October 24, 2014

Mail Bag – Taking on a Small Business Partner for a Startup

For all you small business owners or start-up aspirers out there, this question might be of interest to you because it involves taking on a small business partner.

Mr. Kennon,

I need help and I’ll try to keep it brief.

Mail Bag Questions and Comments for Joshua KennonBackground:  I’m a 36 yr old stay-at-home mom of 3 (all under 5). We are a family of 5 living on $30K and public assistance. I recently started my wedding planning business to bring in more income.  My very first bride thought that I did such a great job that wants to invest in my business as start-up capital. I desperately need this money to get incorporated, to finish the financial part of the business plan, to advertise and attract more business, to eventually help my household and fund 2 additional business ideas.  

The Challenge:  My investor is willing to invest $10K (which will only last 3 months) and in exchange wants 20% ownership + repayments for a lifetime. This is crazy.  I can’t do it – but I don’t know how to counter-offer b/c I’m new to the business world and business/accounting/financing/investing.  I still don’t know what some of these terms mean (i.e. shareholder capital, dividends, etc.) I have so much to learn, but not enough time b/c she’s moving out of the country next month.

HELP!!! What should I do? What should I counter-offer with.  Please keep in mind that she INSISTS on having payments for a lifetime.  

Thanks in advance.

You need to stop.  Calm down.  Sit down.  Relax.  Otherwise, you are going to get yourself into a terrible situation that will cause you and your family a lot of financial pain, emotional turmoil, and wreck any chance of success.  You sound like you are on the verge of making an absolutely idiotic decision.

A Few Things to Look for In a Potential Small Business Partner

If you take on a small business partner, there are a few things I would look for in a person:

  • He or she brings a skill set to the table that compliments and augments my own so that the sum of our activities are more geometric rather than arithmetic.
  • He or she is ethical and honest, having the same values that I do so the culture is compatible.
  • He or she does not suffer from drug addiction, alcohol addiction, gambling addiction, sexual addiction, or another addiction that could cause them to neglect or steal from the business to fuel their compulsive behavior.
  • He or she is willing to risk their own capital alongside mine so that our interests are fully aligned.
  • He or she has the same expectations, which are clearly stated, about the business that I do.  These, along with the way we operate, are spelled out in an operating agreement that we develop together.
  • There are exit mechanisms with pre-determined financial components already discussed so that if something arises and one of us wants out of the partnership, there are no emotions involved and we can avoid an acrid or acerbic fallout.
  • The terms are favorable and won’t cause me to lose sleep at night or feel cheated.  Likewise, I would want the potential small business partner to feel the same way.

First, The Good About Your Specific Situation

First, let’s look at the good about your specific situation regarding a small business partner:

  • You wisely realize that it is impossible to have a family of five and live well on only $30,000 a year pre-tax.  It isn’t a matter of cutting your expenses, you just don’t make enough money.
  • You are researching concepts such as return on investment and trying to educate yourself, which means you are motivated, driven, and want to be self-reliant.  That is a huge advantage.
  • You know that you are ignorant when it comes to many business and accounting concepts.  This, too, is a huge advantage.  Avoiding disaster is easier when you know what you don’t know.
  • You seem to recognize that the fastest way to a better life in the United States has historically come from equity ownership of a business.

Now, the bad.  You might want to get a cup of coffee.  It’s going to be awhile.

You Acknowledge Your Belief That The Deal Offered by the Potential Small Business Partner Is a Bad One … Yet You Still Want to Counteroffer?!

You call the terms that were presented to you by your potential small business partner “crazy”.  Yet, you are so desperate for cash you are contemplating them!  Are you nuts?!  I see people do this all the time.  One of my professors in college would always remind us: You can always change your mind and walk away.  You don’t have to take a deal or a contract.  Just walk away.

The bad deals you avoid are just as important, if not more important, than the good deals you accept.  A bad deal takes time, emotion, energy, and money.  A bad deal invites a partner into your business who wants a say in how things are run.  I hate bad deals.  I’ve said no to a lot of interesting opportunities simply because I don’t even want the possibility of being in business on any terms other than my own.

Oh, and not to mention, decisions made under a tight deadline are almost always going to turn out bad, especially if you don’t know much about the subject.  This whole nonsense about the potential investor going out of the country?  Bullsh*t.  I’m sorry.  It doesn’t matter if I live in Spain or Switzerland, Hong Kong or Dubai, if an investment is promising, money can go anywhere.  The deadline is entirely artificial.

My father has a rule: If he feels rushed, he says no.  It doesn’t matter if he is buying a car, a business, or a piece of equipment for his factory.  He says no even if it means he walks away from a lot of money.  It has served him extraordinarily well throughout his career.  (This is why it is important to be informed before opportunities present themselves, having what Charlie Munger calls a “prepared mind”.)

