A friend of mine runs a business loaning money to businesses. Every once in a while, he asks me to baby-sit a file for him or to help him interview a potential borrower (I don’t loan the money, my job is to vet the candidates who needs loans if he is really busy and I have some free time- yes, I need a life but, in my defense, it is a good way to learn about businesses). If you sit through enough loan interviews and hear enough stories of why a business needs a loan, you begin to pick out a discernible pattern between the desirable borrowers, the undesirable and the “not on your life” borrowers. With lenders increasingly tightening loan criteria, to the extent that the student loan market has nearly collapsed in the United States, what are some things to avoid if you are looking for a loan of any kind beyond the obvious factors such as bad credit score, no documentation etc.?

• “I would like you to loan me a lot of money based on the fact I am nice/the business idea is great but I will put no money in it myself.” Lending is the management of leveraged risk (remember that lenders have lenders too so they are leveraging themselves). The best way to mitigate lending risk is to make sure the borrower shares in the risk by putting in their own money (aka “skin in the game”). If you put no skin in the game, you are telling the lender you have no confidence in yourself or the business (put your money where your mouth is). Even a token contribution from a borrower with little assets goes a long way to showing a lender you are willing to share the risk. One of the few situations I know of where the borrower doesn’t have to put any meaningful skin in the game is the 40 year mortgage and these are walking car-crashes for lender and borrower alike.
• “Sorry, you have the wrong lender…” Make sure you target the appropriate lender. This sounds patently obvious but not all lenders are built equally. The quick and dirty on loan sources are:

• Credit Unions: Good for personal and small business loans; not the best source for larger commercial loans
• Banks: They like loans where there is a lot of collateral. For example, historically, mortgages or commercial real estate and RSP loans. Like unsecured lines of credit and credit cards. Hate student loans, small commercial loans (unless backed by the government). Each bank also has their specialty.
• Private lenders: Typically, higher risk borrowers with sufficient collateral (a 2nd mortgage on an appreciating home or rental property).
• Angel investors/venture capitalist: High flying businesses which have the chance of going public.

• Bad Attitude. Lenders are people too. You may look great on paper but if you have a bad attitude, there is a disincentive to lend money to you. If you are difficult to work with now, and the money hasn’t been even loaned, what happens if you fall behind on payments? I know lenders who may have rejected a borrower but because they had a good attitude, actively helped them find another lender.
• Unreliability. Your parents were right. If you keep moving jobs, cities and spouses (!?!), you look like a flight risk and less likely to get a loan (not to mention all the neighborhood gossip your parents have to deal with arising from your fickle ways).
• “I need cash quick” Total red light for a lender. Why do you need cash so quickly- who or what are you running from?

Good luck with obtaining a loan.

People hate lawyers for a billion reasons. Lawyers charge too much. Lawyers aren’t human. Lawyers don’t speak English. Lawyers only care about themselves and on and on it goes. But I have always suspected the real reason why people hate lawyers is that they related seeing a lawyer with bad times. Most people equate seeing a lawyer with being sued, drafting a will/executing on the contents of a will, reviewing their severance package etc. Other than the purchase of a home (where you really don’t see the lawyer that much), lawyers are not people you see for the happy things in your life.

I find that the reverse logic applies with investment advisors and financial planners. Everyone wants to see them when the markets are up. Buy this. Sell that. Long this stock and throw me some funky financial products please. But what happens during bad times? I find that, in my circle of contacts anyways, there’s a distinct chill that occurs. People don’t want to call their investment advisors about anything other than to get them to put everything in cash. This seems strange to me. In good times, a trained monkey could probably pick enough stocks to make money but, in bad times, shouldn’t the trained and paid professionals navigate you through down markets to minimize damage?

I know there’s a lot of skepticism about the effectiveness of investment advisors and planners; some justified and some not. However, I am known for my catch phrases and one of them that applies in life should also apply for personal finance: don’t judge people when things are going right, judge them when things go wrong.

If you have a good investment advisor or planner, now is the time they will shine. If you have a bad advisor, you’ll really see how bad they are now they have to really work for their money and it will confirm your feeling that it is time to move on. Let me give you an example I have alluded to in the past. My parent’s current investment advisor was appointed by their financial institution after the unfortunate death of their previous advisor. The new advisor simply stinks. He kept trying to get my parents to sell stock when the market panicked earlier this year. I believe he must have skipped class the day they taught “buy low, sell high” but took extra notes on the class about how advisors are compensated. My parents obviously thought he was from Mars and didn’t follow his “advice” (I use the term loosely). Now to find them another advisor…

The point being engage your investment advisor in a meaningful dialogue in difficult times. You’ll know what you have on your hands. The good advisors earn their keep in difficult times while the meek crumble.

Yesterday, I wrote about personal finance risk for three broad categories. Today, I wanted to discuss some of the credit proofing options and tools available to manage risk (remember again, that I define credit proofing to include risk management and not just in the conventional sense of protecting one self against creditors)…. and what would a post be without a disclaimer! Please remember that these are general outlines of credit proofing options; the law varies from jurisdiction to jurisdiction so please seek qualified advice on the options raised herein.

There are primarily three sets of options that one can do in order to credit proof themselves, I generally describe them as:

1. Contracts
2. Structuring
3. Insurance

Ideally, all three options should be done. However, given that we all have finite resources, my favorite credit proofing tool is insurance. It is relatively cheap and it immediately shifts risk away from you and your family and to a third party (with a lot more money than you and I). There’s a lot of bad press about insurance but, if you read the fine print carefully, a contextual and well-drafted insurance policy should provide ample protection.

Contracts

The primary function of a contract is to set out the terms and conditions between parties and, if well-drafted, also minimizes risk. For employee with manageable debt and those without manageable debt (see yesterday’s post for how I define this term), there are two primary situations where a contract can minimize the largest risk factor of job loss:

1. You are part of a union and your employment is evidenced by a contract between yourself and your union (in a unionized context, your employer is your union). In most unionized environments, the primary risk factor that any employee faces, job loss or you cannot make money for any other reason, is minimized in some part by generous severance packages (compared to non-union counterparts), a package of insurance entitlements (health and, depending on the union, disability and critical illness insurance). The down-side is that most unions are found in older industries and, after the generous severance is paid, it is not a guarantee that one can find an equivalent position.
2. You have an employment contract in a non-unionized environment. Depending on the jurisdiction you live in, the law may provide very poor severance entitlements (in Ontario, it is generally one week of working notice or payment in lieu of notice for every year of service). If you are in a white collar environment, however, the courts have stated that middle management is entitled to more service than the law allows (generally between 2-4 weeks of working notice or payment in lieu of notice for every year of service depending on a wide variety of factors). Obviously, the best way to ensure you are paid a reasonable amount of severance is to have it stated in an employment contract rather than fight for it in court. The best approach is credit proofing is to review an employment agreement to see how much of a financial cushion one has in the event of termination and, along with some of the options below, devise a strategy to minimize the shock of job loss to the household financially.

