Effective Business Planning in the Great Recovery
It appears that the worst of the Great Recession in behind the U.S. economy and that we are moving into the Great Recovery. Per a recent Wall Street Journal article, the economy grew at a 4.1% rate in the third quarter of 2013 and unemployment in November was at its lowest level in five years. The same article cited statistical and anecdotal evidence that small business owners are bullish about economic prospects heading into 2014. That's very good for all of us, as it encourages hiring and delayed capital expenditures. However, as many businesses move from survival to growth mode and individuals who've been on the sidelines move back into the game, now is a good time to re-take stock of some poor business practices that led many to grief during the recession.
Too much debt. Debt is almost always a necessary part of building and running a business. Responsibly and effectively used, leverage increases returns and allows for quicker growth than would be possible for a business built and run on 100% equity capital. However, the root cause of the Great Recession was over-leveraging - too much debt - from Wall Street all the way through Main Street to the farthest reaches of the countryside. Real estate investors learned that land and housing values can fall off a cliff and that collateral (if there is any) cannot always be used to repay a loan. A missed payment can bring a letter from the bank to pay the entire balance due within ten days. Borrowers that were planning on rolling over a line of credit at a maturity may find a bank forced by exigent circumstances to call the loan due. Guarantors who never thought they were first in line with the bank can be put under crushing, short-fuse demands from the lender. When considering how much leverage to use as your business tries to take advantage of the recovery, remember the lessons of the recession and ask yourself some critical questions:
- Have you accurately gauged the expected costs and revenues attached to the decision. How much capital will the venture need to reach a point of positive cash flows and how will that capital be obtained? How much guesswork is involved in predicting the expected return on a business decision and how realistic are your assumptions? Do you have a well vetted pro forma that forecasts expected revenues and costs to back up your assumptions?
- How much risk is being taken versus the expected return? Do the risk adjusted returns warrant the investment?
- Who will be required to personally guarantee the loan? Have you considered what that guarantee means to your personal financial situation? (See this article for more information.) If you are only in a deal for 25% of the profits, will you be on the hook for 100% of the liability if the loan goes south? Can your partners make good on their share?
- If payments are missed and a default is declared, you cannot count on the collateral to cover the loan. Will you be facing personal bankruptcy or the loss of substantial personal assets if a default happens? If yes, are you willing to stake your entire financial future on this loan?
Who are you Getting in Bed With? In every business transaction that requires execution (e.g., starting a fast food restaurant, building a residential development), an investor is ultimately investing in people. In any deal, before you commit, look around you and consider your partners. How long have you known them? Are you getting into the deal because you want to do business with your buddies or because the economics are right? Do your partners have a track record of successful investments, or a string of repeated failures? Have any of them ever filed bankruptcy? Have they ever had a bad debt? What do former partners say about them? How long have they been in town? How impressive is their diligence? Are your questions getting answered, with documentation where needed? Why are they coming to you? How transparent are they? Does this all sound too good to be true? If there are red flags, then be careful. If a loan to the venture goes bad, you may otherwise find yourself with bankrupt partners and be dealing with the venture's creditors alone. Worse yet, you may be dealing with the all-too-common recession stories of breaches of trust and fraud. Be very careful who you are do business with. Your reputation and financial well-being are tied to your partners.
Documenting The Deal. When times are good and everyone is making money, corporate formalities and precision in formulating deals between partners and compaines are too often ignored. Operating agreements are drafted, never signed, and thrown in file boxes without a moment of study. Deals are cut on handshakes and vague email exchanges. Corporate meetings are never held and partners start making lone wolf decisions. People mistake "trusting one another" with the need to memorialize the terms of a deal so that the passage of time and fuzzy memories don't create dispute. At Johnson Marlowe LLP, we've seen far too many cases where former business partners spent tens of thousands of dollars resolving disputes between them after-the-fact when a few thousand dollars on the front end would have avoided the misunderstandings that caused the disputes / litigation / arbitrations down the road. If a business deal is imporant enough for you to expend your time, energy, and treasure, it is important enough for you to document the deal with your partners. In the LLC context, this means a quality operating agreement drafted by experienced counsel. (See this article for more information.) In the Sub S corporation concept (a "Sub S" is just a corporation that makes an election on its tax return to be taxed as a partnership), this means well-drafted corporate by-laws and minutes of meetings, once again with the assistance of qualified counsel. For deals between your business and another, whether it's a purchase and sale of assets or stock, or a contract for a transaction, put the deal in writing and make sure the person drafting it has the requisite experience and skill to cover all the bases.
Many of the pitfalls of the Great Recession can be avoided by careful consideration of business capital and leverage, selection of partners, and documenting the deal. A qualified attorney who's seen what happens when deals go south and banks and partners file lawsuits can help put structures in place to avoid those disputes down the road. Remember the lessons of the Great Recession before you do your next deal!