As the business owner, the current owner, the guy who's selling the business, from my standpoint, is there anything that I can do, any precautions I can take to make sure that those customers don't bail out?
Jamie: I kind of flip that question around because typically it's going to be the buyer who has more of a concern there. And I'll answer both ways because it makes sense both ways, because obviously both sides want the deal to go through. But the buyer is ultimately the one who's going to get the customer, the goodwill, and the money from that. There is a simple solution to that which I recommend to clients. Typically it's good to put in the contract language that the seller will facilitate with the buyer in making sure, using his or her best efforts, to make sure that those clients come on board. Because what happens is sometimes the seller sells the company and the buyer doesn't have this language in. And then he takes over and then you don't have the seller who's built the relationship with these clients. That's his clients or her clients. It's all about relationships. We can give the best numbers and the cheapest deals but it's about the individuality, the services. As long as you can get the seller, and the question as you proposed, Jeff, is how does the seller keep it? It's really easy. It's basically letting your customers know what is happening, vouching for the new owner if you can. You absolutely don't want to say this guy, this company, is the greatest thing when it's not, again, it's just being honest. And then for the next month or two, from the business individual needs, obviously the seller is going into another business, he doesn't have the time. But ultimately he should stay on board, he or she, and make sure that that transition is done smoothly, and that is typically in a lot of contracts.
That's his clients or her clients. It's all about relationships. We can give the best numbers and the cheapest deals but it's about the individuality, the services
Jeff: And that's something that I would imagine that you probably advise your own clients to do, and they're probably open to that more often than not I would imagine, is that right?
Jamie: Yeah, and something I see a lot which you should be very careful is, and I see this a lot in insurance agency sales. The insurance agent is selling his book of business, or he's merging in. And that one’s very important because a lot of times you'll take on this insurance agent, you're buying his business, and then what happens is unless you do the documents correctly, a year, two years later, whatever happens he decides to go take his book of business somewhere else. So you just paid money for nothing. Again it goes back to having the documents done correctly with proper non-competes. You can't do non-compete forever, but in that situation what I just told you, you have to put very specific language in the document saying that the clients that belong to Joe Schmoe now belong to you. Because if you just say you're buying this business and you don't have that language then it's Joe Schmoe's business and he could do what he wants with it, or his clients.
Jeff: Final thoughts Jamie Sasson, we're running out of time here. We've got a couple of minutes left but I'd like to kind of just get to maybe some take aways from you. For those business owners planning on selling their business within the next couple of years, maybe two or three key take aways of advice, some tips that you can leave them with, things that can help prepare them to sell their business and do it the right away.
Jamie: Okay, yeah, it's really easy. The most important thing as we said is making sure if you're buying a business, making sure that you do your due diligence. Making sure you really spend time looking through the documents. I advise bringing in a lawyer, an accountant, spend that money upfront to make sure that it's a good deal. You want to make sure that there's no liability. It's a very common thing. Someone buys a company and it turns out that company owe the IRS money, guess who the IRS is going to come after, the person who took on the assets. There are certain things lawyers can do to insulate you from that, from those liabilities. So that's a big one, is making sure that things are done. Typically in any type of buyer-seller relationship the seller is required to sign something called a Seller's Affidavit. And what that basically says is under penalties of perjury, I the seller don't have any liens, I don't have any liabilities, things like that. They usually will protect you but you still have to be very careful that there's not anything out there because let's say they're untruthful, the seller, all you could do now is just sue them. And a lot of times in California, in Florida, these different states, the seller doesn't have any money, they'll file for bankruptcy and you're basically left holding the bag. So it's important before for you ink that deal and pay that money over that everything is basically checked out and figured out.
From the seller's standpoint it's so important to make sure that that buyer is really viable. Because there's a lot of people out there who are just sticking their head out there trying to look for a deal, and then it turns out they don't really have the ability to do the deal. So that's why it's important to get involved with companies such as yourself or business brokers to make sure that these are real people who are looking for a business, and obviously making sure that you're protected by requiring a deposit. Making sure that certain things ... From a seller's standpoint, who wants to spend months and months working for a deal that in the end it falls apart, and all you're getting out of it is a $5,000 deposit? It's not worth it. It's a tremendous business interruption doing these things. So if you're going to try to sell your business or sell your business you want to make sure that it's going to happen and that you're going to get a real good deal out of it, you're going to make money. Because there's no other reason to sell your business unless you're going to be able to make real money and get something out of it.
The most important thing as we said is making sure if you're buying a business, making sure that you do your due diligence. Making sure you really spend time looking through the documents.
Jeff: For those business owners in the State of Florida that may be interested in seeking your counsel how can they reach you, Jamie?
Jamie: Great. We have a couple of different ways to reach us. The first way is we have a website called www.legalbrains.com. The easiest way to get us is to call **law in your phone. It's a number we bought. Basically all they have to do on their cellular phone, hit **law and ask to speak to me. There can't be an easier way to get in touch with us. But take a look at us on the Internet, you'll see the different cases that we've done. We're doing a lot of business litigation and we've been in the newspapers a lot so I'll think you'll be happy. And I love to help people out, it's what I do.
Jeff: Jamie Sasson, we appreciate your participation on the conversation today on Deal Talk and hopefully we can have you back on again real soon.
Jamie: Yeah, I love that. It was fun. I like talking about this stuff.
Jeff: Thank you. That's Jamie Sasson, business attorney and managing partner at the Ticktin Law Group in Florida. He's been our guest today.
