Die Without a Buy-Sell Agreement

I just returned from a week of sightseeing in Boston.  Reading a book on Thomas Jefferson ignited my interest in the pre and post Revolutionary war periods. We did all of the normal touristy stuff.  At the end of our week, we took a Ghosts & Ghouls tour of Boston burial grounds.  As part of the tour I was hanged at Boston Commons.  Please send money to my not so mourning family.  Then the tour guides married me off to a serial killer.  She killed her first four husbands before being slain by her fifth.  It was a tough week.

September 2012 was a tough month for me.  Actually, it wasn't so much tough on me but on my clients.  Four died in one month.  Our staff joked that being my client was a terminal disease.  Three of these clients had their affairs well in order.  But one didn't.  He owned a business with a partner.  He died without a buy-sell agreement or an operating agreement.

Fred and Al owned an IT business that served the federal government.  They provided fail over services for government agencies.  If you had computer operations in say... the World Trade Center, and someone flew a plane into the building destroying your IT facilities, Fred and Al made certain your operations continued as usual.  You can probably understand that Uncle Sam had quite an interest in their services.

Fred and Al were both in their mid-forties and in good health.  Then Fred got run over by a truck, literally.  He died instantly.  Fred and Al had neither a buy-sell agreement nor an operating agreement.  What happens when your business partner dies, and you don't have the legal documents to ensure an orderly transfer of the business?

You end up with unwanted partners, and they aren't usually the silent type.  Al was contacted by a personal injury attorney representing the two daughters from Fred's first marriage.  Al barely knew the daughters existed.  Since, there were no legal agreements regarding what happened to the business upon Fred's death, the attorney volunteered to draft an operating agreement for the business installing the two daughters as Al's new partners.

Here's the problem with allowing a personal injury attorney to write an operating agreement in these circumstances.....  Personal injury attorneys don't know a damn thing about estate law, at least this moron didn't.  Fred's daughters were not the rightful owners of Fred's share of the business even though they were his heirs.  In Virginia, Fred's estate owned Fred's share of the business.  The attorney was busy writing an invalid agreement.

I referred Al to an estate attorney, who began the process of probate for Fred's estate, working with Fred's second wife to close out the estate.  In Virginia, counties administer the probate process.  Periodically, the estate executor files an asset inventory and reports on the progress in winding up the estate.  Besides the legal fees, the county requires substantial probate fees based on the value of the estate.
Fred's share of the business was his primary asset.  So the estate engaged me to provide a valuation of Fred's share on the date of his death.  Al, and the estate attorney, hoped to use this valuation to settle the estate and buy out any claim on the business from the daughters.  Hoped is the key word here.

If you are caught in Al's situation, you can be certain of one thing.  The heirs of your business partner will smell the pot of gold.  They are thinking millions of dollars for their share even if they peed in his porridge while he was alive.  It's party time, baby.  Fred's daughters were no different.

Fred and Al had a nice business, but it was really just two well paying jobs.  They provided all of the services personally, relying on their combined forty years of engineering expertise creating fail over systems.  That doesn't make for a valuable business.  For Al to continue the business, he needed to hire someone with similar expertise.  These people aren't cheap.  In fact, it was going to cost more to replace Fred than Fred's salary.

Fred and Al were very valuable computer engineers, but the business itself was worth pretty much nothing since the pool of potential buyers was almost nonexistent due to the technical qualifications required of a new owner.  I valued the business at just the cash on hand and the receivables at the date of Fred's death.  Fred's half of that was about $100K, hardly the millions his daughters envisioned.

Are you surprised that they weren't happy with me?  Al was faced with tens of thousands of dollars in legal fees, not to mention the business disruption.  He offered the daughters the opportunity to pick a business valuator of their choice.  But, that would cost them money.  They were content to threaten legal action and delay the closing of the estate.  The county was after the estate to close and continued to impose more fees.  The business was being ignored.

In frustration over the lack of progress getting the business out of the estate, Al hired a litigation attorney.  Al's attorney asked the daughters to submit what they thought the business was worth telling them that Al would either buy it from the estate for that price or sell his share for that price.  They would then be obligated to buy Al's share at his option.  Of course, they refused.  They had no money, but they had plenty of attitude.

Al's attorney then told the daughters that Al was resigning from the business.  Since there was no operating agreement, Al was free to withdraw from the business and form his own new company.  Of course, he couldn't take any existing contracts with him, but those contracts were worthless without him.  The daughters would never be able to manage the existing contracts, and the business would fold.  Then Al could bid to get the contracts back.

