A theory on the history of schools

In my last post I discussed why I believe that the school system is doing nothing to elevate the poor. Essentially I argued that the school system teaches people a great deal of non-essential skills at the expense of true life-skills.

No matter how brilliant Emily Bronte is, the fact is that I will rarely (if ever) benefit from my knowledge of Wuthering Heights. In fact, it nearly damaged me since I, an extremely avid reader, hated that book with a passion and have since regarded all "classics" with a wary eye. In the same note, while it's nice to know how molecules combine, my knowledge of chemistry probably isn't going to have much application in my life. Meanwhile crucial life-skills, such as budgeting, stocks, mortgages and the cost of interest, were either ignored or just lightly mentioned.

Now I'm not against teaching chemistry to our children, for some it ignites an interest that will lead them to a great career. But teaching such things at the expense of critical skills seems counter productive to me.

So how did our educational system come to be this way? I have a general theory, though I warn you that it's largely uncorroborated. Perhaps some people can correct or confirm certain elements of this story.

Let's go back first to a time before schools. During that age long past humanity consisted of mostly farmers and hunters. Children were raised and passed on skills from their elders. If you were a farmer, you learned to farm from your father or some other mentor figure. There were no schools, no tuition, no professional teachers. There are also no rich and no poor. Some may have more than others, but there is no effective way to translate a rich harvest into captial. You will simply eat well that season.

Fast forward a few hundred years and you will begin to see people coalescing into communities, and beginning to specialize. As this happens education continues, mostly the same. If your father is a blacksmith, you will most likely become a blacksmith. The only way to escape such a fate is to apprentice yourself to a man of another profession. However, as civilization develops, so does the concept of wealth. Some men are more successful than others and begin to build their riches.

Step forward again. Civilization is bustling. Classism exists. Those who succeed become very wealthy, those who do not become poor. Science and literacy exist, but are known by few. This is the time from which education pulls it's roots. A wealthy merchant hires a wise man to teach his son reading, writing and philosophy. He doesn't need the man to teach his son about business, he can do that on his own. He knows the fundamentals of business and wealth, and he will pass them on to his child. The teacher is hired to teach that which the wealthy merchant can not. Things like Geometry, Literature, and Physics are the subjects at hand.

Let's stop for a second and see what we've just witnessed. The formation of professional education. A teacher was hired (perhaps for the first time ever, making him the first professional teacher), but not to instill basic life lessons. Those lessons would be passed down from father to son, in the same manner as generations before had. Instead the teacher was brought in to teach "higher" lessons. The father had no need of those lessons to achieve his wealth, yet he wanted them taught to the son.

Step forward in time yet again and we will see the first schools established (in the times of the Greeks and Persians). These schools don't teach their students to be good businessmen, or how to build wealth. Their trades will be taught to them either by their fathers, or through an apprenticeship. Instead these students are taught more classic lessons. History, advanced mathematics, literacy, philosophy. These lessons are useful to their students, but they are still expected to learn their trade skills and the life lessons outside of the educational system.

Fast forward to today. College have replace apprenticeships as the prefered method to acquire tradeskills. High schools (and below) continue to teach many of the same subjects as the early schools. But only a small percentage of student will ever benefit from any individual lesson taught. Few who study chemistry will end up in a profession that utilizes that knowledge. Few who study Shakespeare find need of that knowledge later in life. But students are still expected to learn their life lessons elsewhere, under a different instructor.

These life lessons, not your geometry lessons, are what lead you to wealth and financial comfort. Schools may open your mind, and these days college may lead you to a larger income. But the lessons that differentiate the rich from the poor are simply not taught in our educational system.

I am a huge fan of education, and my degree has provided me with a fulfilling and comfortable career. While the education system may not lead you to wealth, I argue that wealth is a hundred times more difficult to achieve without education, especially in today's world. But understand that a good "education" can only take you so far. If you want to build wealth and financial stability, you need to learn the life-lessons that parents are expected to hand down.

  • Save
  • Live below your means
  • Control your risks
  • Make wise investments
Within each is a thousand lessons covering mortgages, compounding interest, the stock market and every other subject. The good news is that tools like the internet have made it possible to share information in ways not even dreamt about as few as 30 years ago. If my parents wanted to invest in a municipal bond arbitrage when they were my age, they would have been out of luck. I, however, can simply look it on on a site like Wikipedia.

As far as wealth is concerned, you are ultimately responsible for your own education.

Does the education system produce poor people?