If you're a professional who normally consults with small business owners, a serial entrepreneur who owns multiple successful businesses, or a small business owner who has sold a business and you'd like to share your experience with our listeners, we'd like to hear from you. Just simply give us a call at Deal Talk at 888-693-7834. Deal Talk is presented by Morgan & Westfield, a nationwide leader in business sales and appraisals. If you're thinking about selling a business or buying one visit morganandestfield.com. I'm Jeff Allen for Deal Talk, thanks again for listening. We’ll look forward to talking to you again soon.
Trisch: Well, first and foremost, most people’s businesses are almost like children to them, in the respect that they created the business, they raised it, and they brought it up. And by the point that they reach out to me, this is their fully-grown child, in terms of a good analogy. And they’re looking to basically set it free to the world, and it’s very sensitive process. It’s a very technical process, but it’s also a very sensitive psychological process, in which a good appraiser has a number of different attributes that aren’t necessarily found or known about by just reading a bio. Maybe just being referred to somebody, which is why I always suggest that whomever I’m working with, or if I can sense in any which way that they might be uncertain about either the monetary involvement to get their business evaluated, or the fact that there’s so much information that I need to delve through, that they meet with a couple of different people.
So they can really get an idea as to the comfort level that they have with the chemistry of that individual and themselves, and also find out about their technical knowledge and the background that they have in terms of how they’ve applied their expertise in the past. So there are a number of CPAs, accountants and so forth out there that have the smarts undeniably to do it. But it’s a matter of finding the complete package to take care of their child, of the client’s child, going back to the analogy, and preparing it to be set free, and to get the most money for the hard work that the business owner has put in terms of growing the business. So it’s extremely important to find all of these different characteristics in a good fit. And you will be working with them, the client will be working with me on average, anywhere, well, it depends on the specific case, but anywhere from a minimum of two months to upwards of a year. So you really have to have somebody that’s smart and somebody that you have good chemistry with, it’s extremely a sensitive process.
Most people’s businesses are almost like children to them, in the respect that they created the business, they raised it, and they brought it up.
Jeff: Trisch, let me ask you a question, are there certain strings in particular, or key attributes, as you talked about just a moment ago, that really stand out? For example, if someone were to come to you and maybe they had questions about your background or your qualifications, are there a couple of leading qualities that you would lead with to explain to them how you are best qualified or suited to help them as an appraiser? Something that I, as a business owner, would really, really be interested in knowing about you?
Trisch: Well, I think besides my background or another expert’s background, in terms of the work that they’ve done in the past, to be able to show that they actually have the work experience, it’s also important to find an expert that has experience within the certain specific service and niche sector that you’re looking for expertise on. So for example, there are many generalists out there. I have a couple of different areas, like medical, facility services; there are a number that I specialize in. And I’m a certified business valuation analyst and financial forensic expert. And so it’s important to find not simply an accountant, but someone that has the specific training to do a business valuation, to do the financial forensic work that you need to have done within the sector that you work within.
Jeff: That’s really important to know because I think sometimes we’re led to believe that appraisers just like any other type of business, you might be able to just simply go to an online resource, pick an appraiser and they’re going to be suitable, provided they have the background and the qualifications to help you up. But it really does, I think, bear some careful consideration that one needs to look for someone who has a fair amount of experience really treating those businesses that are key in your particular industry, or sector as you put it, to help you out rather than just go and find someone around the corner who’s been in the appraisal business for a long time and has extensive experience valuing businesses regardless of their industry. You want to pick someone who has experience who specializes in your particular industry or sector. So I think that’s very, very important news. Now, is there a resource online or a tool that someone can use if they are just embarking on their research right now to look for an appraiser that you might recommend, or what are some ways that they could approach their search? Where should they go? What kind of resources should they consult?
Trisch: Well, I am a member of the National Association of Certified Evaluators and Analysts and I’m one of the state chapter presidents, so I’m very biased towards NAPFA, which is the acronym for the association I’m certified through. But, there are a number of associations, or a handful, I should say - AICPA, NAPFA, ISBA. And on all of these different association websites, there are directories. If I was thinking of myself as someone that was seeking my service, I wouldn’t feel necessarily comfortable just blindly reaching out to someone on one of the association websites, not because they wouldn’t be qualified, but just because I would want to have a referral or maybe do a little bit more research beyond through their website, looking at various articles that they’ve written that show their expertise, that might give examples of testimony that they have given, or different cases that they have worked on and have that peer-based different resources to reach out to. So I think that where you could start, would be through one of the association websites and begin your search. You want to find a site, originally, that has plenty of business valuation analysts to be found.
I wouldn’t feel necessarily comfortable just blindly reaching out to someone on one of the association websites, not because they wouldn’t be qualified, but just because I would want to have potentially a referral, or maybe do a little bit more research beyond through their website.
Jeff: She’s Trisch Garthoeffner, Founder and President of Anchor Business Valuations and Financial Services LLC. And I’m Jeff Allen, you’re listening to Deal Talk, brought to you by Morgan & Westfield. And Trisch, again, we appreciate you taking time out of your schedule today to chat with us about these important ideas, and about the thought to considering the idea of finding a suitable appraiser, and the best appraiser possible to help people with the valuation and appraisal of their businesses. Now, I’d like to shift gears just a little bit and talk about reasons for getting an appraisal; maybe not just an appraisal for the purpose of preparing for the sale of the business, but maybe there are some other really important reasons for gaining an appraisal. Can we talk about some of those? What are some of the reasons that a business owner would come to you, Trisch? Maybe they’re not selling their business right away, certainly, or they’re not looking to do so even in the shorter or medium-term, but what are some other reasons that people might come to you?