The point is that although a contract cannot prevent an employee from being terminated, a contract can set out sufficient monetary protection to ride out the short-term financial impact of job loss until a new job is found.

The use of contracts for entrepreneurs basically deals with minimizing the business risk of any relationship by reducing or eliminating liability from the transaction. This is a completely separate topic so I am not going to address it here.

STRUCTURING

Structure is a catch-all phrase to describe how one can organize their financially affairs to protect assets and minimize risk. There are variety of structuring options one can take:

• Legal structures: Incorporation shields entrepreneurs to the extent that the corporation is a separate legal entity from the owner-manager and liability do not spill over to the owner-manager. However, lenders are increasingly asking for personal guarantees which nullifies some of the benefits of incorporating. Employees traditionally have no idea to incorporate but employees and entrepreneurs alike could consult their advisors about the possibility of establishing trust structures ranging in complexity from informal trusts to full-out family trust incorporating holding companies which owns the corporation which conducts business (which many well-off entrepreneurs set up). Trusts, depending on how they are set up, minimize the risk of paying too much tax and avoid the concentration of wealth in one family members hands. If wealth is concentrate in one person’s hands, the risk is always something may happen to that person and jeopardize the family’s finance affairs. Family trusts are one way around this issue although I readily admit not a contextually appropriate option for most middle management employees.
• Rich spouse, poor spouse: A take on the Rich Dad, Poor Dad brand, this strategy is related to the above and is appropriate for entrepreneurs and employees with unmanageable debt. The primary purpose of this strategy is to place resources into the less risk exposed partner and protect the family resources and expands on my point yesterday that good credit proofing isolates risk not expands it. The strategy is quite simple- put all the resources of the household into the name of the spouse who has smaller risk exposure (i.e. is not the spouse running the business or has bad debt management) and keep the financial affairs of the spouses separate (i.e. no joint accounts, no co-signing anything). Above all, always keep one spouse “safe” by not exposing them to the other spouse’s risk. This includes not co-signing loans, credit cards, personal guarantees etc. To avoid triggering unnecessary tax liability, speak to your accountant before you transfer anything to anyone. What happens if you don’t trust your spouse… well, legally, your lawyer can give you options but you probably have a larger issue which is not part of this blog’s topic….
• Build up your financial parachute. This option is applicable to everyone. Make sure you have a financial parachute/money you can access easily for the worse case scenario whether that be job loss (employees with manageable debt and unmanageable debt), a sudden financial crisis (everyone) or a required infusion of cash into the business (entrepreneurs). Have a source of money you can tap into. I know there is some debate between an emergency fund vs. a line of credit, the point is have one or the other or both before a crisis occurs. If you are an employee with a long employment history, apply for a LOC now.

INSURANCE

I suspect somewhere there is job loss insurance being made available to someone but for those of us without the resources to find and pay for this here are some insurance policies to consider:

• Disability and critical illness insurance: I have written about these types of insurance before and it is appropriate for all with particular importance of disability to entrepreneurs.
• Life insurance: This is pretty self-explanatory. The only note I would add is that most people think of life insurance as a means to look after their dependents, which is certainly true, when dependents are quite young. However, as one’s net worth increase, life insurance should be seen as a option to minimize tax liability for the estate upon death since the proceeds of insurance would be used primarily to pay off taxes. For entrepreneurs, remember that life insurance is collateral in a loan if structured correctly which may, depending on negotiations, eliminate or minimize personal guarantees.

This is some debate on what to get first: life insurance or disability or critical illness insurance. It really depends on the circumstances. An employee regardless of debt levels may have greater need for disability insurance if they are the sole bread-winner and has a family history of poor health. Alternatively, an employee with unmanageable levels of debt may use disability insurance as a forced savings vehicle if they buy a return of premium rider (an expensive savings vehicle but one nonetheless).

Just a few concluding notes:

• if the “barbarians are at the gate” (i.e. creditors are at the doors), there are laws which prohibit the implementation of some of the options above since they could be deemed to be “fraudulent conveyances”. Thus, please consult a lawyer if you are in this situation
• The point of credit proofing is not to eliminate risk (since risk can never be eliminated) but to set up appropriate options to ensure your loss is minimal and survivable financially
• everything is contextual, take a look at yesterday’s post and figure out which category you fit in and assess your risk accordingly. Then see if any of these options fit the bill and see a qualified advisor to discuss.

Good luck.

Four Pillars mused recently that we (the blogging world, authors, financial institutions, television personalities etc.) throw around the term “due diligence” a lot as a “cop out” (or prudent litigation proofing depending on your point of view) after extolling on the virtues of a certain investment. To paraphrase Four Pillars, the term “do your own due diligence” is like a great movie with an utterly bad ending; after this massive build up, it ends with a let-down. I am just as guilty, if not more so, of using the term “do your own due diligence” without explaining what exactly that means or how one goes about doing so.

First of all- what is due diligence? In its simplest terms, due diligence is doing your research and investigation and determining what someone says about something is true. Is this actually a good stock? Should you lend money to someone?Is this house a great investment?

We all do due diligence every day of our lives. For example, you are thinking of hiring someone at work. They claim on their resume that they went to Harvard, graduated at the top of the class, worked at Acme Consulting Inc. and have references from noted leaders in your industry. They sound like a perfect candidate but you wouldn’t hire this person without checking up on their claims would you? Most employers would ask for university transcripts, call the Harvard alumni registry, check up with Acme Consulting and call the references. We call this “reference checking” but this is due diligence (in the broadest sense of the term) just in the HR context.

