By Cliff Ennico
“I’m thinking about joining a new web-based business where I would be one of three founders. The other two founders came from a previous company that’s being liquidated, and the startup is buying the assets of the previous company with the proceeds of a bank loan. The loan money will be used to cash out the other owners of the previous company who are not joining the new startup, but as part of the deal the new startup will be assuming some debt that had been held by the previous startup.
“What sort of legal due diligence should I do before getting involved with this startup?”
There are a number of issues here.
To some extent, this is a family business: Although the other two partners may or may not be related by blood, they are joined at the hip somewhat because of their involvement with the previous company. Assuming they will own the majority of the shares and that you will be a minority partner, you are likely to be the odd person out when decisions need to be made.
One of the oldest rules in the small-business world is never join a family business unless you are a member of the family or marrying into it. Ask some tough questions about the role you will be playing in the company, and make sure you don’t end up the person who has to mediate between the two other founders when they disagree.
Legally speaking, there are three things you need to be concerned about.
First, you should make sure there has been full disclosure that the two founders are owners of the new startup. They may have been bound by a noncompete or other restrictive agreement with the previous company that will need to be waived once the acquisition is completed. If they have not disclosed their involvement with the new startup, someone (preferably their attorney) will need to give you a letter saying that their involvement in the startup does not violate any agreement they may have signed with the previous company.
Second, you want to be sure that you will not be required to personally guarantee the bank loan that will finance the startup. By doing so, you will be putting all of your personal assets — your house, your bank accounts, everything — at risk if the startup fails. If the other two founders insist you guarantee the startup’s bank loan, walk away.
The third concern has to do with taxes.
I assume you will receive sweat-equity shares in the startup as a reward for the knowledge, experience and services you will be expected to provide, and that you won’t be paying cash for your shares. Normally, in a startup situation, you won’t incur much of a tax liability upon receiving these founders’ shares, because a startup is deemed to be basically worthless. Thus, the shares have no value.
But this situation is different: The startup will be acquiring the assets of the previous company and so will have a value on the date it is incorporated. Unless you pay something for your shares, you will be taxed at ordinary income rates (currently as high as 40 percent) on the value of your shares because they will be considered compensation for your labor. Since this is a startup, the company will probably not be able to reimburse you for the taxes you pay, so you will be stuck with that liability.
There’s a silver lining here in that the startup will not only be buying the previous company’s assets but also assuming some debt that it owed to creditors. If the amount of the debt exceeds the value of the assets being purchased from the previous company, then the startup will be deemed worthless and you will not have to pay taxes when you receive your founders’ shares.
This means that someone will need to tell you — in writing — that the amount of debt the startup assumes is greater than the value of the assets it is acquiring from the previous company. I would not accept such a “cold comfort letter” (so called because the person writing the letter does not state positively that the information is correct, only that nothing has come to his or her attention to indicate it is not correct) from the two founders. This determination will need to be made by a professional (accountant, CPA or valuation analyst) at the time the startup is formed.
You should insist on receiving a “cold comfort letter” from the professional saying that, based on a review of the startup’s financial condition on the date it acquires the assets from the previous company, the amount of debt being assumed by the startup exceeds the value of its assets when all the dust settles.
“The professional will almost certainly hedge the opinion by saying that a formal valuation of the company was not undertaken and that such a valuation might lead to a different conclusion. But at least you will have something to show the IRS if you are ever audited and it claims you owe tax on your shares.
Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series “Money Hunt.”
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