Trisch: Sure. I actually served in a public company business valuation sector for a long time, and in the public company in which I worked. We did business valuations for underwriting, and in terms of the analogy for the private company sector, it would be for SBA loans. So business valuations are needed if a private company is seeking an SBA loan. Typically, a bank works together with the business owner to refer them into somebody or the business owner, I always suggest, find somebody on their own so they can be assured that it’s a non-biased opinion.
But actually, when I started my own business, I had found a need in this area for a state and gifting valuation. So whenever a gift of a portion or an asset is done for tax purposes, the IRS suggests or doesn’t suggest it. It demands that a valuation is put into place. And there are guidelines that are put forth by the IRS that are provided by business valuation analysts such as myself. So for gifting, I do a number in this area and then matrimonial is an area in which there’s a high demand. A lot of times, I get pulled into a case in which there is a dispute as to the value of the business, and an outside expert needs to be brought in to assign a value to that business. And very rarely does that business ever go through a transaction…it’s in order to put a value on it, to divide that asset.
Jeff: So, Trisch, I have, let’s say I’ve got that appraisal in hand, and I’ve had it prepared by your office, and I’m using this for tax-related purposes for the IRS and so forth, can I use that same valuation, the same business appraisal for the other purposes that you talked about, such as divorce proceedings and any other thing that we can think that might require a business appraisal?
Trisch: No, there are very strict guidelines in terms of the scope of the use of the business valuation. And they are all specified not only in my engagement letter, but also in the report itself. And the reason behind that, it’s not because I’m being greedy and I don’t want them to be able to use the valuation as much as they can, it’s because for each different scenario and situation in which a valuation is needed, there are different pieces of the puzzle that must be considered. So for example, in the matrimonial situation or different case law, there’s different approaches; there’s different standards. There are different standards, I should say, in different case law that are considered versus, say, for a gifting valuation or for shareholder oppression valuation; and this is where we get into more of the nuts and bolts of the valuation itself. But just as an overall answer to that question, it’s definitively no. And I have had pushback from clients before, specifically on a matrimonial side, because they pay a certain amount to have the valuation done. And then they say, “Oh, the business is worth X amount. Maybe I will consider a sale.” And then they want to start easing that valuation to shy about the business. And I have to go back in point to my engagement letter and say, “That just cannot be done.” So the answer is no, it works that way.
Jeff: Okay. No, that’s okay, and it’s really important too that we clear that up, because that almost fits into that one-size-fits-all category or purpose of the valuation, which in this case we’re learning, is not something that we want to consider. You’re going to have to make your intentions for the use of your valuation or your business appraisal very, very clear to the person who’s doing the work for you. If you’re the business owner, you need to make sure that you know exactly why you’re having it done, and make sure that that is clear upfront, so that if you do in fact want to have it done for a consideration for either tax purposes, to sell your business, for the matrimonial issues we just talked about, divorce settlement and so forth, we need to make sure that that’s absolutely clear then, according to Trisch. Trisch, I want to branch off now and go to a different area of our conversation where we’re going to talk about the types of entities and types of businesses that are out there, incorporations, is there a difference there in terms of the impact or the way that those entities can affect the value of a business? Let’s talk about, and we use the word “entities,” C Corp, S Corp, LLC, are there differences and do they have a noticeable impact on the value of a business and the way that it’s treated?
Trisch: It definitely can; for S Corporations, they flow through an LLC, and so there are tax advantages, they’re avoiding that double taxation, because they’re taxed at one level which is a.k.a., the flow through aspect of it. This is a topic that is heavily discussed in the business valuation world, and it can get really technical, and there are varying opinions and this is where, when people ask me about what I do for a living, I think this is one of the areas in which it’s very clear that it’s not a black and white deal. And so my approach is always to look at S Corporations, look at the tax advantages that you have of that flow through corporation, compared to as if it was a C Corporation, and then I incorporate that more than not into the valuation. Sometimes I don’t, in terms of the particulars, but I always consider it.
My approach is always to look at S Corporations, look at the tax advantages that you have of that flow through corporation, compared to as if it was a C Corporation, and then I incorporate that more than not into the valuation.
Jeff: So I would imagine then, if what you’re saying is correct, having multiple entities complicates the process even more, I would imagine. Is that right?
Trisch: It can, for sure. When it becomes complicated, I have given an example once before when I was asked this question and it was when I had started out on my own early on, and I had work, the gentleman wants before that the valuation for him to sell his business. And then, he came back and wanted the valuation to gift portions of two of his businesses to his son. And when I actually delved into the particulars of the two entities, I saw housed within those entities that one was basically a holding company. So there were a multitude of entities housed/umbrella-ed within the one other entity that I had valued. When I delved into it, I thought, “Oh, wow, this isn’t just two. This is actually going to be a lot more to value than what I had initially thought. So it can be real. If you don’t ask the particulars upfront, and a good business valuation analyst or one that’s been doing this for a long time knows all the ins and outs, and knows the questions to ask, and I always do a pre-screening of the engagement before I accept it, and to give a chance not only to see if there’s chemistry there, but also to find out what exactly I’ll be valuing, and see if I have time to do it, because if it’s a valuation of a holding company with 75 contracts housed within the one holding company, then that’s going to take considerable amount longer than just one retail store.