In the investing world, due diligence primarily concerns whether the financial numbers can support the claims made or valuations given for stock, real estate or a business. On an non-exhaustive basis, here are some typical types of investigation one should make before buying typical investment products:

STOCKS

• What does the company do? Does it do it well or poorly? Is it an industry leader or just another competitor?
• Where does it do business? Is this a safe jurisdiction or are there a lot of risks doing business in that jurisdiction?
• What is its stock price compared to its peers? If it is higher than industry average? If so, why? Is it because it is the undisputed leader in the field or is the price high because of some one time event (i.e.  is it being bought)?
• I always like looking at the statement of cash flows, especially cash flow from operations (i.e. cash it makes from operating the business rather than from its investments). Is it positive? If so, for how many years? It is harder to fake cash; earnings can be manipulated.
• If you are investing in a dividend yield stock, how much of its profit is being paid out as dividend (aka the dividend payout ratio)? Does the company consistently increase dividends? Is there cash on hand to pay the dividend (see my above question about cash flow from operations)

This all sounds very daunting and, frankly, a lot of hard work but most financial websites will now summarize a lot of this information for you rather than reading through hundreds of pages of the financial reports.

MUTUAL FUNDS

• What is the mutual fund’s fundamental objectives? Growth or capital preservation? Does this match your goal?
• What does this mutual fund actually buy? Are they good companies or bad?
• How does this mutual fund perform compared to mutual funds in a similar category?
• What is the mutual funds management fees? Are they higher than lower than other mutual funds in the same category?
• How long has manager of the mutual fund been with the fund (on the assumption that the longer the tenure, the more likely it has performed well)?
• What restrictions are there on selling the fund? Do you have to hold on to it for a period of time?
• What is the investment advisor’s compensation for selling you the fund?

Most of this information is summarized in a mutual fund prospectus which is a disclosure statement required by law to be given to you. Please read this before you buy a mutual fund even if your advisor thinks this is the greatest thing since sliced bread. Most web-sites will also compare mutual funds in the same category.
REAL ESTATE

• Bring your own contractor with you (not your real estate agents) when you see a house, ask them about the house and how much it would cost to fix the deficiencies in your home. Don’t cheap out on this part. Get a true estimate of how much it would cost to bring the house to your desired level of livability.
• Try to meet the vendors of the house- do they look like they kept up the house (for example, if the vendors are in their 90’s, chances are they don’t have the physical capacity to maintain the house in the last few years)?
• Look at the historical pricing for similar sized homes in the neighborhood- is the house listed above or below historical pricing? If it is below, ask why- is there something wrong with the house or has it been priced for a bidding war?
• Is this a safe area? How is the local school rated? Your insurance agent can implicitly tell you if the area is safe or not by the insurance rate they quote you.
• If this is an investment property, conduct a true financial analysis of the costs of upkeep including items such as property tax, utilities (if it is included in the rent), upcoming maintenance issues (which is why you bring a contractor with you), local by-laws (i.e. how many tenants can you put in the house or is the duplex a legal duplex) and compare with rental rates in the area.

Your real estate agent can help you with a lot of this research (make them earn their commission!).

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Effective due diligence is equivalent to being a 7 year old kid. Keep asking “why, why, why” until you get the answers. Drill down into someone’s claim until they can substantiate it. It is not that difficult of a process just a lot of hard work. Good luck.

I received a lot of positive responses from a previous post about increasing your chances of obtaining a loan and some requests to elaborate and put some “meat and potatoes” on what one needs when applying for a personal or small business loan.  Thus, the following is a non-exhaustive checklist with some commentary on what you need to do in order to obtain a loan.  As I mentioned previously, I use to sit on a loan review committee as a community volunteer (yes, I need a life if this is my hobby…) and my general comment from that experience is that preparation and an understanding of what the lender is actually looking for goes a long way in obtaining personal and small business loans. I apologize if some items on this checklist appear to be patently obvious but it is sometimes the obvious that gets overlooked.

Documents about you

• Social Insurance Number
• Work history (yes, it is asked for; lenders want to see stability and job hoppers scare them); get a letter from HR on how long you have worked, current salary etc; They write these often so they know the format.
• Notice of assessment from the tax authorities for last 3 years (this a one page document which is sent to you showing your taxable income and amount of taxes paid); they can be obtained quite quickly by calling the tax authorities.
• Calculate your net worth
• Run your own credit score (here’s a primer on how to obtain your credit score in the U.S. and obtaining your credit score in Canada)
• For small businesses, a business plan is needed in certain circumstances (i.e. government backed programs) but not in others. The newer the business, the more likely a business plan is required.

All of the above apply to small business loans as well since most small business loans are backed by personal guarantees.
I suggest you run your own credit score since financial institutions have a funny habit of running your credit score as soon as you say you are interested in obtaining a loan. The more your credit score is checked, the lower it gets (an often complained about deficiency in how a credit score is determined). The institutions shouldn’t do this but they do.

If you tax returns show a blip (you income dipped one year; you were laid off, took time off between jobs, back-packed through Asia), immediately put in a cover letter why this occurred. Remember always to deliver the bad news first.

Reference Letters

• Bank reference letter (shows you how long you have been with them, approximately balance, whether they have been any defaults, over-drafts above allowable limit and, generally, whether you are a good customer). Only needed if you are shopping around for a loan because it costs money to obtain these (unless you know the branch manager)
• Employment letter (addressed above)
• For small business loans, get a letter from a supplier indicating you pay on time all the time. This gives comfort to the lender. Also get a letter from customers indicating they are happy to use your service in the future (tells the lender you are getting cash into the business).

The Soft Stuff

• Introduce yourself to your branch manager and/or assistant branch manager before you are going to apply; tell them you are going to apply for a loan and ask them what they need (in other words, tell them implicitly that you will make their job easier). Ask them if they are interested in loan money to you.
• If the branch has a loan officer, make sure you are introduced to them and repeat the above.
• Remember to dress professionally- treat this like a job interview (you are applying for money after all)
• If you are shopping around for a loan, don’t just walk into any old branch. Ask someone if they have obtained a loan from the same institution and ask for an introduction to the person who reviewed or administered the loan. In other words, network until you find a loan officer you can work with.
• Always get two quotes. There is no such thing as “home field advantage” in lending; you have to push your own bank to match the competitor.
  