People love to talk about how the rich stay rich and the poor stay poor, and usually the conversation tends to stray in the direction of "tax loopholes" and "the poor being exploited". I'd like to take a second and break into one of my favorite rants on what I think the cause is behind the widening gap between the wealthy and not-so.

I think the cause of that gap is the fault of our educational system.

First I need to convince you that wealth isn't the result of a high salary, but rather it's the result how how you handle your salary. The Millionaire Next Door uses the example of the doctor who earns well into the 6-digits, but is deep in debt due to the vacation home and the boat, contrasted with the white-collar Joe who lives below his means and has saved and invested aggressively. Who is wealthier? The doctor who owns lots of nice things, but has to work every day to make his next payment? Or white collar Joe who has a very large investment pool that will help him stay comfortable for the rest of his life? How many pro-athletes earned millions of dollars, but blew it all on big houses and bling, only to be left with nearly nothing by the time they hit age 50?

So why is this the education system's fault?

As Americans we love to point to our school system as a very fine one. We provide free education to all children up to a high school level. Our children who graduate end up getting some nice jobs in a variety of fields. These children are obvious successes, right?

When I went to high school I was required to take classes in American history, physics, trigonometry, chemistry and literature. All in all I was required to take 28 classes. Not one of those classes was on finance. When I graduated I knew how to calculate the speed of a falling baseball at give point of time, but I didn't know how to amortize a home loan.

The skills I learned in school have helped me tremendously throughout my life. The experiences I had with raw science and literature have definitely shaped me, and in a positive way. The foundations I built have helped me to find a relatively high paying job. But that doesn't necessarily make me any richer.

The problem with the education system is that we teach a lot of fantastic skills, but we don't teach people fundamental life skills. Children are taught skills that can help them earn more money, but rarely are they taught how to handle that money. The reason is that we expect those "life lessons" to be taught by our parents and our peers. We don't need the state to teach you how to manage your money or how to build successful relationships, because that the parent's job.

Where that breaks down is when you find a child with poor role-models. What do you expect a father who blows all of his money on lottery tickets and booze to teach his children about fiscal responsibility? Why are we surprised when the daughter of a beaten and divorced single mom constantly gets into bad relationships? Look at who they learned from. And can we really blame the parents when they themselves never learned any better?

The reason the poor stay poor is because their parents teach them all the wrong financial lessons. A child from this situation will probably never learn about the very basic 401ks or mutual funds, and he will learn to spend what they have instead of saving for tomorrow. Thus the poor begat poor.

The rich will do the very opposite. A child of upper-class parents will be more likely to learn about saving money, paying mortgages and preparing for retirement. When he gets his first real job, his parents will probably tell him to put money into a 401k, and teach him about it. They'll ask him about how much he is saving. They'll encourage him to save up for a house. Even if the child is irresponsible and spends money recklessly, these lessons will be taught. Thus the rich begat the rich.

So is this really the fault of the educational system? It depends on your view of the role of the government. If you feel that the government is the great equalizer, then you should be furious and up in arms wanting change in the system. You should be writing your representatives and demanding that they make basic financial literacy courses mandatory in every high school in America. Every student should be learning about what a 25.99% interest rate on your credit card really means even if your minimum payment is only $100 a month.

So why doesn't the system change? Because the rich realize that the current system gives their children an advantage in the world. And what parents doesn't want their children to have every advantage they can find? And the poor, who should care about this, don't realize it's happening.

Next I want to examine my theory of how the education system came to be this way (which is a largely unproven theory, maybe some of you can help me back it up or prove it wrong).

Property Managers - a new look

In the past I think I've made my views on property management companies pretty clear. I don't like them. I think that they destroy your profits and can often turn a good property into a dump. But to clarify, I'm speaking about companies who manage multiple properties, not individuals that you hire.

The Landlord Blog has a great post about how she is looking for a new property manager. Instead of finding an advertised company, she advertises in the local paper for an enterprising individual. This is the perfect way to have a property managed if you are unwilling/unable to manage the place yourself. By looking outside of professionals, you get the benefit of dealing with someone more likely to remain honest.

John T. Reed agrees. In his review of Rich Dad, Poor Dad he says (italics are mine):

Kiyosaki [author of Rich Dad, Poor Dad] says, “A great property manager is key to success in real estate.” He’s nuts. Experienced property owners do not hire independent 5%-of-the-gross property-management companies. When syndication was big, those companies owned income properties all over the U.S. They tried to use local companies for everything they needed, but they found they could not get good service out of local property-management companies so they all started their own in-house property-management companies. [...]