Jeff: You’re listening to Deal Talk brought to you by Morgan & Westfield; my name is Jeff Allen. My guest today is Trisch Garthoeffner; she’s Founder and President of Anchor Business Valuations and Financial Services, LLC. Now, let’s say, for example, Trisch, that I own a small business and I’ve got a couple of partners in that business. I would imagine that this is going to take some careful handling because down the line, we always try to expect the best and then we’ll want to prepare for the worst, and that involves possibly some court proceedings down the line if we want to go ahead and sell our business off, or if there are arguments or a split between ownership for whatever reason, there is some animosity there. So, multiple owners involved in a company, tell us how that is treated if that also is a rather complicated process, and if that necessitates really being a little more mindful as far as a the business owner is concerned, and the need to maybe have your business appraised in the very early stages of its existence when you have multiple ownership.
Trisch: Basically, what I suggest for business owners to do, right in the very beginning, when they are establishing the entity, when they know that they will have partners, is to give a business valuation at the point in which the operating agreement, the buy-sell agreement, all the necessary paperwork, is being established with the business being established within itself. And then for the buy-sell agreement, you typically have a calculation formula of some type in there, in which the value of the business and the percentage allocation holding of the business to each of the shareholders, there’s a specific instruction in terms of how that entity portion will be valued.
Frequently, I find that small business owners want to cut corners, they want to save money, and so they don’t necessarily get a valuation in place in the beginning. And that’s not a great idea, because as you mentioned, and many times, you can’t predict the future. And unfortunately, in a lot of different situations, there can be an issue when it comes time for one of the shareholders to sell their fraction of the business, and there’s animosity and then there’s conflict and confusion as to what the actual percentage in ownership is of the business. So I always suggest to the business owners right in the very beginning, and it doesn’t have to be every year that you get a business valuation, but you want to have some idea as to how the percentage allocation of the shareholder’s holding within the business is going to be valued when that shareholder decides to leave and/or sell the portion of his business.
Unfortunately, in a lot of different situations, there can be an issue when it comes time for one of the shareholders to sell their fraction of the business, and there’s animosity and then there’s conflict and confusion as to what the actual percentage in ownership is of the business.
Jeff: Obviously, Trisch, a lot to be mindful of there, when you’ve got different folks involved in the leadership and the management of an organization. And so you really want to be prepared for every eventuality, and be as clear-cut as possible. So let’s go ahead and let’s talk about some other things with respect to equipment and capital, with respect to your business, equipment, machinery; are those things separately appraised, or will that be included in my overall appraisal? How does that work?
Trisch: It really depends on the business. So most businesses that I value are going to concern businesses; which means that the business is not at the point, t’s still generating earnings and is profitable, and the asset value is considered more so as an evaluation. So if you’re a business that’s at the point to where it’s not profitable, and you’re going to liquidate your business, then appraisals are needed for the hard assets. I always consider all three approaches in a business valuation/summary evaluation, and an asset approach is one of the three approaches. I will look at any appraisals that the business owner happens to have, or look at very minimum, hopefully have the balance sheet and be able to look at the assets broken apart and the tax basis of those assets. But unless it’s a liquidation event, for most valuation work that I do, I don’t have to get outside appraisals. If I’m doing a family limited partnership valuation in that situation, I frequently have to get, I have to bring in an outside appraiser, and one that specializes potentially in real estate or in equipment, as you mentioned. And that’s a different type of valuation, than, say, a valuation for a divorce or a valuation for merger & acquisition purposes, and then which case those are more prevalent to look at and obtain, outside appraisals for assets, but in average, I’d say no.
Jeff: Let’s say for example, Trisch, and we’re running a little bit down toward the end of our program today; you’re at a cocktail party, a mixer, a networking event of some kind; it doesn’t really matter what kind of event it is, but you are approached by someone who knows what you do, and maybe they’ve had a chance to meet you a little bit, they’re interested in selling their business, but they’re not sure quite what to do as far as first steps; what are some tips, some guidance that you could provide here, general types of things that people need to be mindful of as they’re trying to get their head around the idea that they need to have their business appraised, even if maybe they don’t plan on selling their business right now or even five or ten years from now, maybe it’s long-term, but they need to have their business appraised and they know that; what are some things that you can leave us with as far as takeaways go?
Trisch: Well, I see this a lot and I work with a lot of small business owners; unfortunately, frequently, you get approached by small business owners and people that I know in the community, through different positions that I’ve had that I’ve met through the years, and when they go to sell, they have a business that is profitable, and I know that it’s profitable because of the communications that I’ve had with the business owner, but the tax returns might not necessarily be showing the profitability. And this happens a lot, and I always want the business owners to come to me, at least a minimum of five years, before the time that they consider a sale, so that we can really look at all of the potential discretionary expenses that might be run through the business, that might affect profitability, to look at the way in which the accounts are set up and make sure that all of the expenses are operational in nature.
With business owners, which I’ve been doing several actually right now, happens to be that I give them a quick and dirty valuation of their business. So I might not necessarily have to do a summary valuation, I could do a calculation valuation, in which case we really come through the numbers, and I always put myself in the business owner’s situation of saying, let’s just say hypothetically you have someone interested in your business, they’ve put an interest or a letter of intent on the table and they say, “I would like to buy,” or an indication of interest, “So I would like to buy your business for X amount.” Are you going to feel comfortable with them going through due diligence in your office, and looking through basically all of the information that acquirers look through to verify that the numbers you’re telling them on the financial statements, whether or not they do in fact match up with the tax returns are backed up? And a lot of times, business owners aren’t prepared for that type of invasive due diligence process. And that happens with every acquisition. Business owners need to be really aware that they need to get a true, accurate valuation of their business early on so that they can prepare their business for the sale that will go through at some point or another.