This is the most overlooked part of the loan process. Lenders are human too; connect with them on a human level. I have seen situations where borrowers are perfectly acceptable on paper but, upon meeting them, the lender begins to form doubts based on things like being unprofessional (these were business loans so this was particularly important), being arrogant during the process and saying the wrong things during the process (”…the first thing I am going to do after getting this loan is to take a three week vacation…” This makes the lender think you are spending their money on the wrong thing).

What most lenders do not tell you is that they have the discretion to charge lower rates, go above their loan book (how much they can lend out in certain categories of loans) and extend loan terms. These items being discretionary, it pays to be nice to the lender since it could save you thousands of dollars.

Did I miss anything?

This post is a prelude to next week’s post about Prosper and personal and small business loans loans via peer to peer lending networks (to give you a preview, I am looking at the loan documents provided by Prosper and translating them into plain English). However, with certain regions of North America in a full-out recession, it is topical to address the best way to obtain a personal or business loans from traditional and non-traditional lenders. There are two contradictory trends occurring if you are looking for a loan- money is getting cheap with interest rates going down but lenders are becoming increasingly stringent in who they lend to (”there is more good money than good deals” as the bankers like the say; typically a sign we are at the end of a economic cycle). Thus, attempting to obtain a personal or small business loan is increasingly become an art and lenders are not handing out (stupid) money like it was 2004 all over again.

Having represented lenders in a past-life, sat on loan review committee and lent money in business, here are a few tips to increase your chances of obtaining a loan:

COME PREPARED

Run your own credit score first and clean up anything that can be cleaned up. Obtain letters of reference from other people you have borrowed money from, employers, banking reference (you usually have to pay for this letter) etc. Find your tax returns from the last three years. Compile all the data to complete a net worth statement.

In other words, have your documents ready. Even p2p lending groups like Prosper, which require minimal paperwork, still requires you to dig up some documentation about yourself (like your social insurance number).

Never, EVER, say you need money NOW

To a lender, the phrase “I need money now” sends warning flags up. Why are you in such a rush to get money? Is another creditor after you? Are you behind on other types of payments? Are you desperate? Desperate people do desperate things including lie on their loan application. The practical consideration is that lenders need to conduct due diligence before they make a loan. This takes time (the amount of due diligence a lender has to conduct is the same for a $10,000 loan as it is for a $200,000 loan- this is why lenders tend to shy away from smaller loans).

Plan ahead. If you need money 30-45 days from now, start applying for loans now. Most lenders, even the non-traditional ones, need at least 2-4 weeks to look at your application, interview you, arrange to transfer money to you etc. (I am not talking about payday loans).

WHAT’S IN IT FOR THE LENDER?

What is the difference between investing in equity (stocks) and debt (lending people money)? In equity, you are foregoing certainty on a return on investment for upside potential (save for dividend payments). In debt, the lender seeks certainty of payment in exchange for foregoing upside potential (I am not including convertible debt instruments). Most borrowers fail to appreciate this difference and this difference sometimes costs them a loan.

A lender is not particularly concerned that you could take a $5,000 small business loan and make $200,000 with it. The lender’s primary concern is that they get the $5,000 back at maturity and the interest payments are paid on time. When applying for a loan tell the lender how it will be paid back. Most borrowers spend all their time telling the lender how it is going to spend the loan proceeds. (this raises the question of what’s in it for the lender for borrowers on Prosper who need money to go on vacation- um…). The story you tell cannot be all about you- address what’s in it for the lender.

I will give you an example. I once heard of a private individual who lent money to people to buy cars no matter how bad their credit score was. All the borrower had to do was show the lender that they needed the car to work- either as a traveling salesmen or the job was not accessible by public transit and prove that this job paid enough to pay back the loan after all other expenses (i.e. show a pay-stub, get a letter from the employer etc). The theory behind this loan criteria was that the lender (who I never met) believed someone would bounce a rent cheque before their car loan since the car was absolutely essential as a means of producing income. The lender made the borrower show what’s in it for the lender since they had to prove that the loan was being used to generate income which would increase the chances he got paid.

DELIVER THE BAD NEWS TO THE LENDERS FIRST

There is an old saying in politics- be the first to deliver the bad news. The same rule applies to applying for a loan. If you have a skeleton in the closet (bad credit score, taxes outstanding, behind on support payments), reveal it during the application and provide a plausible and reasonable story on why this is not an issue (I was young and didn’t used my credit card improperly but that was 5 years ago, I have a payment plan set up with the tax authorities etc. etc.). If the lenders have to find this out during their due diligence period, it slows down the application process and a borrower has a better chance of crafting a story around the bad news and mitigating its impact then the lender finding out this surprise and jumping to its own conclusions.

WHAT HAPPENS IF YOU DON’T GET THIS LOAN?

This is a typical question that a lender will ask a borrower. The wrong answer is “its this loan or bust!” In a small business context, the lender is trying to ascertain whether you will put your own money into the business and share in the risk. In the personal finance context, the lender is looking for the same thing- will you come up with more of your own money to buy the house/car/boat etc.; the more money you have in (or the more lenders you find), the less the risk for the lender (and, hence, the entire problem with subprime- the borrowers had no risk having put no money down…).

HAVE YOU SHARED THIS RISK WITH THE LENDER?

To dovetail on my last point, the worse type of borrower is the one who is proposing that the lender put up all the money (and financial risk) and the borrower puts in nothing. Let me put it this way: you go to Vegas and the house gives you $10,000 free as opposed to you putting in $5,000 and the house giving you $5,000. You have one hour to gamble and, at that point, you have to return the free money whether it is the $10,000 or $5,000. Will your betting pattern be the same with $10,000 free or half of your money at stake?

The reasoning behind the borrower “putting skin in the game” is simple: if you have money in, you have shared in the risk. For entrepreneurs, sweat equity is often discounted as skin in the game so keep that in mind. The more risk you have/the more money you are putting in yourself the greater you will want to pay off the loan and the more likely the lender will look upon you favorable and give you a favorable loan term.

For larger loans or loans obtained to acquire assets, collateral will be required. Collateral is a guarantee (usually an asset) to secure the payment of the loan in the event of default (i.e. I take your car if you default on a payment). This is called a secured loan and is probably a much larger topic onto itself. However, the point is you have to show you have a personal stake if things don’t go well. If there is no personal stake then, well, you get subprime and its assorted messes.

