Exorcising the Ghost of Partners Past

Cliff Ennico

“Three years ago, I started a business with two other guys. We set up a limited liability company (LLC), and split the ownership 40%, 40% and 20%.

The business grew for about a year but then really tapered off when the recession hit. All three of us had to take ‘day jobs’ just to make ends meet, but we kept the business going on life support in the hopes things would get better when the economy improved.

Two years ago our 20% partner (let’s call him “Joe”) got a full-time job and decided he didn’t want to be partners with us anymore. The trouble was he had put $25,000 into the business and didn’t want to write it off.

So, in exchange for his withdrawal from our company we agreed to pay him $25,000, plus interest, in two years.

Three months ago the two years was up. We still owe the $25,000, plus another $250 in interest. Our business has some sales but isn’t showing a profit and there’s no way we can make the payment. We tried to contact Joe and offer to extend the loan for another two years in the hopes things would improve. He hasn’t returned our phone calls, and a certified letter we sent to his home was returned to us as “unforwardable”.

So now we have a problem. We’re pretty sure Joe doesn’t have the money to sue us to collect the debt, and even if he did, our company has no money to make the payment (fortunately, the remaining partner and I didn’t personally guarantee Joe’s loan so our houses are not on the line).

How should we deal with Joe at this point? Can we just blow him off?”

I agree that it is highly unlikely Joe will sue you to enforce his debt, at least right now when your company has no assets. But there are three reasons you should not “blow Joe off” in this situation:

  1. In most states, the statute of limitations for “breach of contract” (such as a loan default) is quite long – sometimes as long as three to five years – so Joe has plenty of time to wait until your company is growing and making serious money before he “lowers the boom” and brings a lawsuit against you;
  2. In such a lawsuit, Joe is likely to argue that the two of you didn’t run the business seriously enough, in an effort to persuade the court to “pierce the corporate veil” and allow him to go after your personal assets, even though you did not personally guarantee his loan;
  3. If anyone expresses an interest in investing in your company, you will have to disclose your default on Joe’s loan and your outstanding debt to Joe as a “contingent liability” of your company – a sure “turn off” for any potential investor.

You should make every effort to find Joe and get him to the bargaining table. His full-time employer should be able to give you a forwarding address, even if Joe no longer works there. Hire a private investigator if necessary.

Once you track down Joe, you should definitely offer to extend the loan but will need to include some “bells and whistles,” both to make the deal more attractive to Joe and make sure you don’t find yourself in exactly the same situation two years from now.

Here are some ideas you should run by your attorney:

  • A “call” provision allowing the LLC to convert the debt back into a 20% equity stake in the company if the debt isn’t paid on time;
  • A “preemptive right” provision allowing the LLC to convert the debt back into an equity stake in the company if someone invests $250,000 or more into the company (the conversion price would be the same paid by the new investor);
  • A “net proceeds of sale” provision giving Joe 20% of the “net proceeds” (basically gross proceeds less brokers’ commission, legal and accounting fees, and other transaction expenses) of any sale of the company during the two-year period; and
  • An “equity kicker” provision giving Joe options or warrants to acquire shares in the company, in addition to the interest on his loan.

It might be that Joe is in a better position than he was two years ago and is willing to write off his $25,000 investment in your company. If he does, though, be careful of unintended tax consequences. The federal tax laws treat the “forgiveness of debt” as income to your company. Since your company is an LLC, that $25,000 in “phantom income” would pass through to you and your remaining partner and you would each have to pay taxes on your share.

In fact, if Joe really hated you guys and wanted to get back at you, the best way for him to do that would be to send you notice forgiving the loan. Hopefully he’s not reading this right now.

Cliff Ennico is a lawyer specializing in legal and tax issues for small businesses, and is a popular instructor at eBay University. Copyright 2012, author retains ownership. All Rights Reserved.

Category: Legal
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