Jeff: As a business owner, someone like myself who owns his own small business, the one thing that, I guess I don’t really think too much about when I get up in the morning is, in addition to all the things that I have to do and the clients that I have to work with and satisfy and take care of and fill their orders, the one thing I don’t think about is down the line, is thinking about the day that will come that I might be interested in selling my business, and that it in turn or at the end of the day, the sale of the business is just as important perhaps as the day-to-day operation and generating cash flow and revenue to simply pay my bills and to survive, there’s actually an opportunity, I think, that business owners need to consider that when they’re ready to sell, they have potentially an outstanding pay day that comes along at the end of the line to help them in the retirement years. And so if they’re preparing for that eventuality as they go along, and they’re keeping good, accurate strong records, and they’re doing all the work ahead of time in preparation for that day, it makes your job that much easier. And not only that, but it could help the sales process go more smoothly too at the end.
Trisch: Exponentially, it’s unfortunate because business owners do get caught up in the day-to-day operations of a business, I’m to blame for the same going on. But the bottom line is what happens is I am approached by business owners. I go in and I try to help them. And it’s at the point where they’re at their wit’s end. They’re exhausted, they’re tired, they’ve been working for how many every years, they want to retire, and unfortunately, at that point, it’s too late for us to turn everything around and get everything in a smooth working order for a potential acquirer to come in and have a nice payday. Unfortunately, business owners don’t think about that enough ahead of time, and it’s frustrating for all the parties involved, and it’s not exceedingly expensive to get a business valuation, to get that preparation in place. And you mentioned it, it could potentially make you a lot more money versus not doing that. So it’s extremely important to plan for the sale of your business a minimum of five years in advance.
I always want the business owners to come to me, at least a minimum of five years, before the time that they consider a sale, so that we can really look at all of the potential discretionary expenses that might be run through the business, that might affect profitability, to look at the way in which the accounts are set up and make sure that all of the expenses are operational in nature.
Jeff: Trisch, if there is anyone listening right now that may think, “You know, this lady, I need to talk to Trisch, and I’ve got some questions for her.” How can they reach you?
Trisch: The best way to reach me, I think, is through my phone, through my office, it’s (312) 632-9144, or by e-mail, which is Trisch, “T-R-I-S-C-H” @anchor, “A-N-C-H-O-R-B-V-F-S”.com (email@example.com). I have my cellphone on me pretty much 24/7, and I love to talk to my clients and help them out. I don’t charge for initial consultations, and I don’t nickel-and-dime people. I really love what I do for a living, and then I love it when I can get a good result for each and every one of my clients, and that’s what I strive to do every day.
Jeff: And anchorBVFS.com is the website in case you want to go and learn more about Trisch before you call, or just get an understanding of Trisch’s capabilities or skillsets, and what she’s been doing, and the clients she’s been working with. Trisch, I want to thank you so much for this conversation. I’ve really enjoyed it and it’s been valuable, I think, for our listeners, and we hope that we can have you back on again sometime soon.
Trisch: Thanks a lot, Jeff, I appreciate it.
Jeff: Thanks again to Trisch Garthoeffner, Founder and President of Anchor Business Valuations and Financial Services, LLC, for joining us today. And that brings another edition of our program to a close.
Deal Talk is presented by Morgan & Westfield, a nationwide leader in business sales and appraisals. If you’d like more information about buying or selling a business, call Morgan & Westfield at (888) 693-7834, or visit MorganandWestfield.com. Until next time, I’m Jeff Allen; I’ll talk to you again.
Blen: Well, thank you. I appreciate it. In terms of reading, increasingly, the practice of law is the practice of learning new stuff. It changes every day. Very little that I learned in law school is that germane anymore, other than fundamental principles. You really have to constantly keep up.
In terms of reading, increasingly, the practice of law is the practice of learning new stuff. It changes every day.
Jeff: So basically, what you're saying is you've never left school. You're always going to school and always being educated in some regard.
Blen: The 21st century lawyer is a professional learner, that’s absolutely true.
Jeff: [Laughter] That's right. Very, very good. Again, it's good to have you on the program. There's a lot to talk about and probably too much to cover in the scope of one program, Blen. So, just to let you know in advance, we may be asking you to come back at some point in the future. That all depends on how happy you are with the program when we're done with it. But let's go ahead and we'll dive right into it just to start.
Just out of curiosity, there may be some business owners or even future buyers listening to the show who've done all their homework, and they keep outstanding records. They have a CPA and a tax attorney and a professional business appraiser ready. They've contracted with an agent. Why do they need an attorney to sell or buy a business?
Blen: Every business transaction, every purchase, and every sale has a huge number of issues. Everyone is different. You have employment law issues. You have environmental issues. You have real estate issues. Does the person, in fact, own the real estate? We purchased a car dealership a couple of years ago, and there was an extremely favorable lease that was part of the deal but part of the transaction was making sure that lease was valid, that it was going to be valid five years from now and ten years from now.