It all comes down to a simple question:

  • How much are you willing to give up in exchange for a $10,000 investment today?

Honestly, I think you have so convinced yourself you need this money that you are going to accept the cash, no matter how stupid the deal is, no matter how bad the terms are, and no matter how destructive it will be to your family’s finances in the long-run.  You are convinced that having a pile of money for startup costs is going to solve all your problems.  I’m willing to bet it will make it worse.  But I’ve been doing this for a long time.  I think it is going to end in disaster because your investor sounds like his or her expectations are completely unreasonable and your financial projections (we’ll get to in a minute) are doomed since your business model is fundamentally flawed.

You Have a Much Larger Problem Than Taking on a Small Business Partner.  Can You Explain Why Your Start-Up Would Burn Through $40,000 Per Year?

I happened to be carrying a pile of Mail Bag submission questions into a board meeting for the family sporting goods businesses when I came across yours.  I read it out loud, without comment, and the very first thing that startled everyone in the room was that you said a $10,000 investment in your company would only last three (3) months.  That would indicate that just to keep the doors open, your new business would need almost $3,400 in cash each and every month and if you don’t immediately earn a profit or raise additional money, you are going to be in the same situation 90 days from now.  Only, this time around, you will have already given up 20% of your business plus have a fixed payment going to your first investor who will, no doubt, have to approve the new terms for additional investors.  On top of that, you might break your state securities laws by issuing stock to investors without filing the proper paperwork and getting exemptions.

This makes absolutely no sense.  Your startup costs should be minimal since you get to begin with a blank slate.  Unless you have the capital in place to fund a start-up, you have to bootstrap your way to profitability and demand profits almost immediately, from the first sale.  You cannot behave like an established business; you have to grow in to those facilities.  You’re talking as if you were a suburban housewife with a $20,000 a month income that you can use to support your nascent enterprise.  You’re not in that situation so recognize that and figure out what you can do based upon your own opportunity cost.

If I had to imagine how we would have started a wedding planning business, we would probably:

  • Incorporate the business ourselves, which costs $105 in the State of Missouri and can be done electronically online.  Most other states are comparable in the fees.  Companies like Legal Zoom can incorporate LLCs in many states for as low as $99 or even as low as $359.  You can get an EIN from the IRS online and you can go to your local state sales tax office to get a sales tax number for your business, allowing you to open wholesale accounts with vendors. I mean, I could get a shell LLC open in under 45 minutes with almost every single license required if all the paperwork was in order and the total cost would be $200 to $500.  It’s just not hard.
  • Work from home to keep costs extremely low.  I wouldn’t add a single penny in fixed expenses unless absolutely necessary.  Fixed expenses are what kill a start-up business and force it to close its doors.
  • Self-print business cards and work with every flower shop, church, tuxedo rental store, and party venue in the geographic area, offering them a percentage of the sale for every wedding they refer to you, essentially creating a free workforce that you don’t have to pay unless they bring in cash.  You couldn’t buy that kind of advertising and it is going to be far more effective in many cases than putting ads in a newspaper or magazine.
  • Require a 50% down payment on all wedding planning contracts, providing the working capital you need to buy whatever supplies, etc. are necessary.  In the beginning, you shouldn’t have to use your own equity capital (you don’t have any!) but instead be able to use the “float” from a negative cash conversion cycle.
  • Sign up as a wholesaler for many wedding supply companies so you pay 30¢ to 50¢ on the $1.00 for your merchandise.  I mean, you could open an account with a firm like Kate Aspen in a few minutes and earn a 50% gross profit on any wedding favors your brides used at their events by having them buy the items through you.  Since you took a 50% down payment, the down payment would cover the entire bill and the second, final check for the full amount would represent your profit.  You could do $100,000 in sales tomorrow and not have a penny of your own money involved.  It’s just not that hard.

But this nonsense of requiring $40,000 per year to keep your doors open when you are starting in a business that isn’t capital intensive and can be bootstrapped rather easily is only going to end in disaster.  Even worse, if you’ve brought on outside investors, you may face a situation where they sue you for losing their money.  But there just isn’t a need for outside investors.

Profit Margins Must Be Adjusted for Your Time

Let’s be clear: You aren’t creating a business, yet.  You are creating a job that will allow you to take all of the company’s earnings out in the form of a paycheck.  You hope, one day, to turn it into a business (which is different – a business is a systematic machine that generates profits for owners each year whether or not they show up to work in the morning; e.g., if you owned 10% of Pepsi, you’re going to get richer whether you work at Pepsi or not because there is an entire infrastructure in place focused on growing the company’s sales, profits, and brands).