Just one final note: lenders may reject your loan for reasons that have nothing to do with you. They may have reached their loan quota, be low on money (remember that lenders have lenders), have too many of one type of loan etc. Don’t take a rejection personally- perfectly good loan candidates can be passed up. Don’t burn your bridges. A lender may remember your professional conduct the first time you applied and give you the benefit of the doubt the next time you approach them for a loan. Good luck.

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On March 13, 2008, I wrote “….I waiting for the other shoe to drop and have some mid-tier financial institution go under; every bubble seems to have some semi high-profile causality which usually marks the bottom.” On March 14, Bear Stearns required emergency funding and, last night, JP Morgan Chase acquired the firm for $2/share (financed by government money). Wow, that was fast. Unfortunately, we are no where near the bottom. Best not to watch bank stocks on the short term.

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I am on business travel this week so there will be two guest posts this week and no posts on Thursday or Good Friday. I have guest posted at Million Dollar Journey on the Smith Manoeuvre (SM), the Lipson case and audit risks of the SM. Thanks for the opportunity FT. I understand it is running this Wednesday. Hope you enjoy it.

There seemed to be many misconceptions about successful negotiations. If you watch enough television, it seems like negotiations involve a lot of yelling, throwing of objects and a general scorched earth policy. Meanwhile, one of the most successful books on negotiations, Getting to Yes, has been criticized for not looking at the emotional aspects of the parties and negotiation, opting to rely too much of a clinic analysis of negotiations (to the authors’ credit, their next books addresses the emotional side of negotiation). Unless you are a lawyer, mediator or some other persons who negotiate on a daily basis, most of us don’t use this skill very often but it can be rather painless.

When I first starting practicing the law, a very senior lawyer said to me that the essence of a good deal is that neither side is happy. In other words, both sides gave up something valuable in order to reach a deal. The problem with trying to totally crushing the opponent in negotiations is that no one wants to play ball with someone who will not give anything up at the negotiating table and, after a while, you end up negotiating only with the most desperate and vulnerable which brings up a whole moral/ethical issue.

I am by no means a master negotiator but I have picked up a few tips over the years.

COME PREPARED

This sounds so trite but how many times have you heard of friends driving around town one afternoon, walking into an open house and then buying the place? Then, they are stuck with buyer’s remorse because they didn’t do their research properly and they over-paid for the place or the place is a dump etc.

There seems to be a correlation between the amount of preparation put into negotiations and the result. The less research and intelligence gathered, the more likely the unprepared will be taken. I may have linked to this post before but look at how the writer got the best price for a car by doing their research.

If you are going to make a big-ticket purchase, look at it one day, go home and do your research and buy it on another day. If you walk in never intending to buy and you did, you probably left money on the table.

PEOPLE ARE IMPATIENT- AFTER A WHILE, THEY WILL AGREE TO ANYTHING

When I was in undergrad, my brother called me asking me if I wanted to buy his old Honda. Turns out that he was in the car dealership for 7 (!) hours and, even though he never set out to buy a car, he thought that spending so much time there meant that he HAD to negotiate some type of deal to buy.

I once attended a sales seminar aimed at investment advisors (even though I am not one) and one of the key points was that a good investment advisor got an answer quickly. A “no” is a good answer. It allows you to move on to the next potential client. The worse answer a salesperson can get is “let me think about it.” The key was to force “yes” or “no” answer as quickly as possible. Patience is not key in sales.

The point being that negotiations are often wars of attrition. Whomever can wait out the other side the longest sometimes wins the point. If you don’t have to buy the car or house that day, then don’t. People will cut you deals rather than watch you walk since there is some certainty of sale with the person in front of them rather than the unknown (is someone else going to walk in tomorrow to buy?). Why do you think car dealerships make you wait in office after office; as your impatience grows, your desire is just to get the deal done regardless of whether it is the best deal or not.

On the flip side, tell a saleperson you want to think about it after they have spent some time with you- watch them make you a better offer than their “best” offer 10 minutes ago; you have occupied their time for a while, they don’t want the time spent, and their potential commission, to go to waste so they’ll cut a deal with you even if it is not the best one for them.

PRIORITIZE YOUR DESIRES

I work with a lot of salespeople as co-workers. Whenever we talk about a new project they want everything in the marketing materials- lot of information, lots of pictures, lots of sales language. However, we can’t fit that all into a small brochure. At some point in time, one of the more experienced salespeople will say that they have to pick one thing as a priority whether that be information, pictures or whatnot. At that time, the salespeople really begin to give you a sense of what they want and the conversation becomes much more focused and you hear a lot of: “yeah that would be nice but let’s focus on this…”

It is the same thing with negotiations. Of course, we all want everything but what one thing is more important than others? Use the other important but lower priority desire as a bargaining chip. For example, I watch a lot of these property virgin/1st time home-owner type of shows and everyone always wants everything: a reasonably priced home but with a finished kitchen, large back-yard, minutes from school, access to public transit, a 2nd/3rd bathroom and, oh, the house has to be barely lived in. Then, watch what happens- people begin to find out that they can’t have their cake and eat it too and they focus on the most important desires and give up the other things they want but are not deal breakers (for some reason, it is always the big backyard).

If you cannot prioritize then one of two things happens: you either end up paying a lot more than you wanted to since everything is important and you can’t live without it or you can’t cut a deal because you won’t give anything up at the table to get something of equal value back.

Take a piece of paper and write down the absolute deal breaker terms; it can’t be more than 3. Then write down the “it would be great” terms. These you negotiate as if they were deal breakers but you would willingly walk away from if you got something back in return. It is a good exercise in trying to figure out what the most important thing is for you. When I bought a condo, I threw away my desire for a 2nd bedroom for my priority of living in a great location; I always say I could use another 100 sq. feet but I would not give up my location.

….those are my three big negotiating rules. If you are gearing up for a negotiation of any kind, I would read Getting to Yes as a starting point. Anyone care to share any tips?

After a brief hiatus, welcome back to the unlimited series on the business of blogging where I tackle the business and legal end of blogging. If you are a new reader, please see the resource section of this blog for previous installments. John Chow has started a similar series on blogging income and taxes which is much more specific to his particular situation so please do read his information with that in mind (as a side-note, and this is not a comment on John’s competence as his OWN accountant or the subject matter which he usually writes on, I find it strange that people are asking a stranger like John for specific tax advice even if the summary is excellent. John Chow is a master of making money online. Last I checked, he is not an accountant and he is certainly not his readers’ accountant. Why can’t people pay a modest amount of money to an accountant to save thousands in tax? Seems penny wise, pound foolish to me to try to get specific personal advice from the internet but I digress). The usual disclaimers apply- this post is for information only and not advice and without regard to jurisdiction unless otherwise indicated.