If you are selling, you want to do two basic things. You want to make as few representations and warranties as you can about your business. You will be required to make some, but you want to keep that to a minimum. And you want to get paid. That's not always as easy as it sounds. A cash deal is obviously preferable. If you are buying or you're buying others’ representations and warranties that the seller is making, are they adequate? Is he going to give you a proper warranty about the status of the profitability of the business over several years? Is he going to tell you about a labor issue that has come up? Or are there hazardous chemicals on flight that weren't handled properly? A huge number of practical issues there. If it's a company that's a closely held company, just a few owners, have all the owners signed off on it? Has the Board of Directors signed off on it? If the major shareholder agrees to the sale and close and you find out that there was three other shareholders who weren't informed or were not adequately informed and there was never a vote of the Board of Directors approving the sale, your lawyer has a big, big problem. If you don't have a lawyer, you have a big, big problem. Those are just a few of the infinite number of things that can go wrong.
If you don't have a lawyer, you have a big, big problem.
Jeff: And the list goes on, Blen, as they say. Now, let's say a business owner who is contemplating the sale of their business came to you and said, "You know, Blen, I'm done. I'm ready to sell my company, ready to move on, ready to retire,” whatever the case may be. "What do I need to do first? Who should I call?” What would you say to them?
Blen: If it's the owner of the business who wants to sell out, he's got tax issues, that's number one, and valuation issues, number two. What is his business really worth? Some industries, there's fairly rapid turnover, and people in the industry know what the dealership's worth. Car dealers are good example. Most car dealers know what their dealership is worth, and they know what their competitor's dealership will be worth if somebody wanted to buy it.
Other businesses, you may have no idea how much you're company is really worth. You may have an over-inflated view of it or it may be worth much more than you realize, and there are lots of different factors: earnings in the past, earnings potential in the future, tangible assets. Many companies’ only real valuable assets are the goodwill, the business relationships that they've built up over the years, a name recognition they’ve built up over the years. Other businesses may have tangible assets that are important part of their businesses: furniture fixtures and equipment, especially manufacturing equipment. They could be a major aspect of the business.
An example would be a restaurant. A restaurant will have a great deal of goodwill associated with its location, the customer stream and the reputation in the community. It will also have spent a whole lot of money on equipment, such as tables and chairs. Restaurant equipment can be very expensive. And if you sell that restaurant right there in that location, you get maximum value. If you had to close it down and just sell off the equipment, you would find that that very expensive restaurant equipment is essentially useless, nobody wants it. So, the value in place with a going concern, name recognition, equipment, if somebody doesn't have to come in and repurchase and install, no downtime, all of those things have value. As a lawyer, I can't put a price on that. And you, as the owner, you can't put a price on that. You really need a valuation expert to help you do that in most cases.
Jeff: Let's jump into the franchise question if we can, Mr. Gee, because I know that this is an area where you really have a very deep level of expertise. How are things different when a franchise business is involved? I mean, are there certain issues with a franchise? You just talked about a restaurant, for example, which is a very, very common type of franchise business. Are there certain issues that are unique that come into play in the transaction of a franchise from one owner to another that may not be as critical for wholly-owned and operated private businesses?
Blen: Yes. Franchising, as you know, is a hugely successful business model, and it is also an area that has huge risks. Initially, 40-50 years ago as franchising took off, there was a great deal of dissatisfaction among people who purchased franchises. The Federal Trade Commission came in and started regulating the disclosures that have to be made, and today, if you buy a franchise business, not only do you have to deal with the buyer, you have to deal with the franchisor and that franchisor's going to give you a wad of documents about an inch thick. It may come to you on the internet but if you print it out, it's going to be about an inch thick. Every word in there has been scrutinized by a team of franchise lawyers who are highly sophisticated and stay current with every single case, every single change in the regulations. If you're buying that franchise, you need a lawyer who can look at the franchise disclosure document and more importantly, the franchise agreement that you will be living with for five to ten years at a minimum and tell you what it really says and what your risks are.
One of the things that I emphasize to people who are buying a franchise being is the exit strategy. If you're buying a McDonald's and you put it on a location that you think is wonderful and for whatever reason it doesn't work out, you're not making money, you can sell that McDonald's. Somebody will want to buy it. They will take over your lease, that's a long-term obligation. They will buy your equipment. You may lose some money, but it wouldn't be a catastrophe. So, that's one exit strategy on the high-end. If you're buying a franchise that's lesser known, it's a start-up, or it's a just not a huge franchise, you may not be able to sell that franchise if it doesn't go right. And no matter how well you plan, sometimes it just doesn’t go right.
We represent a chain of pubs, and they probably have opened 15-18 very successful pubs and two or three, the same management team, the same decor, the same staffing procedures, never made money. And your location might seem ideal, you may do everything right and for some intangible reason, you don't make money. If you're locked into a ten-year franchise that has a provision in it that if you terminate early, you will owe the entire royalties that remain in eight years, reduced to the present value, but that's a big number, you will also have a lease that might be three or more years. Certainly, you don't have a good exit strategy. So, that's one of the things that you have to look at with a restaurant or really any franchise: what is your exit strategy?
The business community is livid with franchises that have crashed and burned. So, you need a lawyer to look at that agreement. I always tell people, the very first thing to do is inspect, check out the franchise system carefully yourself. There are lots of resources on the web. There's a group called Blue Mau Mau that gives a lot of information about franchises that are out there. When you get your franchise disclosure document, you'll get the list of the franchisees, call as many franchisees as you can. Go visit their stores. Talk to the people who have done well. Talk to the people who haven't done well. Check out as much as you possibly can.
If you talk to some former franchisees and they tell you they're under a confidentiality agreement, they can't discuss it with you, well, that's a red flag.
