Bottom Line Business Insights : Maryland Business Lawyer & Attorney : Wagonheim Law Firm : Mergers & Acquisitions & Contractual Negotiation

Yesterday at 5:00, I found myself sitting in our conference room across from a very interesting gentleman. He was in his upper fifties, maybe 60, and carried himself as a professional. He explained that he had been in business for upwards of 40 years – that he had made some big mistakes, learned from them, moved on, and built a fairly successful business. 

He told me that the business that he had started had run its course and he wanted to start a new one, having learned from the mistakes of the old. In order to start the company, he decided to bring in 3 additional people. These people were friends of his, experienced in his industry, and possessed of the skill sets necessary to make the new venture run. My visitor had decided to divide 40% of the stock among them, retaining 60% for himself – enough, he felt, to keep control of the company.

He was convinced that giving out shares of the company was the only way to keep the group motivated, absent money to pay each person’s going rate. My visitor was wrong.

Recently, I wrote a piece in our e-mail series discussing the mistake of offering partnership at the outset of a business relationship. And whether the discussion concerns true partnership or co-ownership of a corporation or LLC, the fact of the matter is that co-ownership is a business marriage. And make no mistake, just like the real thing, a business divorce can be expensive and emotionally draining. 

For his part, my prospective client was asking his friends to invest their time and skill in a new business for little or no compensation. What he wanted was a way to show his friends that they would reap the benefits of their investment.   We explored a number of possible solutions, but what we decided upon was offering stock options.

People, you see, are unpredictable. Some may be highly skilled and great friends, but start working together and it’s a trainwreck. Different business philosophies, work ethic, or personalities can destroy a team that could not possibly look better on paper.   Stock options and a vesting schedule are two ways to put together an arrangement now which takes effect later. 

In this case, we could commit to an option to purchase stock in the company beginning in 3 years, discounted for each year the person had been with the company. Moreover, as incentives, other discounts to the purchase price could also apply, provided we took care not to trigger any unwanted tax consequences.

In other words, my prospective client could date before he got married. And in my experience, that’s a pretty good plan.

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“There is a difference,” I was taught, “between ten years of experience and one year of experience repeated ten times.”   I thought about this the other day as I contemplated the calendar change to 2011 and the fact that next year will mark my 25th year in practice. 

Everyday it seems like I see too many examples of companies celebrating survival, rather than progress. We regularly receive letters adorned with “our 10^th anniversary” ribbon stickers and see businesses using the phrase “since 1956” or some such instead of an actual message.   When I was a young attorney (maybe for ego’s sake I should say “younger” attorney), I was hoping to be made partner when the management committee told me instead “we’ve decided that you have to wait 3 more years before we extend an offer of partnership.” 

Now, granted I was young – younger than any of the partners by a long shot – but I had just as many clients and generated more revenue than most.   “Why,” I asked, “does it matter how many more sunrises I see between now and an offer of partnership?” I urged them to give me something different such as a revenue, performance, or even billable hour target to hit. But no, to them it was time. To me, this made no sense.

One of the real values of seeing another sunrise is the ability to leave behind the mistakes and absurdities that had, no doubt, been a part of your yesterday. But equally as important, with the sunrise comes the opportunity to build on yesterday’s lessons. Sometimes that’s painful in business.

Print out your customer list. Not a list of your most active or largest. Print out a list of all of them. Don’t just read the names, ponder them. As to each, are they enthusiastic about your work or did you make a cringe inducing mistake? Were you late? Were you, perhaps, a bit less responsive than you should have been? Are they loyal to you or are they casting a wandering eye across the business landscape wondering if they can do better? 

I have yet to find a business owner who, in his heart of hearts, can honestly say that he did right by 100% of his customers 100% of the time. 

So here are the questions: What are you going to do about the failures? Are you committed to learning? Have you created a company culture open to improvement? Can you begin a lasting and productive dialogue about your failures? Have you ever conducted a bloodless autopsy – one with a mission of education rather than the identification of a scapegoat?

In other words, in 2011, what will you have learned by the sunrise?

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“I got a phone call this morning from one of our oldest customers. He fired us. After 20 years, he fired us. Said he doesn’t know us anymore. I think I know why.” 

The speaker recounted his phone conversation to his account reps, saying “we used to do business with a handshake, face-to-face. Now it’s a phone call, a fax, ‘get back to you later,’ with another fax, probably.” 

This United Airlines commercial was originally aired before e-mail and the advent of social media. First aired twenty years ago, in 1990, it still resonates. So many businesses are started by an entrepreneur, skilled in the producing the product or service that spawned the company. Customers came because of the skill and stayed because of the attention. As the owner of a small business, the founder could track every project and knew every client. When someone was upset; he knew it.

Growth has a way of making that kind of personal attention obsolete. Time passes and a founder looks around to realize that whole projects are being performed for customers he never met.   And what about the ones he knew – the ones who built his business or who inspired him to go into business in the first place? Chances are, they’ve been delegated. Delegated to talented people, to be sure, but delegated just the same. 

