The Most Common Investor Error
Years of M&A deals have left us with a clear picture of the most common mistake investors make when putting money into a business, particularly a small business. They do not seek protections relating to owner-creditors. Here is what we mean.
Imagine. You are finally ready to invest some money into a friend or colleague's business. He assures you that things are going gangbusters and together you can make a fortune. He explains that the next step requires paying down debts and growing the business, and that's where you come in. Trusting him, you invest $250,000. Immediately thereafter, he recharacterizes all of his initial investment in the company as a 'loan', and has the company, now $250,000 richer, pay off that loan to him. All your money goes straight into his personal pocket, and your investment in the company is practically worthless. We cannot tell you how frequently this maneuver occurs. At The Vasilco Law Group, P.C., we build into our investment agreements many restrictions on what the management can do, including preventing them from recharacterizing any equity investment into debt, or paying off any non-arm's-length creditor. It is critical. Do not fall victim to this common form of investment abuse.
The Collusive Default...See It Coming Before Hand.
A distressingly common way managements defraud investors is by teaming up with creditors to engineer an intentional default, seize important assets and then operate them from a new entity. Here is how it works. Management asks you to invest a half million dollars in their startup company, which has a hot new patent sure to set the world on fire. You make the investment for a 49% interest in the company, less than needed to control the board or elect management. They retain control. So far, no problem. Management then borrows money from a very friendly creditor and pledges the valuable patent as collateral. Management then spends the money you put in, paying themselves generously, and as time goes by, when it runs out, they default on the loan to the creditor, who according to a pre-arranged plan, seizes the collateral and sells it in a private sale...to...you guessed it, the management, with money they got from...you guessed it...you. They put it into a new company where you own zero, and go on to make their fortune. The company you invested in is now worthless and goes bankrupt, and its valuable patent is now completely controlled by the people who talked you into the investment. They have everything and you have nothing. This scam occurs regularly, and there are a number of variations. All involve a creditor willing to collude with management in order to arrange a friendly default and seizure of the business.
Another variant involves the classic father, son and son's best friend scenario. At heart, it is a creditor and owner teaming up against a third party victim. Here is how it works. Son and best friend form a business partnership together, 50/50. Needing money, they ask father for a loan. He loans it to them but makes it callable on demand, in other words, the boys have to pay it back whenever father says so. Seeing the business thrive, and seeing his son's friend make half the profits while doing little work, and noting how hard his own son works, he threatens to call the loan, which will immediately destroy the company, unless the friend gives his son more ownership, so his son can be 75% and the friend only 25% of the business. The friend is screwed. If father calls the loan, it will default and the boys will jointly and severally owe the father half the loan amount. Father will not collect from his son, but will pursue all legal remedies against the friend, who will have lost his job, his business, and his share of the loan amount. Like other collusive creditor schemes, there is always a creditor who picks sides and helps engineer a default to benefit his favored side. With practice, you can learn to see these coming before they happen to you. If you believe you have been or may be the victim of a collusive creditor scheme, call us. We want to speak with you.
Don't Worry, My Friend Is Going To Lend Us The Money...
Oh really? How. On what terms. Smell a rat? Sense any danger? After reading the above stories, you should. A collusive default may be in the making. Or at least, one is possible and you should take steps to avoid or prevent it from happening, with restrictions in the shareholder, operating, or investment agreement. A good Denver business lawyer from The Vasilco Law Group, P.C. can help you draft the correct agreements to avoid this kind of situation.
The Old 'Capital Choke' Maneuver. Beware.
When looking for investments, many times you find a business where a major shareholder is also a major creditor. Your neck hairs should instantly be raised. It's more than a red flag. The collusive creditor problem is already there, a creditor willing to side with an owner. Heck, they're the same person! Of course they will help each other! But it gets worse when this owner/creditor just wants to steal the business, or when its an investor who demands to be both an owner and a creditor. It all boils down to the same thing. A creditor willing to collude with an owner to cheat you. Consider this...
It all starts out looking so good. Your successful Arizona company needs $500,000 of cash to expand into Colorado. A fast talking businessman says he'll lend invest $250k into the company for a 10% stake, and lend you 250k on a callable promissory note secured by the assets of the business, including its contracts, name, receivables, inventory, leases, etc. Sounds great. But he has one condition: he can veto any action of yours to raise any further money by issuing stock or borrowing. Well, he says, I don't want my percent ownership to be diluted down if you issue stock, and I don't want any new borrowings to deplete funds available for payments on my loan to you...its only fair and reasonable. Right? Wrong. If you agree to it, he has put himself in a position to steal your company. He calls the note, or waits for you to have a bad year and get behind on payments, and then demands payment in full. You can't pay it all at once, so you try to raise some investment money from trusted friends. You can't though. He has forbidden you to raise capital by selling equity. So you try to borrow it. Foiled again, you can't. His covenants prohibit you from borrowing. You are boxed in and default. He takes the assets and runs the business as his own, having effectively stolen it from you. We call this the "Capital Choke" maneuver. Probably, you can see why. If you have been the victim of a Capital Choke, call us. We want to speak with you.
Isn't business interesting?