Franchising, as you know, is a hugely successful business model, and it is also an area that has huge risks...one of the things that you have to look at with a restaurant or really any franchise: what is your exit strategy?
Jeff: Blen, let me ask you a question here. As you indicated, there are so many different types of franchises out there regardless of industry and opportunities. Is there an industry—whether it be hospitality or the dry cleaning or personal services, restaurants—that has a particular reputation for being, I don't know what word you used, dicey or challenging for a business owner or an entrepreneur to come in and take ownership?
Blen: Cleaning franchises have a terrible reputation. You go in and you buy a franchise. The franchisor tells you they're going to give you leads for cleaning opportunities in your city, and very, very frequently, they're just not what they are advertised as. That's the one that I've seen the most abuse in.
Other things to look at, look for, if you're buying a smaller or start-up franchise, you want to, again, look at the exit strategy. If you're buying one where your financial risks are high, you want to think long and hard about that. There are franchises for daycare and those sorts of things which require people to either invest in a substantial long-term lease for the facility or build a facility for that daycare system. You better check that one out really carefully because you may have a white elephant of a building sitting there that you can't use. Typically, they're non-competition provisions where you can't de-identify or change the brand and start your own daycare system. So, cleaning franchises and daycare systems have a lot of risk. Anything where you have to build, if it's a franchise, you have a lot of risk. You want to check it out very, very carefully.
Jeff: He's Attorney Blen Gee, Jr., and he's in Raleigh, North Carolina. My name is Jeff Allen. You're listening to the Morgan & Westfield podcast and we're talking about things that you need to keep in mind when you're selling a business, even buying a business, really why you should want to get the advice of a business attorney in order to help keep things on the legal side legal and to be very careful, quite frankly, there are a lot of mistakes that are made by people who might be involved in transacting a business from the first time. This is one of those things that you probably don't want to go at it alone, quite honestly. And Blen is able to give us some insight into some of the things we really need to be mindful of.
What is one of the most common mistakes, Blen, that a business seller makes and what do you tell sellers in order to help them avoid making this mistake?
Blen: Probably the mistake that can have the worst consequences and that has the greatest risk is where you do owner financing. A bank has underwriting requirements where they check out those buyers' financials. They have minimum asset requirements. They may require the spouse's guarantee, and the banks still suffer losses. You're not a banker if you're a seller. You are not going to have the same expertise in checking out the buyer's finances. You will not have the same system set up for credit checking, for maintaining that payment, for pursuing the person legally if they default, that a bank has. You should not be a bank. But people do. I rarely have been asked to act as an expert witness, but I was asked to act as an expert witness on a dealer transaction, probably a decade and a half ago. The lawyer had been sued, had a malpractice suit. What had happened was the seller had taken almost all of the sales price as owner financing. And there was a default. The person that bought the business went into bankruptcy. The seller had a huge, huge financial loss and blamed the lawyer, and the lawyer didn't really do anything wrong. The seller just took too much risk, you know.
You can get a lot more money in principle with owner financing because the buyer may not be able to get a bank loan, but if the buyer can't get a bank loan, why are you acting like the bank?
Jeff: Yes, why would I? I'm just wondering why would a business owner, someone who's trying to sell their business, take on that kind of risk. I mean, maybe it's just a kind-hearted act on their part. They're anxious to get out. They want to see that it works and that their business is profitable and that the new owner coming in is going to be able to make a good positive go of it, but why else would someone take on that kind of risk? I'm just kind of wondering out loud.
Blen: Well, it may be someone who has health issues. They've reached a certain age, and they really want to just get out of it. But if it's a risk, then, what you could do is you could ask for the majority of the money upfront, and then, another 20% or so in owner financing then, your risk is a lot less. It might ultimately end up with a bigger return on the sale, but it's a risk. That is probably the number one issue for sellers to avoid.
If it's the owner of the business who wants to sell out, he's got tax issues, that's number one, and valuation issues, number two.
Jeff: So, let's flip it around then. Let's talk to the buyers now who might be listening. Is there one particular pitfall that you've seen time and time again that buyers can avoid with some careful planning?
Blen: Well, the one thing that I see is the seller who has the "My way or the highway" attitude. “This is the deal, take it or leave it.” I'm even seeing sellers who are wanting non-refundable down payments or deposits before the contract is drafted.
What happens is you find that they use that as a leverage to keep changing the deal, to keep making new demands, and you find that you're negotiating position continually gets eroded. And what I will recommend to my clients is at the very beginning, when you get one of these—when you see "take it or leave it" or some unreasonable demands—and sometimes it's the lawyer, sometimes it's the seller, sometimes it's both of them, but what I recommend to the client is at that point, you should be willing to say "no" and be willing to walk away from the deal. And one or two things will happen. Either you'll say "No" and they'll say, "Alright, the deal's off," and you'd saved a whole lot of attorney's fees. Or they'll cave, and they know that you're serious. You want a good deal, you want to buy the business, but you're not going to be taken advantage of.
So, from the buyer's point of view, the "my way or the highway" seller or the lawyer that takes that position, say "No" early and mean it.
Jeff: There you go. It’s the same way that you would treat buying a car, going to shop for a car that just seems to be way out of range, and it's not what you went in there for. You'd handle it much the same way, so in this particular case, take the same kind of approach that you would when you're investing. But when you're buying a new car, the same kind of deal, just basically stand up for yourself there, and you may end up at the end of the day getting a better deal when the guy comes back and chases you down and said, "Okay. I'm ready to talk."