This post was supposed to address how much a blog is worth but I thought I would step back and discuss the process of selling a business/blog in general since it is usually a once in a life-time event for most people (perhaps twice if you are a serial entrepreneur).

THE SHARE SALE

If one’s end goal is to build a blog to sell it then one should ideally incorporate and, when the time is right, sell the shares of the corporation (ownership in a corporation is evidenced by shares). The primary reason is tax driven. In Canada, an individual who sells shares of a qualified corporation is eligible for a life-time capital gains exemption of $750,000. In other words, the first three-quarters of a million in profits is tax free (see here for more details on the lifetime capital gains exemption). Even if you live in a jurisdiction where there is not a capital gains exemption, capital gains tax is generally lower than tax levied on income/interest and, depending on the jurisdiction equal to or lower, than dividend income (speak to a professional about your local tax laws). In other words, a share sale puts the most amount of money in your pocket.

What exactly are you selling when you sell all the shares of the corporation? Everything. Since shares evidence ownership in the corporation the process of selling all your shares means you have sold the corporation and all the assets and liabilities it owns. In the blogging word, this means the domain name, ad revenue, the copyright on the posts- everything.

Purchaser do not like buying shares (as the saying goes: “sell shares, buy assets”). Why? In a share sale, you inherit the liabilities of the corporation. If the corporation owns back-taxes, unpaid employee/contractor wages/pay, contains some libelous comments which may be subject to a future lawsuit, the purchaser inherits it all. Good due diligence and sufficient legal measures (such as obtaining an indemnity from the purchaser) should shield a buyer from most of the “skeletons in the closet” but, frankly, the pain in the butt factor is high to respond to the tax authorities and third parties for something you did not do.

THE ASSET SALE

If the blog is not owned by a corporation or the buyer is a savvy negotiator, you have to sell the assets which compromise of the business of the blog such as the domain name, computer, copyright etc. For the purposes of clarity, it is possible for a corporation to be a “shell corporation” and have no assets in it. Thus, it is possible for a corporation to sell all, or substantially all, of its assets and continue to own the shares which evidence ownership in a corporation- the corporation just happens to own nothing.

An asset sale is more complicated than a share sale because you have to assign a certain tax value to each asset which compromises the blog. For example, if the assets compromising of a blog are sold for $20,000, the domain name could be worth $1,000, the copyright/intellectual property could be worth $5,000, and the ad revenue bought on a dollar for dollar basis for $5,000. In this example, you have only assigned $11,000 of the total purchase price and have $9,000 left over. This excess amount is called “goodwill” in accounting terms. It represents the amount of the purchase price which cannot be directly attributed to assets and liabilities. Goodwill is typically a large component of sales involving technology based businesses (including blogs) since the assets are really not worth much (a two year old router really doesn’t have a lot of market value).

There are two issues which arise from the above paragraph. The first, more relevant issue, is goodwill is taxed unfavorably relative to capital gains. In most jurisdictions, it is taxed as income. Thus, if the value goodwill is quite high, you may push yourself into a higher tax bracket if you sell outside a corporation (the way to mitigate against this is to divide the purchase price between different tax years which gives you tax savings but the advantage is off-set by your additional exposure to non-payment of the remainder of the purchase price). Other jurisdictions limit the amount of goodwill the purchaser can write-off.

Thus, the purchaser may want less goodwill assigned to the purchase price (given it cannot write it off that aggressively) by negotiating a higher tax value to the assets which leads to the 2nd issue. (if this all sounds as clear as mud, it is; preparing a business for sale is a fine art form which is not a DIY adventure because of the tax pitfalls involved) A seller may have to assign tax values to assets which are higher than the depreciation value of the assets which leads to recapture. Recapture is a fancy term which is the difference between the (sale value) - (tax value).

For example, prepare you bought a truck for $100,000 for business purposes. You write off $50,000 of that cost for tax purposes. Thus, in the eyes of the tax authorities, the truck is “worth” $50,000 (tax value and real life values are two different concepts). The truck is then sold for $60,000. Recapture is $60,000 - $50,000 = $10,000 and tax is payable on the recapture amount (based on either the individual or corporate tax rate as applicable).

Having said all of that, the possibility of recapture on selling a blog are quite low. No one really wants to buy your 2 year old Dell Computer; most of the purchase price will be in goodwill. However, I highlight this possibility to show how much more difficult an asset sale is than a share sale. The due diligence and professional work involved in an asset sale is typically more involved than a share sale so, beside the possibility of a higher tax burden, you are paying more in transaction fees.

If your head is spinning reading an asset sale, it highlights the difficult tax and legal issues underpinning an asset sale compared to a share sale and why a share sale is more desired from both a tax and legal perspective.

OTHER THINGS TO CONSIDER

This was a pretty technical post so I wanted to end with a few more general notes:

1. Any savvy purchaser will want you to sign a non-competition and non-solicitation agreement. So be prepared to sit on the sidelines for a period of time after sale.
2. A business should ideally be prepared for sale months before-hand. This means having an accountant make appropriate tax adjustments, putting verbal contracts into writing, tying up loose ends etc. etc.
3. Selling a business is stressful. It requires a great deal of patience and, in every deal involving major dollars, it looks like the deal may fall apart on several occasions. You have to brace yourself emotionally and mentally during the process.

As the above shows, selling a business involves quite a bit of technical legal and tax work. Thus, the first step in selling a business is to see your accountant to put the ship in order. In my next post, we’ll get to the good stuff- how much can you get for selling your blog.

I have the pleasure of being the featured blogger on Geezeo discussing tracking financial goals. I have also agreed to write a monthly update for Geezeo. You can track my progress on their blog and I’ll link to it as they are posted. Thanks for the invitation Geezeo! Goal setting and tracking has become a personal passion of mine, partially born out of the fact I use to set a lot of goals and never reach them, and I wanted to share an excerpt from my post:

“...First, my goals are time-specific to achieving certain goals by year-end. I avoided front-loading all my goals to a short period of time for a reason: good goal setting is not a short-term exercise. If I set out long term goals, I am consistently thinking of them and working toward it.