That means you absolutely must factor in the cost of your time!

If you do a job for $1,000 and earn a $200 profit, you might brag about a 20% profit margin.  But if it took you 40 hours to complete the job, you only earned $5 per hour pre-tax, plus you are going to get hit with the full 15.3% self-employment tax since you are both your boss and the employee.  If you can earn that same amount but only spend 5 hours on the project, you are earning $40 per hour.

Your time, and the amount you can earn for each unit invested (1 hour), is one of the most important keys to your success.

You Are Being a Shot Gun Not a Rifle

If I had to bet money, there is one line in your message that almost makes me positive your idea will fail:

I desperately need this money to get incorporated, to finish the financial part of the business plan, to advertise and attract more business, to eventually help my household and fund 2 additional business ideas.

Yeah, that last line is a problem.  Legendary football coach Jimmy Johnson once told a reporter that he succeeded when others failed because most people are shot guns – they spray their energy out like crazy, never focusing on one thing, just like the buckshot that comes out when the trigger is pulled.  He, on the other hand, is a rifle, with a single, high powered bullet that focuses on a single target.  He is going to achieve that target and not stop until he has.

You haven’t even proven you can make money from a wedding planning business.  You haven’t proven you can turn it into a machine to fund your family’s lifestyle.  You haven’t proven you can build a company.  You haven’t proven you can attract sales.  You haven’t proven you can earn a profit.  Yet, you want to pursue three – THREE – simultaneous startups?  That is nuts.  It virtually guarantees failure.

Even those who achieved a lot in different fields – think Benjamin Franklin, who was an inventor, scientist, politician, investor, author, philanthropist, philosopher, etc. – didn’t try to do all of these things at once.  He spent years of his life focused on single tasks and mastering them.  Had he tried to achieve them all simultaneously, he would have failed miserably.

Every man, woman, and child is given 525,600 minutes in a year, and roughly 477,700 effective hours of life adjusting for sleep and other factors.  You have to invest that part of your two-buckets in the project that promises the best return based on your wants, desires, skills, and risk level.

Over time, as you became profitable, then you could consider other venues that allowed you to reinvest your profits, such as buying a local floral shop or tuxedo rental shop and doing it all in-house so you made even more money from each wedding.  Or expanding into baby showers and corporate events … the list depends upon your own opportunities, skills, desires, and resources.  Your goal is to do intelligent things that don’t risk your family’s well-being and only you can decide what those are.

Those are the things that would be on my mind.  I wish you luck and hope you are successful, but would urge you and caution you to seriously evaluate your current plans and operating philosophies.  

  • FratMan

    Hey Joshua–I had a mailbag question for you, and I don’t know if this is something you’ve had to deal with much, but how do you remedy situations where you’re typecast? Obviously, this can be either positive or negative. I once had a teacher who would give me an A on anything I turned on, mostly due to the name at the top of the paper, as opposed to what I actually wrote. But it can cut the other way too–family members who treat you a certain way based on old perception of you, or to use my first example, I once had a teacher who was close friends with someone who saw me, how shall I put it–not at my best, so he was convinced I was an idiot and never gave me the benefit of the doubt. I suspect ‘typecasting’ might be a contributing reason as to why people often don’t show up to reunions of sorts–anyway, how would you deal with people who try to compartmentalize you into a box based on how you were five, ten years ago if it no longer reflects how you are today? 

    • Gilvus

      Five internet bucks says Joshua will say something pertaining to his internal scorecard :-)

      • Joshua Kennon

        I could always flip it around and say it backwards as, “Don’t let social proof influence your thought process.”

        • Gilvus

          FratMan, I owe you five Internets >:-(

  • FIJIM

    I came across this site when I was researching holding companies. I have been checking the site ever since.  I must say this article is the best advice I have ever read about starting a company.  As a Owner in a small business, if someone would ask for just one piece of advice, I would just print this article out and say send your thanks to Joshua.  Great work, please keep it up!

    • Joshua Kennon

      That is very kind.  Thank you very much; I’m glad it was helpful.

  • Joshua Hill

    Gosh, Kennon, you ripped this woman apart when it came to this interesting situation XD. For me, I would just said no to the repayments for a lifetime. Has me thinking about that show, Shark Tank, I wonder if the entrepreneurs know that they are getting duped. They are rushed into explaining the entire thesis of their company in a very short time. Not to mention that now their name is across the media outlets attracting others to that niche market that the entrepreneur created. How do you develop that mentality to refuse big offers (e.g. $100,000+) how do you refuse that negative and positive sword of capitalistic greed? How can you not be dazed by dollar signs when you know that money invested can lead to huge results over the long term but giving up huge ownership?

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