Blen: Or, instead of spending $50,000 and have the deal fall through, you spend $2,000.
From the buyer's point of view, the "my way or the highway" seller or the lawyer that takes that position, say "No" early and mean it.
Jeff: There you go. Now, to the meat of our chat, and I guess maybe we've saved the best part for last on our discussion here, but it really is worth it that we kind of build it up to that. It may not be possible to be lawsuit-proof, especially in our capitalistic environment in this country, Blen. As you know, you've been in the business, you've been an attorney for such a long time, and indeed, you've had the chance to see a number of different scenarios play out and been involved in many cases. But what should business owners do, regardless of the size of their business, to help lessen the chance of litigation, to help keep them out of court?
Blen: I tell people that their first defense is doing things right. If it's a well-run business, you get into trouble less. Your second defense is insurance, and sometimes insurance is magic. You have this horrible situation, and you call up your insurer. They say "Yes, there's coverage," and it goes away as a business problem. You may end up testifying in court but in the practical matter, the distraction of that litigation goes away so. Insurance can be magic. You can have a contract dispute that may have a negligence claim phoned in to the other contract clients. Contact your insurance broker and say, "This has come up. Is there a possible coverage for this lawsuit even though it's mainly a contract suit?” and sometimes, there will be coverage because there is a negligence claim. So, doing things right, insurance are the first two lines of defense.
The corporate shield, the reason you set up a corporation or a limited liability company is you put up a reasonable investment in the company but not everything that you have. And that corporate shield can protect you. If it's done right, if you have a corporation you need to have a lawyer set up the corporation, you need to have initial minutes and by-laws and to do your annual minutes, just like the lawyer's going to tell you in that cover letter that he sends you with your corporate minute book, and so many people don't do that. But do your annual minute, they don't have to be a work of art. I've seen typewritten corporate minutes that are half a page long, hunt-and-pecked typed, that's wonderful. That just make sure your litigation lawyer is so happy if somebody's trying to pierce the corporate veil that you have all those corporate minutes.
When with liability companies, the same thing. You should have your operating agreement in place, signed by all owners. And that corporate shield can be invaluable if the worst happens, and there's a huge judgment against you.
Other things to be alert to that many people forget about, especially if you have a larger organization, you want to make sure that you promptly receive that lawsuit. You don't want to end up in a situation where it is found on the corner of somebody's desk and not been dealt with, and you're in the fault position. You're already starting from a difficult situation. In the olden days, at least in North Carolina, you had the sheriff come to your office to you have the sheriff come to your office to deliver the suit papers or you got a certified letter with the suit papers and hopefully, whoever got that certified letter would get it to the proper department. But today, in North Carolina and also in the federal courts, you can get a lawsuit by FedEx. And if you have that FedEx sitting on somebody's desk, especially in federal court which has a 20-day time period for answering, 22 days later you may have a very difficult situation that you have to dig out of.
Bankruptcy notices. You may have a claim against the bankrupt company that is very valuable, and the notice may come in regular US mail. If that sits on somebody's desk, passed the deadline and bankruptcy courts are very unforgiving with missing deadlines, you might be out of luck. So, that's a very important thing that sometimes people overlook. You want to make sure that any official government or lawsuit gets to the right person as quickly as possible. If you have claims, statutes of limitation varies from jurisdiction to jurisdiction so don't sit on a potential suit if you've been treated badly. Arbitration claims, time limits could be shorter. You may go in North Carolina where there's a three-year statute of limitations, but you may find other estates have a shorter statute of limitations for a breach of contract claims. So, those are issues to be alert to.
In the 21st century, if you know that someone is thinking about suing, you have to preserve all digital records. That's just the rule these days. If you know that it's possible you will get sued, you need to put the word out, all right? Don't delete anything related to this file. If you have some old computers that have potentially digital information about that particular subject, you got to put them in a backroom, you can't throw them away. The 21st century is different, and you've got to be preserving all the digital avenues, not only because of the fact that it may turn out to be beneficial for you but, if it's destroyed or lost, you may find some federal district court judge very upset with you and sanctioning you for not preserving that evidence. So, that's an important thing that most people don't even think about these days.
I tell people that their first defense is doing things right. If it's a well-run business, you get into trouble less. Your second defense is insurance, and sometimes insurance is magic.
Jeff: Very, very quickly, Blen, if someone would like to get in touch with you at your office, they have questions or maybe they're seeking representation or seeking your advice and guidance and counsel, who can they call?
Blen: Well, we’re on the internet, of course. My direct telephone number is 919-645-4503 in Raleigh. Typically, we’ll chat with someone on the phone off the clock to see if there is a fit, if this is something that we can help them with, and if not, frequently, I can make recommendations.
Jeff: There you have it. Blen Gee, once again, we've ran out of time on this segment. Thanks very much for joining us. I hope that we can visit with you again soon here on the Morgan & Westfield podcast.
Blen: I appreciate it very much.
Jeff: Thank you again to Blen Gee, Jr. from Johnson, Hearn, Vinegar, and Gee PLLC in Raleigh, North Carolina for joining us today.
The Morgan & Westfield podcasts are presented by Morgan & Westfield, a nationwide leader in business sales and appraisals. Now, if you'd like more information about buying or selling a business, call Morgan & Westfield at 888-693-7834. Again, that's 888-693-7834 or visit morganandwestfield.com. 'Til next time! I'm Jeff Allen. I'll see you again.