Blogs by William Manchee
3 - Defending the Small Business: Looting
10/13/2008 6:32:18 PM
Often the owner is the biggest threat to a small business.
From my observation over the years, looting is the primary reason small businesses fail. Looting results from the mistaken belief that the SBO is owed a certain standard of living. Usually there hasn't been a study or budget projection done to determine what compensation the business can support. The owner either sets an arbitrary salary or takes money from the business as he needs it. Either way the business starts to slowly wither as the owner pockets precious operating capital until there isn't enough left to pay the bills as they come due.
Several years ago I represented a corporation that had been wholesaling gift items to retailers. There were four owners, all who were previously employed by a another very successful company in the same business. Over the years they came to realize that their hard work and skill was making their employer very rich. This realization caused them to ask for pay raises and better fringe benefits, which the owner refused to give them.
They were bitter and frustrated over this and, one day a few months later, they all decided they knew enough to quit and go into competition with their employer. Each of the four partners were well respected, knowledgeable in the trade, but none of them had ever operated a business before. Despite this handicap, their new enterprise flourished largely because they were able to take with them some very large customers.
Two years later when they came to see me, they were deeply in debt, owed substantial taxes to the IRS, and had been locked out by their landlord. As I was filling out a bankruptcy questionnaire, I asked them what compensation each was taking from the business. The CFO replied that each of the four stockholders had an annual salary of $150,000 and, of course, each was provided a Mercedes. When I quizzed them further I found there were only a half dozen other employees all earning less than $30,000 a year.
Common sense should have told them they didn't have a prayer of survival with this type of a cash flow drain, but each was used to a big salary with their previous employer and just assumed their new startup company could provide the same for them. What they should have done was not take a salary and split eighty percent of the profits each quarter. This might have been painful to them, but at least the business would have had a chance of survival.
This is an extreme example of looting. Usually it is less obvious. For example, one of my first clients was a fine tailor from Italy, Gino Ricardo. He was always very busy, often working ten or twelve hours a day. Operating as a sole proprietor, he had only one checking account from which he paid all his personal and business expenses. Being good Catholics, they had many children, and as their kids got older, household expenses rose dramatically. Soon the business started to have cash flow problems. The rent was late, tax deposits were missed, the electric company was threatening to cut off the power, and checks were bouncing. That's when Gino and his wife came to see me.
It was painful to see them in this situation as I had known them for several years. I met them while selling life insurance when I was in law school. I sold Gino my very first life insurance policy a week after I went to work for Metropolitan Life. Three years later when I hung up my shingle, they were there to have me draw up a will. They were very nice people and I loved all their kids.
The first thing I do when a client with financial problems comes to see me is create a budget. It only takes an hour or two and the cause of the problem is pretty apparent when the process is complete. Sadly, for most of these clients it's the first time they have ever done a budget. When I start asking questions they usually put up a fight, complaining that they don't have all the information they need, or they need their bookkeeper or accountant to help them. But I don't let them off the hook, because if I leave it to them it will rarely get done.
So, I assure them that all the information I need they will be able to give me off the top of their head. They usually give me a skeptical look but I just smile and start asking questions. The reasons my clients are so resistant to doing a budget are twofold. First, they think it is more complicated than it is, and secondly, they are afraid of what the budget will reveal.
Many small business owners, if not most, keep track of their business in their heads. They know, or think they know, from day to day where they stand both financially and operationally. Unfortunately, as the business gets more complicated these mental impressions are often false.
I tell them a budget is really quite simple. All they need to give me is an estimate of what revenue they have coming in each month and what expenses they expect to incur. As I pull up a simple spreadsheet on my computer, I start throwing out categories like sales receipts, advertising expense, travel, maintenance, and then record their answers. If they shrug and claim not to know, I make them give me a guess-timate which they can later verify. When the spreadsheet is printed out, it will usually reveal that their monthly cash outflow far exceeds their monthly receipts. This often shocks them, but just as often they just shrug like they knew this all along.
Gino shrugged when I told him his expenses exceeded his income by nearly a thousand dollars a month. In his heart he knew it, but hadn't been able to face reality. He figured business would improve and eventually his income would catch up with his expenses. This was extremely unrealistic but a common belief among SBOs.
One of the problems I always face when dealing with SBOs is how to get paid. With money in short supply, paying an attorney is no easy trick. Gino offered me a custom suit in exchange for my help. It was the last thing I needed but I couldn't let down my very first client.