Sooner or later, the thought has to occur to these customers – your old friends -- that if they mean little enough to your company that they can be delegated, your company means little enough to them that they can go elsewhere.  

Looking ahead to 2011, most business owners set targets for growth -- more revenue, more customers, bigger projects, better distribution. But how many set goals reflecting stronger relationships, customer retention, and expressions of gratitude? 

Many years ago, I read a book in which the author urged business owners to “pay attention to the ‘fine’s.’” He meant that people rarely voice their complaints. When asked about service or the particular product they purchased, even when dissatisfied, they’d normally respond that things were “fine.” Not every customer can be counted on for enthusiasm. After all, there isn’t an infinite amount of enthusiasm to go around. But the silence and the “fine’s” speak volumes to those with a keen enough ear and enough focus to notice. 

So what are you doing to focus on client retention, rather than just growth? Studies indicate that a new client is 7 times more expensive in terms of marketing and advertising dollars than existing clients. The point is that it is much cheaper and more efficient to keep the clients you have than spend every ounce of energy trying to bring new prospects in the door. 

If you do not already track trends in returning business, 2011 is an ideal time to start. After all, nothing speaks to customer satisfaction more than repeat business. Even more than tracking it, look for the things that increase the pace of returning business over time. 

Perhaps, like those executives in the United Airlines commercial, you can forgo e-mail, faxes and phone calls, and, just once in a while, put in the time to travel even great distances for a handshake.

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Newton’s First Law of Motion, though revolutionary in its day, is simple enough: An object in motion will stay in motion and an object at rest will stay at rest, unless acted on by an outside force. 

This Law has helped legions of students understand physics and has shaped the world view of generations of scientists. And it works, too, until one gets down to the subatomic world where quarks, fermions and baryons dwell. There, as Daniel Pink says in his revolutionary book Drive about employee motivation, “things get freaky.” In other words, things don’t work the way logic and history teach us they should.

Surprisingly, the same can be said for employee motivation. 

The quest for employee motivation is about control and the application of external force. Speaking as an employer myself, I am constantly thinking about what I can do to control the outcome I desire. I think: “What can I do to raise our revenue by increasing the rate at which files are opened or the efficiency with which work is performed.“  

My mindset, in other words, tends to reflect conventional wisdom of “pay more, get more.”  If you want more widgets produced, hours billed, or projects completed, create a bonus structure that rewards production.   When I took Introductory Economics at Duke in 1982, our textbook instructed us that in a world of perfect information, the parties will work toward a wealth-maximizing result. In other words, wealth was the determinative factor in human motivation. And if wealth is the determinative factor, business owners like me could manipulate wealth, thereby increasing motivation.

The problem is that it just doesn’t seem to work that way with anything but repetitive piecework. Where creative, problem-solving work is concerned, things tend to get freaky.

Time and time again, people leave lucrative positions to take lower paying jobs doing what they truly like. They’ll forgo a W-2 environment for the much riskier (and more work-intensive) entrepreneurial undertaking. They’ll spend hundreds of hours playing clarinet when they don’t have a hope of getting to the stage. They’ll spend hours on Sudoku or puzzles without any kind of incentive or reward. 

My brother-in-law has spent his career as a long-haul truck driver, now working for UPS. From his observation of several large, nationally known companies, he concluded that most people wanted to do a good job. But when companies began installing incentive programs, long-term productivity plummeted. In the short run, of course, the drivers worked to attain the bonuses. Then, as the company began raising the targets and installing more incentives to hit, people began to tie their motivation to the bonus(es) they hoped to achieve. Once they determined that an incentive was out of reach or unimportant, their productivity dropped off to a point far below pre-incentive levels. 

Pink comes to this same conclusion by traveling a different path. Pink refutes the historical incentive laden bonus structure by pointing out such seeming anomalies as the rise of open source products such as Firefox and Linux, the triumph of all-volunteer Wikipedia over the heavily funded Microsoft Encarta, and the pervasive presence of non-compensated, open resources offering everything from car repair advice to recipes. 

In 1999, thirty years after his groundbreaking work as a psychology graduate student at Carnegie Mellon University, Edward Deci, reviewed 128 separate sociological experiments and came to the conclusion that tangible rewards tend to have a substantially negative effect on intrinsic motivation.    Why? Because the creativity and sense of accomplishment that people once enjoyed had, when presented with productivity bonuses, suddenly become “work.” As Pink stated, “over and over again, they discovered that extrinsic rewards – in particular contingent, expected “if-then” rewards – snuffed out the third drive [of internal motivation].”

The challenge, therefore, is a daunting one. It is easy, after all, to figure out the results we want and provide a monetary reward based upon achievement. The challenge, however, is to create an environment that sparks each producer’s internal drive to succeed. 

As we approach the New Year and contemplate, as business people, what we can do to make our own enterprises better in 2011, nothing merits consideration more than the question of employee motivation. We have to determine:

1. What outcomes do we want to inspire; and
2. What can we do as managers to incentivize the outcome without snuffing out that all-important self-motivation?