I believe I am setting myself up for failure if I set goals which I have to achieve in a short period of time. Life happens. Something is always going to come up which hinders our abilities to reach our goals whether it is a health issues, family emergency, changing jobs etc. If we set goals that have to be met short-term, and we fail to achieve them, it can shatter our confidence. Goals which have to be achieved in longer periods of time allow me to think about them one day at a time and in more “bite sized” pieces. As I meet each bite sized piece in the larger goal, I am gaining more confidence every day.

The other point I wanted to share with your readers is the Pareto Principle also applies in goals setting. Most of us know this principle as the “80-20” rule: 80% of our results are from 20% of our efforts. There may be long stretches of time where I may not be doing anything to reach my goal. As I stated above, I am waiting out the market. It is not necessary to always be in motion in goal setting. A lot of goals can be reached in short spurts of activity.”

Check out the rest of the post. Thanks.

Geezeo is part of the growing trend to offer on-line personal financial tools. If you are not familiar with it, a user uploads their bank account information to the site, sets personal finance goals and as your bank account information is updated daily, so is your progress towards your goal. There are also groups and discussion forms you can join. I would review the security features of the site and do your own due diligence to determine whether you are comfortable using this site.

I also mentioned Stickk in my interview which was first brought to my attention in Money Sense magazine. You make a contract with yourself on-line on your goals, appoint referees and make a wager that you can reach the goal- if you win the wager, you keep your money. If you lose your wager, it gets donated to a charity.

One last link which isn’t an on-line goal tracking tool per se but a great visualization tool. Dividends4Life posted a workable spreadsheet which allows the user to picture their net worth based on contribution and assumed rate of returns (please read his disclaimer before you use it). It is a great illustration of the power of contributing even a little early rather than a lot later. For those who often worry about their cash flow and do not invest even small sums of money, the model should illustrate that this short-term thinking has long term ramifications.

I did notice one theme in a lot of on-line tools- goal planning being a social activity. Peer pressure and being accountable to others keeps us focused and honest. My only caveat is please don’t delegate achieving goals to your social group/accountability partner. It is still your responsibility to set goal setting meetings and put an honest effort into reporting. Do not presume that because it is now a social activity someone else should push you along.

I am a real Luddite. I still prefer personal contact to meet my goals. I have accountability buddies to help me out on that. No matter what methods we use (telephone, lunches, round-tables), we always stress that it is up to the individual to take responsibility.

The above links are presented as information only and examples of tools available. Everyone has a favorite goal tracking tool so find one that you can work with best. Good luck.

Are you using any on-line tools for goal planning and setting? If so, what are you using and how is it working?

Welcome back to the business of blogging- a unlimited series on the business and legal aspects of blogging. Part one and two dealt with some legal risks of blogging. Today’s post addresses the question of whether a blogger should incorporate its blog or not. The usual disclaimers apply- this post is for informational purposes only and without regard to jurisdiction. It should not be considered advice. Please see a qualified professional if you have any specific questions.

First, let’s deal with some definitional issues. A corporation is a separate legal entity from its incorporators, directors, officers and shareholders. In most jurisdictions, it has the power of a “natural person” which means a corporation can do whatever you and I could do such as enter into contracts, have its own bank account, hold credit cards, sue and be sued. In many ways, think of a corporation as a puppet the owners (known as shareholders) control- the puppet can be attacked but the owners are shielded (subject to certain exemptions which differ from jurisdiction to jurisdiction).

There are three major stake-holders in a corporation: (i) shareholders own the corporation; (ii) directors are the guiding minds of the corporation; and (iii) officers carry out the day-to-day functions of the corporation. The three stake-holders can over-lap in that one person can act in all three capacities.

For the purposes of this post, I am only going to address what is known as “limited liability corporations” and not address unlimited liability, not-for-profit and other variations of this structure. A limited liability corporation shields the shareholders of the corporation from the corporation’s liability and limits the loss of the shareholder to the money they invested (this is the general definition; the details vary from jurisdiction to jurisdiction). In most jurisdictions, directors have personal liability for unpaid tax liabilities, wages etc. but are otherwise shielded from the liability of the corporation assuming that the director was not using the corporation to carry out some fraud, inter-mingled its personal and corporate affairs or personally guaranteed the obligations of the corporation (see below for more details).

There are two primary factors in determining whether a blogger should incorporate or not:

1. Shield against liability; and
2. Lower taxes

SHIELD AGAINST LIABILITY

Let me start with one contextual point before I address this topic. If a blog is purely an on-line journal of the comings and goings of the author without addressing the outside world or commenting on others, the risks of operating this type of blog are quite remote (financial blogs that chronicle someone’s journey to pay down debt would fall under this category). Liability generally tends to increase in one of two scenarios: (i) one becomes quite opinionated or outspoken about others; or (ii) the blog looks like its clearly making a lot of money (John Chow would be a good example of this since he states his staggering monthly revenues). In this situation, the blogger is doing one of two things- making a lot of people, some of whom have high-priced lawyers, mad or putting a walking target on their back by telling predatory litigators they have deep pockets.

Will a corporation shield against liability? Generally, yes. The liability belongs to the owner of the blog but here’s the catch- you have to clearly indicate that the blog belongs to the corporation. (see Canadian Capitalist for a good example- look at the bottom of his blog- it indicates it is corporately owned). If a blogger does that, it is telling the world that it is the corporation’s responsibility in case anything goes wrong and the claim is against the corporation and not the writer/shareholder since the revenue of the blog is being paid to a corporate entity and not an individual.

The issue in the blogging world is that many corporation which are set up to hold the assets of a blog are generally one person corporations- the shareholders, officers and directors are all the same individual. Will a corporation provide sufficient protection in this type of situation?

It depends on the conduct of the individual viz a viz the corporation. “Piercing the corporate veil” is the term used for the Courts to disregard the corporate entity and find the director or officers personally liable (shareholders are generally immune from liability as long as they are not acting as directors or officers as well). The test to pierce the corporate veil varies from jurisdiction to jurisdiction but, generally, the Courts will sanction personal liability where:

• the directors/officers are acting in such a manner that there ceases to be a separate existence between the directors/officers; or
• some type of fraud or injustice is being carried out in the name of the corporation (this typically arises when the alleged wrong is intentional such as fraud, nuisance, trespass etc. rather than unintentional torts such as negligence). If this exists, the Courts may find the directors/officers personally liable where the directors/officers were deliberately using the corporate entity to commit some wrong (again, the test varies from jurisdiction to jurisdiction so please seek appropriate legal advice).

