Structuring an Investment in a Business: Understanding How Capital Structures Affect Risk

A cash investment in someone else’s business can occur in a variety of situations. Some of those situations might be funding an early stage company, an employee buying into the business and a joint venture where one party funds the venture.

An investment of cash can be structured in a number of ways. How the investment is set up and where that investment fits within the overall capital structure of the business being invested in affects the risk/reward profile of the investment, often in ways not fully understood by the investor. For example, structuring the investment as debt is generally perceived as less risky than structuring it as equity. However, consider two investment structures for an investment of $500,000. One is structured as debt. However, the investment is used for marketing costs (as opposed to hard assets) and the company in which the investment is being made has a capital structure which before the investment consists of (i) a $2,000,000 loan, which is secured by all of the assets of the company, and (ii) $200,000 of equity. If this company fails, the investor will likely lose his entire investment. That is because the secured lender will likely take all of the assets to satisfy its loan, leaving nothing left to pay our investor.

Consider on the other hand an investment structured as equity. However, the company in which the investment is being made has no debt and owns a piece of real estate worth $1,000,000. Further, the investor will receive in exchange for the equity investment half of the equity in the company. In this case, the investor has a very low risk investment, since if the business ceased doing business, his ownership interest would entitle him to half the value of a $1,000,000 piece of real property.

Thus, the form of the investment does not necessarily determine its risk. Rather, one needs to examine how the investment fits within the overall capital structure of the business. Consider this carefully when structuring your investments or determining whether you are getting an appropriate return for the risk you are taking.

Please feel free to contact the author by calling at 312-948-8129 or visit his website at www.devries-lawfirm.com

The True Value of a Well Thought Out Form Customer Agreement

               Although businesses vary in terms of how well they document their relationships with their customers, most business owners have at least a vague sense of the importance of doing so.  However, if asked to articulate why that felt it was important, I believe that most business people would give an abstract answer about “protecting themselves”. 

 

This answer reflects a common underlying context that business people (and even many lawyers) have about using contracts generally.  This context can be described as ‘managing distrust’.  From this context, the contract has life and meaning only in the event of litigation or some unforeseen eventuality.  Moreover, the contract is perceived as having nothing to do with better customer relationships or improved margins.  From this perspective, businesses often satisfy themselves with form agreements which are abstract, boilerplate provisions which may bear no relationship to the realities of the customer relationship or the practices of the business in relationship to its customers.

 

While I believe that identifying and planning for unforeseen risks and contingencies is not to be ignored, I also believe that a properly thought out and drafted form contract can assist a business in the following ways:

 

               1.            Clarifying Expectations with Customers.  A clearly communicated understanding between parties regarding their expectations from each other helps to establish a foundation of trust.  A clear contractual promise to your customers about what they can count on you for helps to create trust and confidence in you and your products and services.  Conversely, clearly spelling out the limits of a customer’s expectations also sets the appropriate groundwork for a relationship with your customers.  Where this pays off is that often customers will exploit areas where their expectations were not clearly limited.  When this happens, most businesses feel compelled to make some concession in favor of the customer for the sake of the relationship, even where they are legally on solid ground to do otherwise.  Having the limits of a customer’s expectations clear helps to limit the occasions when those concessions need to be made, thus adding money to the bottom line. 

 

               2.            Establish Standard Operating Procedure.  Your form contract should reflect the operating procedures you actually use.  However, the process of creating the form contract may also identify places where the procedure is not standardized or is unclear.  It is generally less efficient and effective to have your employees needing to improvise every time with every new customer.  The form contract will help to solidify and establish a structure for a standardized procedure, which creates efficiency and ensures quality. 

 

               3.            Disciplining Your Negotiations with Customers.  A well thought out contract with standardized terms and conditions of doing business is a structure for disciplining the negotiations between your sales team and the customer.  The desire to be approved of and to please another person is a basic human dynamic that influences any negotiator.  This may be particularly true of salespeople, who are trained to be (and perhaps by disposition are) empathetic to the needs of the customer.  A set of standard terms can help serve as a backstop against being overly influenced by these concerns. 

