[6] (Part 2: Penny Wise & Pound Foolish – A True Story) De-Risk Your Biz: Minimum Small Business Legal Requirements

Penny Wise and Pound Foolish: Pay $10k or Lose $10 Million?

I once had a client who came to me during an exciting time in his business. He started his company only a few years earlier and it quickly reached escape velocity. He was doing several million dollars in annual revenue pretty much from the start and by year three had already tripled his business a few years in a row. A private equity investor approached him to buy his business. The buyer was anxious to do a deal and willing to move quickly. The table was set for a quick windfall and my client wanted to capture the moment.

My client was in his late 40s at the time, maybe early 50s. Sharp guy. He had spent most of his professional life as a corporate cog in the wheel of the industry where he now had his own business – a recurring theme that I was starting to see in my legal practice. We always think of the wunderkind entrepreneurs who shoot out of the gate at 20, code up some website, and create a billion dollar company. But I was noticing a trend of successful entrepreneurs who spent 20 or so years working their way through an industry, learning the ins and outs, and then setting up a business to capture the economics of some niche they discovered along the way. The success rate with those folks is much higher than the wunderkind.

Yet, his business was fraught with issues that weren’t addressed upfront. While he understood his industry in and out – he could call out the pitfalls in a vendor contract in a matter of minutes and knew how to grow his customer base with his eyes closed – he was lost when it came to setting up the basics of his business from a legal and tax perspective. He blew through several stop signs and yellow lights in the early stages and duct-taped together a basic legal entity structure with the wrong tax classifications and no corporate paperwork. Here was this guy running this multi-million dollar business, built on quicksand.

I quickly uncovered all of this at the onset of our engagement and let him know about the problems. I indicated that all of this would need to be disclosed during due diligence with the buyer and could cause some problems. He assured me that the buyer was willing to overlook several of the issues, so we pressed forward.

The problem was that some of the issues ran deep. Failings in corporate structuring, lack of documentation, and not choosing the right tax classification are often not easily correctable. For example, there was an early potential business partner who was around a bit in the beginning and then left the business without documenting anything. Some early tax forms were filled out improperly and some were never mailed out. Also, his choice of entity type was inappropriate for his circumstances. All of this stuff seems like “no big deal” until it’s time to sell your company, then it all comes back to haunt you.

Nonetheless, the buyer was motivated to close and willing to overlook most of the problems I identified.

We somehow stumbled through due diligence and drew up the paperwork to close the deal. To use round numbers, let’s say this guy’s company was valued at $30 million at the time. On the eve of closing, the buyer demanded that we put $10 million aside into escrow as a reserve in case any of the early corporate or tax issues bubbled to the surface down the line. My client came to me exasperated, “Surely they don’t need a reserve of $10 million for some pesky little corporate paperwork issues, right Samuel?” Unfortunately, I had to tell him the truth: the buyer was right. The issues were severe. If he wanted to proceed with the sale of the company at that time, he would need to concede to their demands or walk away. Any other buyer of some sophistication would have asked for the same thing.

Ultimately, we closed the deal and it turned out the buyer was spot on with their assessment: the $10 million in escrow ended up going to legal and settlement fees to resolve the corporate and tax issues and my client didn’t see a penny of it. Instead of pocketing $30 million, he walked away with $20 million. Still a great payday, but what an expensive lesson!

Sometime later I was having coffee with a fellow attorney and told him the story, leaving out names and details of course. He asked me how much it would have cost my client upfront if my client had taken the time to pay a corporate lawyer (me) and tax adviser to advise him on the proper corporate structuring and tax paperwork.

I threw out a ballpark: “Ten to fifteen grand. His set up was simple.”

“You’re telling me that this guy lost $10 million just because he didn’t have the wherewithal to fork over ten grand upfront?! Unbelievable!” 

Crazy, but actually quite believable. It really happened.

This was probably the biggest case of ‘penny wise, pound foolish’ I’ve ever seen, but unfortunately I see stuff like this more often than you’d think.

The purpose of this story and the following blog posts is to focus on what my client did wrong. Not that I’m picking on him, he’s a great human and we are still good friends. But there are valuable lessons embedded in his cautionary tale and hopefully they can help you not make the same mistakes.

In the next post, we’ll start going through the basic legal requirements needed to de-risk your biz – starting with corporate set-up.

De-Risk Your Biz: Minimum Small Business Legal Requirements