The daughters' attorney called for a mediation meeting and the daughters settled for almost the exact value I had calculated.  Al had his company back after spending $20K or so, not exactly a happy ending, but a satisfactory one in the end.

Dying without buy-sell and operating agreements is malpractice for a business owner.  You are ensuring heartache for your family.  Of course, if you hate your partners, spouse, and family, go for it.

Thanks for reading!  For real tax and accounting advice, please visit the main S&K web site at www.skcpas.com.  Also, please like the "How to Screw Up Your Small Business" Facebook page.

Until next time, let's do it to them before they do it to us.

Hire Your Relatives – A Biblical Story

Get out a box of Kleenex. This is a really sad story. I mean that sincerely. This situation upset me more than any other business situation I have endured over more than twenty years in practice. You may already be familiar with this story.

Adam was an elderly gentleman, who owned a landscaping services company located in the Garden of Eden. He had two sons, Cain and Able, who each owned ten percent of the company. Adam had retired fifteen years earlier and left the operations to his sons. Able ran the office, created proposals, and was in charge of sales. Cain ran the field operations and took care of the main customer, Jehovah. The company had been profitable since nearly the beginning of time.

As Adam neared age sixty, you can take the Bible ages and knock a zero off, he retired and put the company in the hands of his sons. Adam, however, kept his eighty percent ownership in the company. He reasoned that if his sons mismanaged the company, he could take back control and right the ark. Noah hadn't been born yet. Adam also owned the grass hut that the company used for office and warehouse spouse. He didn't get a big salary out of the company in retirement, but he took enough to live on. He also charged the company rent on the grass hut office space. He certainly wasn't wealthy, but had enough income to live comfortably in retirement. Fortunately, financial planners had not yet come into existence.

Adam planned on passing on his majority ownership of the company to his sons at death. However, after a few years, Cain and Able grew unhappy. They wanted to own the company right away. They weren't willing to wait for Jehovah to transfer Adam out of the Garden of Eden into heaven. They had no intention to cheat Adam. They just wanted to purchase his ownership stake for a fair price right away. That purchase price would allow Adam to continue living at his current level in retirement.

You might fairly ask why the sons couldn't wait for Adam's death since they pretty much already controlled the company. Able was in his forties, and Cain was in his late thirties. They simply didn't want to wait another twenty years potentially to own the company. I thought their plan made good business sense. The purchase agreement could even be written so that Adam could reclaim the company in the event the sons defaulted on the agreement. Over a period of a couple years, the sons presented their plan several times, but Adam wasn't interested. They told him that his name could be removed from any company guarantees, and he would have no further personal risk in the company. He would continue to get his income and rent for the grass hut. Nonetheless, Adam wasn't interested, which was his right.

Able was quite a skilled business manager and salesperson. He had helped the company grow substantially in the years he had managed it. Since the company was an S corporation (LLC's weren't invented until several hundred years later when Moses delivered the eleven commandments, the eleventh of which was “Thou shalt create limited liability companies to eliminate personal liability.”), in theory Adam got eighty percent of all the profits Able worked so hard to create.

Able wasn't willing to wait any longer. He left the company and went out out his own creating a company to build residential huts in Eden. The company's stockholder agreement was set up so that Able received basically nothing for his ten percent ownership share and many years of hard work. Able left anyway, since he knew he could recreate his success with his new company.

That left Cain in charge of the company. Since he had been the field manager, he didn't have experience in the other areas of the company. Adam was well aware of this. He asked me, the first CPA in Eden, to keep a close eye on the company's financial operations. I was a little reluctant to take on so much responsibility. I knew their main customer, Jehovah, wasn't a big fan of CPA's and money changers in general. Five thousand years later, his son threw us out of the temple. We know the Garden of Eden existed five thousand years before the birth of Christ, because Sarah Palin tells us so. She discovered this fact around the time Al Gore discovered the internet. (I am an equal opportunity political basher.)

For the first few months, the company performed pretty well operationally and financially. I met every month with Cain and his bookkeeper, Ruth. I was responsible for Ruth's hiring, and I knew her well and trusted her. She was one of the ten percent of bookkeepers, who are competent. (Please refer to earlier blog entries to get my opinion on bookkeepers.) I knew Ruth would keep me informed.

Early on in Cain's tenure as head of the company, he asked me if I planned to report everything he did to Adam. He told me he didn't want to be micro-managed by his father any more than Able did. I agreed that I wouldn't run to Adam with an account of every event. However, I did tell him that I would report anything I saw that was significantly out of order.