We wanted to set up a payment plan, but the landlord was threatening to lock Gino out, so we had to put them in Chapter 13 to protect them from a lockout. This worked out well and, after three tough years, Gino paid off all his creditors and life got back to normal. Gino and his family had survived and I was looking good in my custom-made Italian suits.
Even when I was able to get a client to acknowledge that he was looting his company, it wasn't always easy to get them to stop. I must confess I was guilty of looting my own law practice for many years. We were simply living above our means and the only source of revenue was the practice. I took what was needed to pay my personal bills, and there was nobody to tell me to stop.
When a business runs low on cash the natural thing to do is to borrow money. Unfortunately, this only makes matters worse as interest expense is added to the already overburdened budget, and eventually the borrowed money has to be repaid. Since bankers don't usually lend money to a business without collateral, the business owner now must pledge his assets and personally guarantee the indebtedness.
The only way out of this inevitable path to doom is extraordinary sales, unexpected windfalls, or wealthy relatives. Even if the small business owner is a great salesman or a gifted scientist, the lack of fundamental business acumen will eventually catch up with him.
This was the case with a computer genius, Sam Sturgeon. He had invented one of the first personal computers back in the eighties and had received a lot of good press. Sam, too, had made his employer very rich and decided he wanted some of that wealth for himself. His new line of computers were state of the art and selling like snow cones on a hot Sunday afternoon. He had a nice manufacturing plant in northwest Dallas with about twenty-five employees.
Six months later Sam came to see me about a Chapter 11. This is another form of bankruptcy utilized normally by corporations or partnerships. During the interview process I confirmed that he was indeed brilliant and quite a good salesman. He told me how well he had done and how much money he had made almost overnight. But when I compiled his financial statement he had virtually nothing. Then I discovered he'd been sponsoring a NASCAR racing team!
After shutting down his racing operation, we put his company in Chapter 11 and tried to reorganize. It was difficult case because he had waited too long to file and had virtually no cash. We did finally get his Chapter 11 confirmed, but while he was distracted by the bankruptcy, his competitors overtook him and he was never able to get back on top. Eventually he had to shut down.
It's not uncommon for someone who struggles for success and finally achieves it to think the battle is over and let down his guard. But the truth is, it's often harder to keep money than it is to earn it in the first place. The temptation to spend money sitting in a bank account or to let someone else spend it for you, is often so intense that only getting rid of it will once again bring peace.
A professional athlete was referred to me many years ago. He had come from a poor family and had been a neighborhood hero throughout high school and college. When he made it big in professional sports his family and friends decided he should open up a chain of restaurants. I was excited about seeing him because of his notoriety, but I was also anxious to help him get his business venture off to a good start.
Unfortunately, when he came in he was accompanied by his mother and several close friends. They were treating him like he was some kind of god and made it virtually impossible for me to talk candidly with him. As the meeting progressed, he told me of several loans to friends he was thinking about making and several joint ventures he was in the process of negotiating. Although he had a nice salary, he had no other assets. I cautioned him to take it slow and not get involved in a bunch of ventures he knew nothing about. His mother and friends became indignant and, needless to say, my services were quickly terminated.
A year or two later his career started going downhill and it wasn't long before he was out of the NBA. Although I don't know for sure, I suspect he has nothing left of the millions he received while playing in the NBA.
The point is, smart and talented business owners need to have a sound game plan just as much as the average ones. Brains and talent may prolong the date of business failure, but they won't prevent it.
The only way to stop looting a business is to set a modest, realistic salary that the business can easily support. Then at the end of the year, if there has been a profit and there is extra cash in the bank, the owner can take a bonus at that time. Conversely, if the business is still losing money, then the salary is too high and must be cut. This isn't to say that the business owner can't do other things to increase revenue or cut expenses, but until a profit is realized and there is extra cash in the bank, no bonuses should be declared.
I realize that often the salary a business can support is insufficient to meet the minimum needs of the owner. If this is the case, difficult decisions will have to be made. Perhaps the owner's spouse will have to get a job, or their lifestyle will have to be curtailed until the business is built up and can support a larger salary. The small business owner must be strong in this regard and avoid the temptation to loot the company. If this can't be done, then the sensible thing to do is shut down the business and go work for someone who can afford to pay you the big salary.
Coming Next - 4-Suffocation
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