Incorporation Disaster

Incorporation of a small business can have unexpected results. 

Let’s say Bob owns and operates a gift shop as a sole proprietor.  He has an employee named Jim, who has worked in the store for two or three years.  Bob and Jim get along well together.  Bob doesn’t want Jim to leave, and the shop needs remodeling requiring $25,000 that Bob doesn’t have.  Jim does, having just received a modest inheritance from his Aunt Sally.  Bob suggests that Jim buy into the business.  Bob will form a corporation and get 51% of the shares.  Jim will get 49%.  Bob will contribute the business to the corporation, and Jim will contribute $25,000.  Sounds like a good idea.

Bob goes on the Internet and finds a do it yourself incorporation package, fills in the blanks in the articles of incorporation, and sends them off to the Secretary of State.  The rest of the forms and the instructions are complicated.  Bob and Jim do their best.  They sign the form of organizational minutes, making themselves directors and officers, and fill out two of the preprinted stock certificates.  There’s also a form in the package called an S election, which Bob’s bookkeeper says is a good idea, so they fill that out and send it in too.

Bob puts all the papers in a looseleaf binder that came with the package, with “Minute Book” stamped on the cover in gold letters, and he and Jim put the notebook away.  Time passes.  The bookkeeper produces corporate tax returns and K-1 forms to go on their personal tax returns.  The remodeling is a success and business improves, but only for a few years.  The new gift shop in the new mall down the street sucks away many of their previous customers.  Jim decides to move on to greener pastures.  He tells Bob he’s going into web design and wants his $25,000 back.  In exchange he’ll transfer 49% of the shares to Bob.

Having a secret gambling habit, Bob still doesn’t have $25,000.  He goes to see a lawyer, Mike, and brings the corporation’s profit and loss statements and balance sheets with him.  Mike looks them over.  He explains to Bob that a departing shareholder has no right to get his investment back, and explains to Bob that a fair price for Jim’s shares would be 49% of the value of the business, based on its liquidation value or its value as a going concern.

The liquidation value seems to be close to zero.  The inventory and fixtures have little market value, there are no receivables, and the lease won’t be over for another four years.  There’s also a  loan from Bob’s Aunt Mary, which he took out when he started the business.  The outstanding balance is $30,000.  The going concern value of the business is also marginal.  Bob and Jim have never been able to pay themselves more than somebody they could hire to do their jobs. Bob tells Jim he’s sorry, but all he can pay Jim for his 49% is $5,000.

Jim goes to see a lawyer, Dick, who also happens to be an accountant, and brings along the financial statements and the Minute Book.  Dick looks at them and has some comments.  There’s nothing in the Minute Book about salaries, but in good months Bob seems to have taken out considerably more than 51% of the net profit before taxes.  There’s also nothing in the organizational minutes indicating that the corporation assumed Bob’s loan from Aunt Sally, although the payments on the loan by the corporation total $45,000.

Dick agrees that the business isn’t worth much, but he explains to Jim that as the owner of more than 35% of the shares he can force the liquidation of the corporation, and in the liquidation there will have to be an accounting.  The accounting will show that Bob must reimburse Jim the amount Bob took out of the business in excess of 51%, and that Bob owes Jim 49% of the payments the corporation has made to Aunt Sally.  The reimbursement looks like $23,000, and 49% of $45,000 is $22,050.  Jim’s shares may be worthless, but Bob owes him around $47,000 anyway.

Bob is outraged when Jim tells him the news.  Bob promptly goes to Mike and asks him to notice shareholders and directors meetings so that Jim can at least be removed as a director and officer.

Adding insult to injury, Mike informs Bob that California has something called cumulative voting for shareholders.  Bob cannot remove Jim as director or elect a new board with a compliant replacement for Jim unless Bob owns 68% of the shares.  Directors’ decisions are made by majority vote.  Bob can remove Jim as an officer and fire him, but Bob can’t get rid of him, except by liquidating the corporation.

Bob swallows hard.  Luckily his Uncle Steve is wealthy and has a soft touch.  Bob tells Mike to offer Jim $10,000 through Dick and threaten litigation.  Dick laughs, counters with $45,000, and tells Mike he’ll see him in court if Jim doesn’t accept it.  After considerable yelling and screaming, as well as attorney fees, Bob and Jim reach a settlement at $35,000.  Putting it mildly, Bob regrets incorporating and offering Jim 49% of the corporation.  Instead Bob should have borrowed the $25,000 for the remodel from Uncle Steve.

San Diego Business Attorney Stanley D. Prowse specializes in California Corporate Law. We are located in Carlsbad California and welcome your legal inquiries.

By Attorney Stan Prowse
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