I’ll write more on this subject in upcoming blogs. Please feel free to weigh in with your comments.

Questions? Comments? Concerns? Raise it for discussion on Facebook, Twitter, or LinkedIn.

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I’m of the opinion that the best way to finance a new business is via the “3 F’s”: Friends, Family, and, for lack of a better term, Fools. Of course, the risk and headache you undertake when you accept money from relatives and close friends is often more aggravating and gut-wrenching than simply taking money from a faceless third party, like a bank or a venture capital firm. Unfortunately, however, because bank and venture capital financing is usually not viable for startups (and I’ll discuss why next week), new businesses are often left with no other alternative than to hit up the 3 F’s.

So, do you like your friends, family members and relatives? Want to continue to have a warm, fuzzy relationship with them? (I’m perhaps assuming too much here, but stay with me.) If the answer is yes (or even if it’s no), and if they’re considering providing funds for you to get your business off the ground, or to keep it running through a rough patch, then take heed of the advice I’m going to discuss here: come to an agreement with them in writing. BEFORE they give you the money.

Perhaps the best way to explain why you need to arrive at an agreement in writing with your family members or friends before they stroke you a check is by discussing what the agreement should, at minimum, include. Here are just a few of the issues you’ll want to focus on while you’re putting together some sort of document to memorialize the arrangements: 

• Did you discuss whether the money was going to be classified as debt (a loan) or as equity (an investment) in the company?

Debt and equity are treated very differently for tax and legal purposes, and they have very different characteristics with respect to repayment and expected returns. Lenders won’t (or shouldn’t) expect much more than 6% - 12% annual interest, plus return or amortization of principal on some agreed-upon schedule. Equity investors, however, often have visions of buying a Greek island with the triple digit returns they expect to make via an investment in your company. Which would certainly help out the Greek economy, these days.

If the money is a loan, you’ll want to deliver a Note to your lender (yes, even if that lender is a relative or friend) which includes, at minimum, the principal amount, interest rate, maturity date, default provisions, repayment/amortization schedule and terms, possible collateral (in which case you’ll also need a security agreement and a UCC filing or a deed of trust), and dispute resolution terms. If the money is an investment (equity rather than debt), you’ll want to include the family member or relative as a shareholder or member of your corporation or LLC, and the rights and obligations of both the company and the equity investor must be spelled out in detail in the company’s constituent documents.  If you want to avoid problems both legal and personal, that is

• Did you provide anything in writing describing your business and the expected return on an investment in your business (e.g., a business plan or a more sophisticated document, such as a Private Placement Memorandum)?

Bear in mind that even the smallest startup is bound by the antifraud provisions of federal and State securities laws with respect to the raising of equity capital, as opposed to debt financing. There are filings to make (such as a federal Form D and state Blue Sky filings), documents to deliver (such as subscription agreements, accredited investor questionnaires, and shareholder or operating agreements), and regulations to follow. Each investor must receive exactly the same information as each other investor, so if you delivered a business plan or PPM to any investor, you’ll need to deliver the exact same document to ALL potential investors. Running afoul of any of these requirements could result in serious problems for your business if you ever find yourself in the middle of a dispute with your investors.

It would also be very useful to prepare a set of pro forma financial projections demonstrating the expected return on an equity investment. This is not only useful for managing expectations, but it’s also important, from a legal perspective, that you disclose any and all material facts about your company and its prospects to your potential investors.

• If the company goes belly-up (and lots of startups do), what are the rights of your lenders or investors? Remember, we’re talking about your friends and relatives here. Will they expect you to personally make good on their losses? Will they silently seethe and exclude you from all future family functions while badmouthing you within the business community? Are you sure you’ve discussed these issues with them and that your documents accurately reflect both your intentions and your investors’ or lenders’ expectations?
  
• Suppose the company needs additional cash. Do you have a right to subordinate the loans of your family members to subsequent lenders (such as other family members)? Can you subordinate their Notes to a bank? (It would be a very good idea to retain this flexibility in case it’s ever necessary to utilize it.) Or, in the case of equity, do you have the ability to dilute the shares or equity interests you issued to your family members or friends by issuing additional equity to third parties?
  

These are just a few of the many issues you’ll need to consider as you raise money at the startup phase or for ongoing operating expenses. Which is why it bears repeating: if you’re going to be raising money from third parties (even if, or especially if, they’re relatives or friends), be sure you put the terms in writing. A very detailed writing. When all parties understand up front what their rights and obligations are, it’s much less likely that you’ll end up estranged from your family members down the road. Remember that you’re going to be married to your relatives and friends for an extended period of time via your mutual business interests in the company. There are rarely any divorces, and courts are not sympathetic to family issues in corporate disputes.

So, before you take money from the 3 F’s, ask yourself: Are you ready to get married? And is the necessity of financing the business worth the potential family issues that could arise down the road? If the answers are yes and yes, be sure you put the arrangements in writing at the outset, and be sure all parties sign that agreement before any money changes hands.

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