Silver Zephyr Restaurant
Attorney Linda McGrath leaned back in her chair and surveyed her clients as they conducted several conversations simultaneously. The "Magnificent Seven," as the group had labeled itself, consisted of Alan Anderson, C.P.A.; Bill Barnes, M.D.; Carl Cochran, M.D.; Don Davis, president of Davis Petroleum Distributors, Inc.; Eilene Ellis, co-owner of the Collectors' Gift and Antique Shoppe, Inc.; Farrah F. Fischer, artist and widow of the former president of Northern Savings and Loan Association; and Gino Ginelli, managing partner of Wichita Falls Vending and Catering Company. The group had retained Linda McGrath six weeks earlier to assist them in starting a restaurant in Wichita Falls, Texas.
The idea of a new family-style restaurant with a distinctive motif had been developed by the group at a series of neighborhood dinner parties during the winter months. Linda could not help smiling as she recalled that Eilene Ellis and Bill Barnes had commented that they were the "chief engineers" of the railroad theme that the group favored. Fortunately for the other members of the group, Alan Anderson had taken the initiative and seemingly done a thorough job. He had prepared pro forma financial data, determined the costs of various sites, and gathered preliminary bids from several contractors on the site work, paving, and restaurant facility.
Alan and Don Davis had discussed the project with the executive vice president of commercial lending at Texoma Bank, and it was Alan who had suggested that Gino Ginelli was the logical person to operate the restaurant and should be included in the group. According to Anderson's figures, the acquisition of land, building, and fixtures would require approximately $875,000 to $890,000. Further, Alan had estimated in the pro formas that working capital needs in the first two years would reach between $180,000 and $200,000.
In addition, Eilene and Farrah Fischer believed that the unique furnishings and railroad memorabilia could be obtained for $125,000 to $150,000. Based on a forecasted total requirement of $1,200,000, officials at Texoma Bank had suggested capitalization of $600,000 and were willing to loan the other $600,000 on a five-year note, floating at 3 percent above prime, assuming unlimited personal guarantees by all group members and their spouses. Although Alan and Don commented that they were surprised Texoma had not asked for their first-born children as further collateral, they told the group that there had been indications that the loan officers would be willing to extend the term to seven years and perhaps accept an initial debt-to-equity ratio of 1.5 to 1.
Individual Concerns
Whenever the group had met with Linda McGrath, all of the members had professed a strong desire to initiate the business. Gino, who had successfully managed a restaurant in Omaha before purchasing his present business in Wichita Falls, was particularly enthusiastic about getting back into the restaurant business. Eilene and Farrah had talked excitedly about collecting the furnishings needed to create the desired atmosphere, and Alan and Bill had always seemed solidly in favor of the venture. In fact, Alan and Bill had discussed the possibility of having a series of railroad restaurants and involving other investors if this venture was successful. In private conversations with the attorney, however, several of the group members had expressed concern about their involvement in the project. Inasmuch as everyone agreed that Gino should have the controlling interest in the proposed business, Gino was somewhat apprehensive about the amount of initial capital required and its potential effect on the vending and catering business that he and his brother had developed and were expanding.
Bill, on the other hand, expressed concern that opportunities to establish other locations might be foreclosed by Gino's reluctance or inability to expand beyond Wichita Falls. Don, accompanied by his accountant, had asked several questions concerning the marketability and protection of minority interests in closely held companies and the tax consequences of his investment. Don and Carl Cochran were quite disturbed by the bank's requirement of unlimited guarantees by all investors. Indeed, Carl stated that he would rather invest in real estate than in restaurants but felt that he had given his word to his colleague Bill and would be horribly embarrassed to withdraw at this point.
Lastly, even Alan, in spite of herculean efforts on behalf of the group, admitted to Linda that he would prefer the relative safety of a limited partnership, as he was aware of the high rate of failure among restaurants.
Legal Advice
Attorney Linda McGrath quieted the group and began to speak: I've given the restaurant venture a lot of thought this week, as I'm sure all of you have. Based on my analysis of the situation, several alternative forms of ownership appear feasible. Each of these legal forms has certain advantages and disadvantages, and I certainly want us to explore thoroughly the pros and cons of each legal form before you reach a decision. However, before we discuss the alternatives, please let me make a few observations that I believe are germane to your decision- making process. First, the legal form you choose must be flexible enough to include seven people.
To be sure, you appear to be seven of the most congenial and compatible persons I have ever encountered, let alone represented, in a business situation. On the other hand, you must be aware that you are also seven unique individuals with different circumstances, perspectives, and perhaps objectives as they relate to the restaurant. Hopefully, we can devise a vehicle which will meet the needs of everyone, but some compromise of individual positions may be necessary to ensure the initiation of the venture.