A couple months later, I got a call from Ruth. To obtain a big job, Adam had contributed $250K to secure a contract for bonding on a job. A bond company was guaranteeing to Jehovah that the company would be able to complete a very large project. If the company failed to complete the project, the bonding company would pay to complete it. Of course, the company had to pay the bonding company for this guarantee. In addition, the bonding company required the company to place $250K in an account that could be accessed by the bonding company in the event Adam's company failed to complete Jehovah's job. Jehovah doesn't mess around. Since the company didn't have $250K lying around, Adam put his personal money into the account. Ruth called me to tell me that Cain had taken most of the money out of the bonding company account without Adam's knowledge.

I called a meeting with Cain and Ruth. I told Cain that taking out the $250K without Adam's knowledge was a significant event that I felt obligated to report to Adam. He told me he would put the money back into the account within two weeks. He did.

A month later, I got another call from Ruth. She told me Cain had again taken the $250K out of the bonding company account. I didn't know this at the time, but a snake had approached Cain with the idea of opening an apple farm. You may have heard that the snake approached Eve, but most serious Biblical scholars (including Sarah Palin) have concluded that since women were not taken seriously five thousand years ago, the snake definitely approached Cain. Of course, Cain knew nothing about growing apples. What the snake really wanted was access to the company's cash and a steady job.

This time I called Adam. Of course, he was unhappy and immediately met with Cain to review the financial status if the company. I was not invited to the meeting. As a result of the meeting, I was fired as CPA, and Ruth was fired as bookkeeper. Later Adam told me, that since he had put Cain in command, he felt obligated to let him make his own decisions.

A little over a year later, I heard from Able. He told me that the company was in bankruptcy,and that I should expect to hear from the attorneys the company had been using under Able. Of course, Cain had fired them as well. They hired me to try and determine what was left of the company's finances and to complete any unfiled tax returns.

I walked into the biggest business mess I have ever seen. Cain had taken the $250K and a lot more to invest in the apple farm with the snake. The snake didn't come alone. He brought with him a weasel as financial controller and several other vermin he placed in key management positions. The new company was a miserable failure. Taking the money out of Adam's company left it desperately short of working capital. Working capital was so scarce that the company was unable to complete Jehovah's major project. The bonding company had to step in and pay all of the unpaid subcontractors for the job as well as pay for the final completion of the job. They weren't happy people and were suing the company and Adam as the guarantor of the performance bond.

At the time the bonding company came after him, Adam's assets consisted of the $250K he had set aside in the account for the bonding company, his personal grass hut, and the grass hut he was renting to the company. Of course the $250K was long gone thanks to Cain's foray into apple farming. Adam sold the hut that served as the company's office space, but that wasn't enough to repay the bonding company. He was forced to move out of his home and move he and his wife into a small rented apartment. Even that wasn't enough to satisfy his obligation to the bond company. He filed for bankruptcy. At age eighty, he was financially ruined. If only he had sold the company to Cain and Able a few years earlier. He would have eliminated his personal risk.

Now you know why this story is probably the saddest series of events in my career. Of course since this is all about me, as all of you know, I still haven't recovered. What lesson can be learned from Adam's story besides never trust a snake? The obvious lesson is not to be in business with our family. That is the nominal lesson I wish to convey, but there is another lesson to be learned. When it is time to leave your business, leave your business. Adam's time in his business was past. He should have sold out to his sons. Maybe they would have succeeded together. Maybe they would have failed. I believe Able's leaving killed the business. Nonetheless, Adam could have left the business without any personal risk. In the end, he left all his chips on the table and lost his entire financial life in a business he no longer controlled. I am truly, and will always be, sorry for his loss. He deserved far better.

Thanks for reading. My search engine optimization guy has made me promise to mention the Stitely & Karstetter web site http://www.skcpas.com. We have a more informative blog there and you don't have to deal with my snarkiness (is that really a word?). Redskins fans – Aaron Rodgers was drafted immediately before Jason Campbell. Doesn't it make you want to vomit? I am headed to the bathroom now.

Hire Your Relatives

I'm not certain why I should have to write this chapter. This idea seems so obvious. However, I also expect that at least half of you have already done this, and you likely disagree with me. “My business hasn't failed,” you tell me. The problem with hiring relatives isn't that your business automatically fails instantly. What really happens is that your business dies a slow death.

Imagine a business where employees are hired based on family relationship instead of competence. The bookkeeper was hired because she is the owner's wife. The sales manager is the owner's brother-in-law. The operations manager is the owner's brother. Oops – is this your business?

