Published on November 22nd, 2016 by Alan L. Sklover
“ In capitalism, those with the capital usually get the ism.”
ACTUAL CASE HISTORY: Paul and his partner, Elise, seemed to be “riding a rocket.” Their six-year-old software company had come up with a very neat solution to a common business problem, namely, real-time updating of the prices charged by a company’s critical suppliers. It almost ensured lowest prices.
Their success, though, was their problem: they needed to hire very talented coders, who were in increasing demand, and for this reason quite expensive to hire. This left them cash-starved, and unable to continually update and enhance their product to meet market demand. Fortunately through their accountant, they were introduced to an investment firm that was interested in providing a cash infusion in return for a piece of the company’s ownership.
The initial meetings went quite well. In return for a $5 million cash infusion, the investors wanted only 10% of the company’s stock, and 5% of its profits. After a brief time Paul and Elise suggested that their business attorney – an expert in software patents – prepare the necessary legal papers. Instead, the investment firm suggested their own internal attorney should prepare the legal papers, in order to save money for Paul’s business, which was “music” to Paul’s ears.
After presentation, review and minor modifications of the legal papers, the investment was completed, and Paul and Elise were more ready than ever to grow their business through new – and now affordable – hiring opportunities.
All went well . . . for about six months. Then the Board, now composed of Paul and Elise, and three younger members of the investment firm, had one of its monthly meetings. At that meeting, the Board voted 3 to 2 to cut salaries and benefits by about 10% in order to slow the company’s rate of “cash burn.”
Paul and Elise didn’t think it would be a good idea, but they gave in, and explained to their staff members that this was a sign of “long term thinking,” and necessary to show the investors their deep commitment. They also cautioned their staff that the cuts were necessary to keep relations with the investors on a positive note.
Two months later, the “fit hit the shan” when the Board voted to issue a “special dividend” to the investment firm, in effect, to themselves, and replace the company accountant and the company lawyer with their own. Paul and Elise started feeling like someone had “hijacked” their company. Unfortunately, they were right. What they had built up over years of effort and sacrifice was, slowly but surely, slipping through their fingers.
The changes kept coming, including a decision to pay the investment company a monthly “management services fee,” a company name change, the office was relocated, more debt was piled on, and the investors even brought in other investors, with what was called “super-voting” shares. Before they knew it, the best assets of the company were being sold to competitors, while Paul and Elise were reduced to mid-level managers of a company they once independently ran. This was not what they had envisioned. Not near it.
When they consulted their own attorney, they soon learned that his expertise in software patents was not expertise in company operating documents, and that embedded in the legal documents they had signed, nearly invisible to them, was their agreement to permit the investors to do essentially whatever they wanted.
Yes, the investors still owned just 10% of the “stock,” and received just 5% of the “profits.” While at first that seemed comforting to Paul and Elise, the larger “control” decisions being made daily made “ownership” and “profit” issues not to matter much at all.
LESSON TO LEARN: “C.O.P.” stands for “Control,” “Ownership,” and “Profits.” It is an analytical and explanatory rule of thumb I have made up and use often when working with the creation, growth and evolution of small and/or young companies.
“C” stands for “Control.” Control means who will make decisions, how they can be made, and what limits exist on those decisions. The “Control” provisions of a company’s operating agreement (no matter what its title may be) are rather boring, often confusing, and almost always ignored by the non-lawyers. That often leads to tragedy, because “control” provisions can change who owns a company, what profits they get, and even who will remain owners, officers or employees of a company. “C” comes before O and P in the alphabet, and comes first in “C.O.P.” because it is far and away the most important of “C.O.P.”
“O” stands for “Ownership.” Ownership means who owns how much of a company. While it seems to be so very important, if those who “Control” a company can change its future ownership, what “ownership” means, or who gets the usual “fruits” of being an owner, it makes the initial ownership not as important as it often seems.
“P” stands for “Profits.” Profits means who gets moneys that the company earns, after paying the bills and taxes, and how much they get of the profits. Profits is the least important, because it can be changed in so many ways by those who have Control to do so. “P” comes after “C” and “O” in the alphabet, and comes last in “C.O.P.” because it is far and away least important of the three.
The legal documents that govern how a small or young company operates are essentially devoted to (1) who will make what decisions, (2) how those decisions will be made, and (3) the limits, if any, on those decisions. (Sort of like the U.S. Constitution, come to think of it.) Unfortunately, these documents are often very confusing, obtuse and highly “legalistic,” enough so that they can put an insomniac to sleep. Attorneys not familiar with the issues that arise in the “governance” of smaller businesses, and the applicable law, often meekly comment “Looks pretty good to me,” which is a sure sign that he or she is well beyond his or her legal expertise and street smarts.
When presented with a business operating agreement by potential investors – a “partnership agreement” for a partnership, a “shareholder agreement” for a corporation, or an “operating agreement” for a limited liability company – principals and their attorneys often mistakenly focus, first, on “Ownership,” and numbers of “shares” or “units,” which describe who owns how much of a company. The thought is, “If we own a majority of the shares (or units), majority rules, right?” The truth is, “No. Not necessarily.”
Next, principals and their attorneys, when presented with a business operating agreement by potential investors, often next focus on the “Profits,” or the phrase “profit distribution.” If a certain amount or percentage seems reasonable, then they are often pleased, seeing a reasonable sharing of profits as a sure sign of good intentions and reasonable business investor-partners.
What they rarely focus on sufficiently, because it is a “fuzzy” concept often “buried” or “disguised” in a whole slew of provisions written in legal mumbo-jumbo (that is a Latin phrase meaning “hocus pocus”) is the most important issue: “Control,” meaning “Who makes what decisions, how, and what limits exist on those decisions?” At the risk of being sued, I will refer to this issue as “The Art of the Deal” although, in truth, it is often more accurately characterized as “The Art of the Steal.”
So, the focus of thinking, analyzing and negotiating investment in small businesses must be on “Control” because whoever has control can later change both “Ownership” and “Profits.” Got it? “C.O.P.” and “C” comes first.
Don’t get me wrong: ownership and profits are really important issues. But if someone has the “Control” to change them, against your judgment or will, the initial “Ownership” and the initial “Profits” don’t mean a hill of beans, as those with “control” can change them. And, if they have the “Control” to fire you, or your partners, or change the name, location and model of the business, what good is their investment in the first place?
There are innumerable ways that “Control” can be disguised, stolen and “fuzzied.” The idea is to make sure it is hard, if not impossible, to make later important decisions against your wishes, in violation of your vision, and against your interests, by asking for changes, or insertion of limits, that will protect your “business baby.”
Bear in mind, something that is also quite important: only you understand your business, how it works, what makes it tick, and even what your vision is. Don’t presume that your lawyer or any other lawyer knows those things – and the things you fear, too. We all know you want your business to succeed and grow. We don’t know that much about what you would find hurtful to your dream, because, frankly, it is your dream. The best collaboration with an attorney on these issues takes several cups of coffee, multiple mugs of beer, or at least a whole lot of candid conversation.
Bottom line: as you can see, a 10% ownership and 5% share of profits, can – by legal papers – be turned into a sale of a company. When it happens in a large company, we call it a “corporate takeover.” In a smaller version, it is simply a personal tragedy.
WHAT YOU CAN DO: Like it or not, investors in a smaller or younger company often have different interests than those who have started and/or built it. And their perspectives may be different, too. If your company finds itself about to speak with “money people” regarding their coming in as investors, don’t let them hijack the ship. Use “C.O.P.” as your analytical and navigational tool. Here are 18 pointers, hints, and insights to help you do so:
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