The issue is in one person corporations is whether the directors are, indeed, maintaining a separate existence. Are there separate bank accounts/books between the blogger and the corporation? Are annual corporate minutes being kept? Has the blog clearly indicated it is being corporately owned? Is the domain name owned by the blogger personally or the corporation?

In the case of one person corporations, it is harder to maintain this separation. And, thus, it may be easier to pierce the corporate veil in these situations. However, lest your heart skip a few beats faster, the Courts are loathe to pierce the corporate veil for policy reasons (if it occurred too easily, it would create a chill in the number of people starting corporations). In other words, RELAX BUT make sure there is appropriate indicia that the corporation is maintaining a separate existence from its directors/officers.

I wanted to end this discussion with a few final comments:

1. Shields are only useful if there is something to protect (hence, my previous comment about putting a target on your back but telling people how much money you make). Incorporation, contextually speaking, may be overkill if the blogger isn’t “worth” suing. Credit-proof bloggers, bloggers under a great deal of debt, bloggers without a lot of assets don’t make great litigation targets. Even if the suit was successful, the victory is hallow since the blogger may not have enough money to pay out the judgment or the plaintiff’s legal fees (in some situations, the losing party has to pay the other side’s legal fees).
2. Corporations cost money to set up and maintain. In jurisdictions where the paper requirements are heavy (many parts of Europe), the cost can be quite high. The question becomes whether there is a cost benefit of incorporation costs versus protecting one’s assets. If the risk exposure is quite low (i.e. assets are, relatively speaking, not enough to satisfy a claim), there may not be sufficient benefit to incorporate. Lawyers fees can be well in excess of $25,000 if a lawsuit is commenced. Thus, even if one wanted to initiate a claim against a blogger, the potential plaintiff has to weigh whether the blogger could actually pay the judgment or settlement (in reality, over 90% of lawsuits settle before they go to trial). The practical truth (and something lawyers don’t like telling the public) is that unless your net worth (and I am talking about assets which can be liquidated to satisfy payment and not subjective paper gains) is into 6 figures, one is just not worth suing or continuing an action
3. The good thing about blogs is that they can always be changed so the damage can be limited by editing content, issuing an apology etc.- it is not like print where the offending content is in the public eye forever. Quick and proactive action once one has been informed that there may be a legitimate legal issue can, in some cases, settle a potential claim quickly.

In conclusion, incorporating to shield against liability make sense if the blogger has a lot of assets to protect. In most situations, however, this is not a clear-cut situation so an appropriate cost-benefit analysis must be undertaken. The best resource would be your lawyer- she would understand what type of risk exposure you would have.
LOWER TAXES

Corporations tend to pay lower taxes than individuals (again, check your jurisdiction) assuming it meets certain requirements. Corporations also pay taxes based on taxable income (revenue - legitimate business expenses) and not gross income. Thus, there can be significant tax savings if one incorporates. For example, the top individual tax rate in the Province of Ontario is in excess of 46% whereas an eligible corporation has a tax rate of just under 19%.

However, there are a few factors to consider. Tax savings are only material if taxable income is quite high. There is no hard and fast figure on what this is but some have suggested that unless your business/employment plus blogging income is in excess of $120,000, there is not enough tax savings to consider incorporating for the primary purpose of saving tax (removing for the sake of this analysis, the liability argument for incorporating). If a large percentage of a blogger’s income is from blogging and not employment income or investment, then there may be a strong argument to incorporate to take advantage of tax savings. Having said that, if blogging income is modest (say, under $10,000 per annum) there may not be enough income to justify incorporating (especially if one lives in a jurisdiction with low income taxes).

Let us not forget that, in most jurisdictions, one is allowed, as a sole proprietor or as a member of a partnership, to deduct legitimate business expenses against business income earned in order to calculate taxable income (in most tax returns, you have two reporting sections- one to report employment income and one to report business income; in the latter, you report your taxable income and not your gross income). The rules for deducting expenses are substantially no different for individuals carrying on business than corporations. Certainly, there are a greater tax planning structures available for corporations than individuals. But, if one is running a very simple one person business where the book-keeping is simply “cash in, cash out” (which most blogs are), one may be in substantially the same tax position regardless of whether one incorporates or not.

One further issue to consider- the corporate tax rate only applies as long as the blogger keeps the money in the corporation. As soon as it is paid out, unless it is to another corporation (and subject, again, to appropriate tax rules), the payment is taxed at the individual tax rate (again, check for details in your jurisdiction). Thus, if one is blogging as a hobby and making side income out of it, it may not be cost-effective to incorporate since the money that flows into the corporation will be taxed at a higher rate as soon as it is paid out to you. However, if one wants to make a business out of blogging and will be using profit to grow the blog, it may be advantageous to incorporate for tax reasons in order to save as much money as possible.

Incorporating primarily for tax savings becomes a fine balancing act. Is the blogging income so great that it would put you into a higher tax category if it was received personally? Are the business expenses incurred from blogging (typically a computer, some stationary, professional fees etc.) going to off-set most of the gross revenue? Are you even certain you will be blogging for years on end and making revenue during that time?

These are very individual specific questions to answer. Thus, run the numbers with your accountant and see if it makes sense for you.

____________________________

Two concluding remarks:

Experience has shown that people tend to incorporate too early in the cycle. They over-perceive risk when their business (assuming it is not a high-risk industry) is starting up and over-estimate the tax savings that a corporation could yield in the early stages (as a side-note, most entrepreneurs are too aggressive with their deductions- even if they are legitimate- which actually hurts them on exit but I’ll address this point two posts from now when I talk about selling a blog). Notwithstanding the foregoing, there may be certain situations I outlined above where incorporation may be ideal assuming one has received appropriate advice.

Finally, unfortunately, life does not fit into neat compartments. Most people do not clearly need to protect against liability or require tax savings. Most people fall into the mushy middle where some liability protection or tax savings may be required. This is why the mantra for most lawyers and accountant is “it depends.” Life is context specific and one should be leery of applying cookie-cutter solutions into the complexities of every day life.

Next week, I’ll tackle some practical issues if you do decide to incorporate. Enjoy the Super Bowl.