Plain English Project #4
A True Story
Welcome to the fourth edition of the Plain English Project. It’s been awhile (sorry), so here’s a quick refresher of what we’ve been talking about:
PEP #2: “Can vs. May” discussed times when you have the ability to take some action, but not necessarily the right to do it. A contract can strengthen your rights without having any useful effect on your abilities. PEP #3: “Make Me” expanded that idea into the role of courts in the can-vs-may dynamic. Sadly our court system is too inefficient to give meaningful help in small-dollar contract disputes (“small-dollar” can include suits involving $100k or more).
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In this edition I’ll reinforce the earlier themes with a true cautionary tale.
I once had a 19-year-old client named Carlos. He had inherited $50,000 from his aunt and had no idea what to do with the money. All he knew for sure was that he did not want to spend it on college, and he wanted to put the money to work immediately. Anyone who talked to him could see the dangerous mixture of ennui and restlessness sloshing in his brain.
Carlos talked a lot about his new wealth to anyone who would listen. Carlos’s roommate suggested that he invest in a new company that the roommate’s friend was starting. This “friend” was an older man named David.
David claimed to be a general contractor and needed money to start a new construction company. David proposed starting a new LLC with Carlos as a part-owner. David would even give Carlos a job working on the construction sites and pay him a salary. The very best of all possible worlds.
Carlos saw this opportunity as wonderful luck. He was determined to invest without delay and sign any document David gave him. Carlos’s family begged him to slow down. They convinced him to hire me to negotiate changes in the LLC’s operating agreement.
Red Flags and Futility
I raised red flags when David agreed to every change I asked for in the contract…except for one. David’s only demand was that he controlled the checking account. David claimed this was because he alone had experience operating a construction company (an unverified claim).
After negotiating I told Carlos that the contract looks like what a good contract should look like, but I still thought it was a bad idea to move forward. I explained that if David takes his money or runs the company poorly, Carlos will have no way to get his money back. And after all, what is the rush? Carlos went ahead in spite of warnings from me and his family.
The story ended abruptly and predictably. Within one month of starting the company, David cleaned out the checking account. When pressed for an explanation, David said that he paid himself the money as reimbursement for (undocumented) startup expenses that he had fronted. David then “ceased operations” because the company was out of money. Carlos was an unemployed, part-owner of an empty and lifeless shell. David stopped responding to all contacts from Carlos.
An Astute Adversary
David understood our legal system well. He agreed to any changes in the contract terms because he knew they didn’t matter. He knew that all he needed was the ability to write himself a check for $50k from the LLC account. Carlos could have all the legal rights he wanted. By the time David emptied the account, enforcing those rights would be impossible. (Carlos had no money to file a lawsuit with!)
Even if Carlos’s family had the money to fund a lawsuit, they didn’t want to because the lawsuit would easily cost between $100,000 and $300,000, with no guarantee of winning and no guarantee of collecting money from David.
David also understood that he had no obligation to answer any questions from me or Carlos…until a judge forced him to. David gave a vague explanation about why he took the money (which he didn’t have to do), then went radio silent.
The practical burden to force David to speak or produce receipts, and the burden to prove that David’s actions were improper, was 100% on Carlos.
Carlos made a risky decision and lost big. Here are two of the $50k lessons he learned:
1. Caveat Emptor: People get abused every day in the same way that Carlos did. A good contract can protect you from many foreseeable problems, but not all problems are foreseeable. Even a good contract can’t protect you from someone secretly determined to hurt you by any means possible. Be careful who you do business with.
2. Other People’s Businesses: We would all love to multiply our money by investing it in an operating business and letting someone else do the work. There is a reason why primarily wealthy people invest in small businesses that other people operate. Only wealthy people have enough money to pursue a $100k-$300k lawsuit, if it is necessary to do so. Also, only rich people can afford to lose 100% of their money if a lawsuit is impractical.
If you give any money to anyone, whether it is an equity investment or a loan, and you don’t hold back enough money to pursue a lawsuit, then your fate depends on the virtue of the person who has your money. You are “depending on the kindness of strangers.”
Keep in mind that there are other ways to invest money with less risk of losing everything. Buying shares of large companies in the stock market is different from investing in traditional small businesses.
Two key differences: First, if you invest in a company that has been operating for decades, you can trust that they will not suddenly cease operations. I expect McDonalds will be selling nuggets for a very long time. Second, if a publicly-traded company wrongs you as a single investor, they’ve done the same to millions of other investors. You can reasonably assume that big companies will try to avoid massive investor lawsuits.
Thanks for reading this edition. The next article will give a recap of abilities vs. rights from a different perspective. I will focus on the role that incentives play in contracts and business relationships. You can subscribe here to be notified when the next article comes out.
I’ve changed the names and facts so that it’s impossible to deduce who the real people are.
In fairness, I would have the same problems as him if I were in his shoes at 19 years old.