Monday, October 22, 2007

Steam from the Copper Kettle

It's a rare occassion when I blog back to back, but I've got a little steam to work off today. The front page of the Daily Record reads "Evicted" and it's the story of another old line Ellensburg small business biting the dust. Read all about it here. Now there are many, many very interesting tidbits of information here ranging from contract issues, to lawyer fees, sales of existing businesses, and, well, retirement planning in the burg.

First, let's introduce the parties, Mr. Kruckenburg (restaurant owner) and Pautzke Bait Company Defined Benefit Plan and Trust (building owner). What's very interesting to me is the building owner. Not so very much that it's the Pautzke's because technically it's not, it's the pension plan. For the uninitiated or those who live outside the walls of this valley, the Pautzke family owns the bait company-yes it is soft and satisfying and mostly brightly colored. Out of this mini empire of fake fish eggs has come an enduring and endearing small business, a real estate agency, and presumably many other holdings that I know little of.

But again, not so interesting. Defined Benefit Plan and Trust, now that's the stuff you can really sink your teeth into. It's the pension plan and as such must manage the assets in the plan in such away as to meet the plan's benefit commitments. Under this type of plan, the trust must pay out a certain dollar amount every month. This unlike defined contribution plans (what more and more of us poor sods rely on at least in part) wherein the promise is only a return on the contributed amount. Note, that in the defined contribution plan the person receivng the pension bears a significant amount of the risk.

Now then, let's say you are a company and you've entered a contract with your loyal employees to provide them x amount of dollars in retirment. In doing so, you've sought to take advantage of tax incentives provided by the federal government and agreed to be in compliance with federal laws most notably ERISA(Employees Retirement Income Security Act) and the Internal Revenue Code. And, let's say you have had a long string of years where, well maybe you as the employer, didn't have to contribute too much money because the stock market was doing pretty well and your real estate investments were doing pretty well too. Some years you might have even moved some money out of the pension funds for other uses, because there was a "surplus."
But, then you notice that your former employees are living longer than expected. Oh, and let's not forget that very soft stock market return, well. relatively speaking after all those exceptional years. Suddenly. you find your pension fund struggling to meet it's expenses, but you have some rental real estate . . . might raising the rents be a way out of an otherwise difficult spot? Especially, when the penalties on defaulting on the federally regulated pension plan can carry some pretty nasty penalties including those troubling criminal charges.

So, while I have no information one way or the other to indicate that any of these issues came into play in our own Copper Kettle story, it's certain;y something to ponder when one is searching for an explanation for the seemingly inexplicable.

Now back to Mr. Kruckenberg. Not knowing him, it would be easy to write him off as a poor manager, right? Not so fast. This was a career employee of what looked to be the previous two owners. And, presumably, the previous owners who sold to him, had confidence in him, because the daily record article states that they still carry the contract on the sale of the restaurant to Mr. Kruckenberg.

Which then leads us to the next interesting tidbit to chew on. They sold the restaurant to Mr. Kruckenberg for $214,000. We know that the previous lease was based on a percentage. 5% to be exact. So, let us work the numbers. In the best months. $2,300 was the lease payment. This means that in the highest grossing months of the year the business might have cleared $46,000 monthly. Unfortunately, many months grossed just $26,000. So for the sake of the argument let's figure 4 months at $46,000 and $26,000 for the remaining 8 months. So roughly a $380,000 gross.

While some businesses warrant a 100 % conversion from gross to purchase and sale price, they are very rare. A general rule of thumb for businesses without customers under contract is a third of the gross, and with businesesses that are very dependent on personal services that number falls even lower. Using the 33% rule, Kruckenberg probably paid twice what he should have for the business. And, that's probably just one reason the previous owner's carried the contract, because it was unlikely that commercial financing was available at that price.

So along with reading all the documents that were part of the sale, a more thorough examination of the underlying financials of the deal might have been in order. So, now not only Mr. Kruckenberg is in a loss position and so are the previous owners who were obviously relying on the sale proceeds to help fund their retirement. Might all parties have been in better shape had the deal been structured in a way(i.e. a more reasonable price) that would have allowed a commercial lender to participate? The underlying lease contract would have been subject to scrutiny by the underwriter and might have been resolved at that time. Of course, this might have necessitated another price reduction.

Copper Kettle is not the only business that has been sold in Kittitas county in the last few years for more than it was worth. One thing these businesses have in common is that they've run their conceptual or aesthetic life. Or, they are on the downside of their lifecycle. And, we are all familiar with the businesses who closed their doors without a sale after asking high prices which did not appear to bear relationship to the existing business.

Many, many of those businesses which sold and didn't sell, had another thing in common with the Copper Kettle Story. The underlying leaseholds were not secure in the long run or were too highly priced to allow for any downturn in revenue or upswing in costs. In a retail or restaurant business where location is a premium asset of the business, having a secure leasehold is a major part of the businesses assets.

One of the least scrutinized aspects of the grueling ordeal of the purchase of the train depot by the city, is the underlying lease of the land of which BNSF would not grant more than a five year term. This with a building needing literally millions of dollars of restoration funds to make habitable again. BNSF is but one downtown property owner that has placed unreasonable burdens on existing and potential tenants.

So as a potential buyer how do you protect yourself?

Under the traditional school of thought, it's been posited that it's often more appropriate to lease your site. However, if you are really interested in building your business as a long term asset AND your business is highly dependant on location, you will want to own your land and your building in this town. Understand also, the underlying cyclical economy in this town, with summer months being the most profitable. Understand the economic culture of the area, wherein most people are relying on the volatile real estate market to provide for their "retirement." Understand that the successful retail businesses and even some service businesses (mine is a prime example) in this town rely on their internet business/marketing to carry them through the slow times and factor that into purchase and finance decision making.

If you must lease, find out who rented your space before you and go and talk to them about the landlord, the foot traffic and the quality of the property management. Do some research on your landlord. Are they a trust that has a duty to maximize current return and not interested in investment for the long run? Have they been in court frequently with tenants? Will the landlord attract customers to your business or drive them away?

Before buying a business with a lease and any supply contracts, audit, audit, audit and audit again with the assistance of attorney and accountant. And, then listen to the recommendations of both. Make sure you know what you are getting into three, five and ten years out. It's far easier to negotiate terms before the contract to purchase is finalized than after.

What if you are business owner looking to sell?

It's as inappropriate to rely on selling a small business for retirement without diversification as it is to rely on holding a block of a single stock. So, the key is to diversify. In my opinion, both spouses should never work exclusively in the same small business. One should have an anchoring job elsewhere as an employee, preferably with solid benefits including health and retirement. The Small business itself should have some sort of retirement plan. Avoid the trap of making decisions on spending solely for deductibility. When feasible, buy the Ford rather than the Mercedes and stash the difference for retirement. Build solid value for your business by actively reviewing underlying contracts such as leases, vendor agreements and customer contracts on an annual basis to make sure your are creating an asset that another party can assume.

Now onto lawyer fees. I've only been in practice in Ellensburg for a year, but I've come to the conclusion that not too much thought is being put into the cost of being in court. I'm not really sure why that is. In this case, there was $16,000 in attorney fees. Roughly the same amount in controversy. And, it's very likely the building is going to sit empty for awhile. Even if Pautzke, er . . . Defined Benefit is awarded fees in the amount of $11,500, will they be able to collect? Doubtful. Stay tuned and let's all watch what becomes of that very interesting corner location.

The jury agreed with Pautzke that they were right on their technicality, but came back with a fairly strong statement by only awarding $1. That speaks volumes.