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    3 Replies Latest reply on Jun 25, 2008 4:41 PM by Santa Fe CPA

    Need advice: I'm at risk of losing stake in S-corp

    wheelboy Newbie
      I'll try to make a long story short. I started an S-corp with my mother in law (hereafter "MIL") to make medical devices. Neither of us has any business experience. We contracted a CEO back in March. He seems like a very honorable guy. He subsequently brought on an R&D/manufacturing fellow from HP, an administrator who is a former colleague and our first investor (currently owns 1% equity), and two consultants who are now on the board acting as CFO and COO. All these people, including myself and my MIL, are on the board. We incorporated as an S-Corp.

      My MIL and I together own 10% and 41% equity in the company. The rest is spread out amongst the investor (only 1 so far), the CEO, etc., with 25% remaining for PPM investors. We are avoiding VC at this time. I'm an MD and act as Medical Director, although currently we're not in a financial or readiness position for me to do any such directing; therefore my MIL and I are the only people on the board who do not have a daily active role in managing the business. We have a product pipeline of 3-4 medical and consumer products being developed currently, but only 1 is in prototype stage, and the company has only $50K in equity (as well as 1 patent).

      The consultants (CFO and COO) have determined that investors will have nothing to do with our company unless the ownership of the corp. is reapportioned such that more of the business is opened up for investment and unless those who are daily managing the company obtain higher percentage equity. That means my MIL and I will lose our combined 51% stake in the company. The others on the board are to presumably receive a percentage of the stock, and my MIL and I are to receive a percentage of shares commensurate with our daily contributions to the team (i.e., not much). Our most recent board meeting (yesterday) ended with the formation of a committee to recommend to the board the "appropriate reapportionment of the shares". My MIL and I are outnumbered on the board 4 to 2, such that we have basically no legs to stand on should the rest of the board decide to adopt the recommendation of the committee.

      My questions are:

      1. Is this a normal part of the growth of a company, with the founders receiving only a small portion of the total shares, or are my MIL and I about to be screwed?

      2. Is there a way for my MIL and I to ensure that we retain a substantial portion of the shares, perhaps in the form of a shareholder vote (in which we would be the majority)?
        • Re: Need advice: I'm at risk of losing stake in S-corp
          Bridge Navigator
          First let me say that you have serious legal issues and should contact a reputable corporate attorney ASAP!

          This does not pass the "smell" test and (based on thelimited information provied) looks as is if your compnay is being hijacked.

          Observation - ownerhsip has to equal 100%; the 25% remaining for PPM investors is ownerd by somebody today, who is it? I would suspect it is you an MIL hence you own 76% of the company - you are in control.

          As a side note:

          You list 10%, 41%, 25%, and 1% stakes, that is only 77%. Again, where are the other shares?

           

          Shareholders elect the board of directors. Talk to an attorney about the proper way to oust your current board.

          What is the basis for having a board at this point? How is board duty documented? You own the company - you may be able to just fire the CEO; again check with an attorney. I suspect there is quite a bit a paperwork in place about how all of this was setup that will need to be undone.
          • Re: Need advice: I'm at risk of losing stake in S-corp
            Lighthouse24 Ranger

            I concur that you'll want to consult an attorney on the legal aspects of this.

            As far as my take on whether or not you're being taken advantage of, it is not unusual for the person who brings the original idea, invention, patent, or other intellectual property to the table to end up with a relatively small portion of an emerging business. It doesn't seem fair in one sense, but then again, an "idea" or patent doesn't generate revenue -- all the business processes that get the product to market do.

            Consider that a hit song, purchased and downloaded a million times for 99 cents, will generate nearly a million dollars -- yet the person who wrote the song gets $0.045 per sale at most (even less, until he/she is "known"). That's about $45,000 tops. Everyone else in the picture (publisher, artist, producer, studio, label, distributor, merchandiser, and retailer) makes more than that.

            On the other hand, if that same songwriter also owns the publishing company, and also happens to be the star performer who sang and played on the recording, then he/she will make more on each sale. Most businesses work like that to some degree -- apportionment is based on the "daily contributions" that have to do with getting the product to market and making it a "hit." So one way to retain more of your ownership interest is to increase your involvement in that aspect of the business.

            As a person who enjoys the "creator" role in a business, I think of myself as the "spark plug" -- the business "engine" can't run without me (and they know it), but I'm also the cheapest component and the easiest to replace in the whole operation (and I know it). So we all get on fine.

            I wish you and your MiL the best in resolving this situation to your satisfaction.
            • Re: Need advice: I'm at risk of losing stake in S-corp
              Santa Fe CPA Adventurer
              Hi here, Wheelboy.

              Yes you are between the proverbial rock and hard place.

              As has been suggested, you are in serious need of a Corporate Lawyer also an accountant, preferably a CPA, with extensive accounting and "Write-up" experience.not just a tax preparer. They can certainly advise you on the way the percentages are distributed and where the common shares are placed.

              It has been my experience that in dealing with outside investors that they do require significant pieces of the pie, all negotiable. Any outside investor wll have a pre-determined requirement as a return on his or her investment. This is not without reason as they are making a bet on several unknowns -- the founders nad their track record, the products, the marketplace for the products, and the regulatory environment, (in your case is the FDA involved?) How much are the founders invested in the business in comparison to all investors and employees? How do you as founders plan to particiate in the business operations. Frankly, a hands off approach by yourselves is not a good idea, the founders have to be able to "watch the store."

              As a final thought, 5, 10, or even 15% retained in a going concern spinning off salaries, cash, and dividends is significantly better that 100% of an enterprise that fails.

              Good luck and happy hunting for the future.