In a similar vein, I want to emphasize the long-term nature of the commitment you are about to make. Although it is far more exciting and romantic to focus on the construction phases and gala grand opening, I believe you must adjust your thinking-particularly as it pertains to the choice of an appropriate legal form-to the long and sometimes arduous days of operating the business, and even beyond, to its termination. In other words, you have selected Gino Ginelli to manage the restaurant and are agreeable to giving him control through a majority interest. This is fi ne. However, we must prepare for the time when he may either wish or need to terminate his interest in the venture.
How will management continuity be ensured, and how will your interests be protected? Certainly these issues should be addressed in your decision. If Gino Ginelli is able to operate the restaurant at the levels you have projected, all of you will have opportunities to profit or, perhaps, to "capital gain." Accordingly, we need to be cognizant of marketability or transferability of interests both for those who may choose to "cash out" and for those who wish to remain. In the event additional resources are required to support this restaurant or the development of other locations, you may well need the ability to add investors to secure equity capital
I am also compelled to say that we should prepare for termination under unfavorable circumstances. Without reflection on Gino Ginelli's abilities, I must tell you that statistics indicate that more than 50 percent of new restaurants fail within two years. This means that it would be foolish to consider only the "upside" potential of the venture and not the "downside" as well. Most of you own businesses and all of you have estates, and I believe that the liability issue must be one of your foremost considerations. Indeed, part of the responsibility that Gino Ginelli must accept for the control or authority that he would be granted in the proposed venture is unlimited liability.
Gino Ginelli understands this point and has indicated his willingness to comply with this condition. However, it seems unreasonable that the rest of you, who will not have the management control and cannot achieve as large a reward as Gino Ginelli, would be willing to risk so much by agreeing to unlimited personal guarantees. It is my belief that we definitely need to reduce your potential risk or liability through the choice of a suitable legal form, with some "bare-fisted" negotiating with Texoma Bank. Another major point is the matter of initial investment. Once again, this is going to have to be negotiated with the financial institution, but I naturally advocate as little initial capital and as much leverage, particularly longterm debt, as possible to maximize your return on investment. Of course, there is simply no substitute for managing the assets properly, but some of the legal forms offer greater advantage and return-on-investment possibilities than others.
A final consideration involves taxation of the business and tax consequences of the venture for each of you. I'm confident that Alan Anderson would concur with the statement that tax regulations are going to affect the restaurant and you from the initial choice of organization form to its hopefully profitable conclusion and beyond. With Alan's help, I can state that we will always try to minimize the adverse effects of code regulations throughout your involvement in the venture. In summary, I submit that you should consider carefully the following issues before selecting the most desirable legal form of organization for the restaurant:
1. Your liability as investors
2. Management and control continuity
3. Marketability or transfer of interest
4. Ability to secure additional equity capital
5. Initial capitalization and return on investment
6. Taxation
And please consider these issues while recognizing your different perspectives and the long-term nature of your commitment of resources.
Linda paused and then presented the following alternative legal forms:
The first alternative would be to incorporate, with Gino Ginelli holding 50 to 52 percent of the stock and the remaining shares divided among the other investors. All stock would be issued as Section 1244 stock. Of course, the more adventuresome among you could buy more than your pro rata share of the stock issued, if you so desired. A second possibility would be to incorporate as a Subchapter S corporation. Again, the stock would be issued as Section 1244 stock, and the ownership percentages would be the same as with the first alternative. A third alternative would be to form a limited partnership, with Gino Ginelli as a general partner and the rest of you choosing either limited or general status.
A fourth alternative would be to establish a limited liability company, which would allow more of you to participate in management and still have favorable liability and tax treatment. A fifth alternative, which I believe may have real merit, would involve the creation of two or more legal entities. In other words, one company with several of you as investors might own the real estate and lease it on a long-term basis to the restaurant business, which would be owned by the remaining members of the group. The lease could be secured by the personal guarantees of the stockholders in the restaurant business.
I don't know if the idea of multiple entities appeals to you, but it seems to me that you have, in essence, three companies: a restaurant, a furnishings business, and a property company with land, building, and fixtures. We did this type of thing with the warehouse, truck fleet, and operating company of Allied Van Lines in Abilene, and it may prove to be a better match of personal interests and risk-versus-return than squeezing everything into one organization. In any event, these are five possibilities and I'm sure others exist, so let's begin to discuss things. And, once we have reached a consensus on the appropriate legal form, we will want to consider a buy/sell agreement with a method of valuation and various funding options.
Questions
1. Evaluate the simple corporation, the Subchapter S corporation, and limited partnership options. Note the advantages and disadvantages of each.
2. Explain the nature and significance of Section 1244 stock.
3. Could a limited liability company be the answer for the "Magnificent Seven"? What would be the disadvantages of this legal form of organization?
4. Explain how the multiple entities option might be worked out, and evaluate the extent to which it might be used to meet the varied interests of the group.