 

Viewing your company’s form contract with these potential benefits in mind will help it be a useful tool, rather than an abstract piece of paper in a file drawer.  If your company’s form contract is not doing all it could, please contact me at ljdevries@devries-lawfirm.com or visit my website at www.devries-lawfirm.com

What to Look For When Choosing an Attorney

I have practiced law for over 20 years.  During that time I have observed many lawyers whom I admired and many I did not.  In light of this experience, I have given considerable thought to the qualities I would look for in an attorney were I to need to engage one.  

 

What I have also come to realize and appreciate is how important this topic is for business people looking to find an attorney to assist them.  The quality and competence of attorneys varies widely.  However, because the law is so technical and legal training is so far removed from the experience of most people, the differences in the traits, habits and thinking that separate really good attorneys from the average and not-so-good ones are nearly impossible for a layperson to discern.  

 

I have found this to be true, even where people have worked with a particular attorney for years.  I can personally think of several situations where people were satisfied with the job their attorney was doing, even though their attorney was selling them out, interjecting himself into a situation without adding any value or making mistakes which had an immediate financial cost to them.  The reason for this is that the clients either simply did not have the perspective to notice the difference or expect any better.     

 

Given this, the perspective of an attorney on this issue can be quite valuable.  With that in mind, this article contains some of the traits I as a a more experienced consumer of legal services would look for. 

First and foremost, the attorney I chose would be someone I could trust.  My attorney would earn that trust by demonstrating a commitment to me and my interests that would not be compromised by his or her own greed, ego or competitive instincts, or his or her desire to be liked or respected by me or members of the profession.  In this regard, I would caution people not to choose an attorney based entirely his or her name recognition or visibility.  Often the trait that has a lawyer seek the limelight is an unbounded ego.  While this trait may seem initially appealing, the downside of it is often an inflexible working style or insensitive billing practices. 

Second, the attorney would further demonstrate trustworthiness through his or her billing.  His billing practices would be forthright and honest and would represent a fair reflection of the value delivered.  Most importantly, I could give him or her a free rein and trust that he or she would operate in a manner that would be most cost-effective to me. 

Third, he or she could stand his or her ground while advocating an unpopular course of action, but would also respect my right to make decisions for myself.  He or she should also help me make good decisions on complicated matters by articulating clearly and simply both the relevant law as well as the practical and strategic consequences of various courses of action. 

Fourth, a lawyer I would choose would have considerable experience in the kind of matter I would need him for.  In general, I would not choose someone who did a wide variety of matters, particularly if those matters were not logically related in some fashion.  The obvious advantage of having a depth of experience in a particular area is an immediate and intimate familiarity with the laws and issues in that area. 

The less obvious advantage is that by working extensively in a particular area, a lawyer develops certain skills which are often uniquely necessary to operate effectively in that area.  For example, my experience is generally in the area of business law.  By operating in that area, I have developed skills in negotiation, conflict resolution, managing a complicated process (a closing), understanding financial statements and projections, and appreciating the relationship between financial risk and return.  By contrast, an attorney who spent most of his or her time litigating who develop a very different set of skills, which would include the ability to persuade a third party (the judge), think strategically within the process of litigation and manage a caseload.  A lawyer who has specialized to at least some degree in the kind of needs you have will have developed the skills necessary to be effective in that arena.

Fifth, he or she would define the quality of his or her work by results that are important to me, as defined by me, not by the internal standards of the profession.  A little known fact about lawyers is the extent to which they are influenced by the opinions of other lawyers.  This is only human.  The effects of this influence could be as benign as a lawyer’s unwillingness to send out a less than perfect draft for the sake of time because it might reflect badly on him.  On the other hand, it could be as harmful as a reluctance to press an important issue for a client, because the lawyer does not wish to appear unreasonable in the eyes of the opposing attorney.  A good lawyer should always be aware of that tendency and guard against it. 

Lawyers have acquired a bad reputation of late, perhaps deservedly so, and the services of a lawyer do not come cheaply.  However, there are still lawyers who ascribe to the standards I would seek.  If you can find one, they are well worth the fees that they charge.  

 Larry DeVries is the managing principal of DeVries and Associates.  He specializes in assisting small and middle market businesses to structure, negotiate and document their important business matters and relationships.             (If you have any comments or questions regarding this article, please feel free to contact the author author by calling at 312-948-8129 or visit his website at www.devries-lawfirm.com