Let me ask you a few questions. Did you hire your wife as bookkeeper, because she has an accounting degree and tens years of bookkeeping experience? Did you hire your brother-in-law for his experience running a competitor's sales department? Did you hire your brother, because he spent fifteen years in charge of distribution for Wal Mart? Of course not. You didn't hire any of them for their qualifications. You hired them because you trust them (hopefully), and because they were convenient hires. You didn't have to search much to find them. Did you hire the rest of your staff this way? The problem with hiring relatives is that they aren't qualified in any meaningful sense. What do you get from unqualified employees? Misery. You know better. Nonetheless, you did it and will continue to do it.

One of my clients. Ted, had a brilliant idea no one had ever thought of before. That concept alone should set off alarms. I have never had an original thought in my life. You haven't either. Every time I think I have one, I end up losing money. The best ideas are stolen ones. Let someone else prove there really is a market for toilet paper with George Bush's face on it – either George Bush. Personally I would buy it with Jimmy Carter's face on it. Maybe not, my butt has standards.

Ted owned an average white guy small IT firm. It was really small – just him. He hoped to land some lucrative federal contracts. However, the federal government really doesn't award many contracts to average white guy small IT firms. To get these contracts as a small company, you have to prove some sort of historical discrimination or disadvantage. Ted thought for awhile. He was the stereotypical average forty year old white male on his second marriage with two rotten kids. To make matters worse, he paid his taxes on time, had no felony convictions, and gave money to his church. What government would possibly want to do business with a guy like this?

Ted knew of a Small Business Administration (SBA) program that allowed companies owned by women, racial minorities, and other oppressed groups to receive special preferences in bidding for federal contracts. He thought, “Hey, I'm married! This must be God telling me why I got married. I couldn't figure out why otherwise.” Ted had the brilliant idea to make his wife, Cindy, the 51% owner of his company.

The SBA isn't completely made up of morons, idiots, and ne'er do wells. Ted's idea wasn't exactly original. In fact, thousands of average white males have thought of this trick before, and the SBA has attempted to enforce rules against sham ownership to qualify for set aside programs. However, since the SBA is made up of bureaucrats, who spend most of their time before congress shilling for more money, this scam works pretty much 100% of the time. Nonetheless, women-owned businesses are supposed to be run by qualified women.

Here were Cindy's qualifications for running a small average white guy IT firm. She had spent her five years with Ted doing the laundry, cooking poorly (according to Ted),and wiping the noses of snot-nosed little spawn of Satan. Actually, that last part really is a good qualification to run an IT firm. It pretty much describes the IT work force of the twenty first century. So you think I'm being harsh? Have you ever wondered why Windows crashes so often? In fact, it just auto rebooted on me during the previous paragraph. I rest my case. Children of God wouldn't have created Windows. No, they didn't create the Mac either. The developers of Windows are snot-nosed spawn of Satan billionaires. No I am not envious – as I drive my Kia down to the Smart Shopper to purchase generic gruel for my family. Really.

Ted went to his attorney and signed over fifty-one percent of the stock in his S corporation to Cindy. Ted went off to secure a few really nice federal contracts and hired twenty little spawn of Satan programmers to service the contracts. Cindy, now president of “her” company, continued ruining laundry, embarrassing the culinary world, and wiping snotty noses.

Life was wonderful for a couple years and Ted was able to pay Cindy and himself six figure annual salaries with generous pension contributions. However, heaven apparently can't last forever. Maybe Ted was tired of ruined laundry and dog food meals. Maybe Cindy caught him tongue dancing and doing the horizontal bop with her best friend. I was just the CPA. Who am I to judge? In any event, they decided to split.

Actually Cindy decided to split. As president of the company, she ran down to the closest bank branch, walked right up to a teller's window, and demanded to close the company's accounts. She wanted the $300K in the accounts on a cashier's check made out to her personally. Of course, we have all been to bank branches. The tellers have less authority in most banks than the janitors. The teller sent her over to the branch manager, who excused herself and called Ted. The game was on. Cindy didn't get the money. The branch manager told her she needed to have a resolution from the company's board of directors authorizing her to close the accounts. This was about half true, but it stopped Cindy from getting the money.

Divorce lawyers were summoned, and the real fight began. Cindy claimed that she owned 51% of the company and she was firing Ted. Ted claimed the ownership transfer was a sham. Yes, he really did argue that he had committed fraud with the SBA regarding the woman-owned business classification. I don't believe that Cindy actually wanted to fire Ted and own the company. What would she have done with it? By the time of the divorce, the company's major government contract had expired and was not renewed. There really wasn't anything left to own at that point. I suspect she just intended to use her majority ownership share to get more of the remaining money. Ted and Cindy reached a property settlement and divorced. Ted kept the company – what was left of it. The moral to this story is clear. If you make your spouse an owner, you have a problem if you get divorced. Since about half of all marriages end in divorce, consider yourself hereby warned.