Winning at Entrepreneurship. Rod Robertson
in you are very serious responsibilities. Your conduct is held to high moral and legal standards as well. It is a mixed blessing to have partners/investors. Many sole proprietors without outside monies have the luxury of running their business like a frat house. A friend just told me that he bought a Rolls Royce and charged it off to the business, and he is not in the limo industry! I have heard legions of stories of cash under the table, home improvement charges run through the company, and multitudes of other questionable expenditures, all undertaken to beat the taxman. These owners are taking a BIG RISK and, in most every instance, have the capital to pay taxes but have decided to try to throw the slider by the government. They usually do not realize the double and triple jeopardy they are playing. If a miffed employee plays whistle-blower or ownership activities throw a wrinkle in their financials that leads to an IRS audit inquiry, the unraveling of their misdeeds can be catastrophic. Not only are they called on the carpet for their one-time sin, but the IRS auditors also will then have the ability to look back year over year for other suspicious activities. Besides the obvious costs and trepidation, IRS deep dives lead to paralysis and then a public censoring that will tarnish the business for years. Any such transgressions could lead to investor lawsuits as well.
Below are a number of ways to run afoul of the IRS.
1 Not having good record keeping from the beginning. It is essential to the financial well-being of your company that you start good bookkeeping from the very beginning and build a sound practice from there.
2 Make sure to separate personal financials from your business financials. Co-mingling funds could lead to a personal audit as well. You may “lend” money to your business, but it must be recorded and eventually paid back.
3 One must always set aside cash to pay for estimated personal income taxes. Cash flow is always tight up front, but one must be disciplined to set aside monies. Once a new owner falls behind and cash flow is restricted, this can lead to poor decision making at tax time.
4 Make sure not to take a convenient short cut by paying employees as “independent contractors.” Although keeping employees under thirty hours or outside of the company avoids health insurance costs and a multitude of other “tag along” issues, the IRS is becoming a stickler on giving workers more protection. They can look at back records and make an owner pay severe retro costs, so beware of this possible trap.
5 Do not ignore IRS calls or inquires. They will not go away. They will circle back, and eventually the owner will have to confront these issues. In recent years, stories of IRS employees browbeating citizens has actually made for a more friendly IRS. Avoiding the IRS is TAX EVASION.
6 When you own a business, speak with your accountant regularly, especially in the beginning of ownership.
7 Keep your business-related receipts, and take the time up front to log everything accordingly. Credit-card receipts without a record of who was entertained are not enough. If the IRS sees sloppy record keeping this year, they may start looking back several years …There is no need to be afraid of the IRS, but self-employed people do have to pay attention to IRS regulations that affect their business. The incredible freedom of owning your own business comes with some additional responsibilities.1
There is much operational good associated with taking on investors. Many operators have a tendency to slough off on operational procedures and slip into an operating mode that would be unacceptable to an outside entity. Most investors invest in companies where they have some industry-related experience or have been aware of the company’s performance for some time. This level of knowledge changes the landscape, and most sound operators will tighten up their procedures and reporting with other partners on board. Investors should request or be provided with periodic financials that show the course of the company and highlight management’s efforts on their behalf. This minimal oversight is extremely beneficial to ownership— no more Rolls-Royces!
“Smart money” that actually wants to assist the company is the best type of investor. This class of investor, usually with industry connections and expertise, will assist in driving revenues and have the owners running a tight ship. With industry experience, the investor can make recommendations on operations, as well as contacts and introductions, that will enhance the returns on their investment.
But what about the pain-in-the-ass, “know-it-all investors? This breed can be a scourge, especially when they think they know a better path and are ready to tell the owner/operator ad nauseam how to pilot the ship. Their clucking and hissing can be the proverbial nails on the chalkboard. Bringing in these “masters of the universe” could lead to a serpent in the nest. If the business goes sidewise and these unemployed know-it-alls believe they can do a better job or contribute on a full-time basis, watch your back for their unwanted intervention.
— CASE STUDY —
We had a client, Rich, an officer and a gentleman, who founded a business and grew it to over thirty million dollars in revenues while making it very profitable. Along the way, he took in two hundred thousand dollars from seemingly professional investors. After a good run, however, the company was hammered in the recession and was tottering on insolvency. Rich, like so many clear-thinking executives in his position, decided to go through a quick sale to a strategic player. He had the safety and well-being of his employees in the forefront of his thoughts and realized he could use the strategic horsepower of a major industry player to bring his products to market. We, as intermediaries, were moving briskly to a close with Rich’s company to an industry player when the “investors” reared their ugly heads and tried to step in and take over the company while disrupting the sale by every means possible. This included calling the bank that was holding the loan and other shareholders and even threatened us with a lawsuit if we continued with the selling process. They were after a hostile takeover, which was eventually quelled. These were sophisticated investors who simply were looking for a job and attacked the company like bull sharks. Rich held them off and sold the company to an industry leader where the company flourished once again. Post-sale, Rich stayed on as CEO and ramped up sales quickly, and all ended well.
Always understand the motives of your investors, as many can be angling for more than just a return on investment.
A FULL INVESTMENT CYCLE
This chart sets forth a classic example of an individual starting a company that is doing well and needs growth capital. It depicts the sums of cash going into the business (“Funds Invested”) by each group and the approximate valuation of the company after each investment. The “Founder’s %” column shows the diluting effect to the founder as more cash flows in through investors.
The sequence below of a sample transaction of forty million dollars shows the estimated cash or “waterfall” of cash that will trickle down to the final tally for the original founder.
FOUNDERS CONTRIBUTION: ($0–$100,000)
What can you afford to ante up? You certainly do not want to be known as the “mouse that roars.” No matter what path you are going to take—sole owner, partner, franchisee—you have to have skin in the game to be taken seriously. Financial players and backers will understand if you’re a person of modest means. I often find myself quoting Winston Churchill, “There goes a modest man with much to be modest about,” when I see a founder not putting in any cash. If the investors feel you are putting in half of your available cash and that contribution is only, say, 5 percent of the equity needed for the acquisition, they know you are risking your cash reserves. They want you to feel the pain!
Sweat equity: work and effort by an owner that results in an increase in value of his or her company; also the work by an employee that eventually gets stock in firm.
Contributing sweat equity is fine, but to maintain a reasonable stake in an enterprise, one must have equity (cash) in play. When one is cranking up a start-up and actually has created value in the enterprise, then the upcoming dilution