The problem with property-management companies is that they neglect properties and use expensive suppliers and subcontractors. I estimate that approximately 90% to 95% of property managers take kickbacks from those expensive suppliers. When I was a property manager I reported a number of bribe attempts to my boss. Both my predecessor and my successor at the job took kickbacks. (A subcontractor showed me a canceled check cashed by my predecessor and my successor was fired for taking kickbacks.) My secretary had worked for a major property-management company before working for me. She said every property manager in her old company took kickbacks.

If you ask the typical successful investor if he ever used a property manager, he will shudder at the memory, admit that he did once, and somberly swear, “Never again.”

Anesia at The Landlord Blog is, in essence if not fact, finding independant contractors to manage her properties. She is creating her own in-house management team. This provides a large number of specific benefits.
  • Reliance upon her - Unlike a Property Management Group, her managers probably only manage the properties she assigns them. If she is displeased with their performance, she can replace them. Compare that to a company who likely manages properties for dozens of investors. If you break contract with them they still have plenty of other streams of revenue to fall back on.
  • Lack of a network - Because these individuals are likely to only be managing her properties, they most likely don't have a network of contractors that they frequently use. As a result, they're less likely to take kickbacks or order unnessecary work.
  • Work on her terms - If you go to a major Property Management Firm and bring your own contract with you, you'll be laughed out of the door. These firms have their own contracts they you have to sign, not the other way around. But when Anesia hires these individuals she can draw up the contracts that they'll work under. Obviously both side need to come to agreement, but that gives you a lot more leverage than the standard PM boilerplate.
Obviously the down side of such an arrangement is that she'll have to be much more active in helping these people manage her properties, in addition to the extra workload of hiring new personnel when one of her managers is fired/quits. But that additional work is worth the risk reduction of having more control over how your properties are handled.

If you choose a professional Property Management Group because you were too lazy to manage your properties, I seriously suggest that you consider other forms of investment (try an S&P 500 index fund. Good returns with minimal effort). But if you want your properties to be managed to free up some time for other activites (like finding new properties), I strongly urge you to review Anesia's methodology and try it for yourself. It'll be far more profitable in the long run.

And if you are in the Phoenix area and are looking for a way into real estate, I suggest you apply to her for the job. Not only can you earn money towards that first down-payment, but you will learn a tremendous amount about real estate and will have regular access to an experienced investor.

Properties in the UK

I'm currently engaged to be married in December. Shortly after, my new spouse and I intend to move to London. Now this is possible due to my partnership, my partner will continue to manage the properties and I will continue to do all of the accounting and tax work. One of the absolute joys of having a responsible partner.

But on the other hand, I'm beginning to realize that with all of the information out there for real estate investors, nearly 100% of it seems to be aimed at Americans. I have yet to come across a decent number of sites dealing with property, landlording and investing in countries such as England.

Specifically I've been looking for websites or blogs that discuss the properties laws of England, what would a first-time home buyer do in England (what are mortgages like over there?! What are their rates?), what is the market like, and what are the general laws pertaining to landlording? Is the 6% sales commission the standard for them too? All of this information is easily at hand for an American. Just go to any number of sites, from bankrate.com to yahoo.com (not to mention all the fine blogs out there) and you'll find plenty of articles dealing with every aspect of home buying and investing. But I still can't find the UK versions of these websites.

So here's my question to you, kind readers. Am I looking in all of the wrong places? Does this information on real estate in the UK exist and I just can't find it? Or is there an enormous hole that could potentially be a lucrative niche to fill?

When a resident breaks a lease...

I came across an article on apartment ratings that discussed some of the complexities of breaking a lease from the tenant's point of view. At the end of the article is a very long list of comments from people who felt they've been "wronged" by their landlords and deserve to get out of their lease. I'm not here to discuss who is right and who is wrong, since I don't know much about individual situations, but I thought I'd look at some other their comments and talk about them from the landlord's point of view.

I live in Kenosha, WI and rented a condo on Dec. 12, 2005. My lease was extended until May 2007 and I can no longer afford this condo. This situation is so messed up and the story is so long I can't even get into it. How can I break the lease early and still get my deposit back?
Always be prepared and make sure your tenants understand the lease. As I wrote in an earlier post, a lease is simply a list of rules that both you and the tenant agree to wrapped up in legalese. It doesn't have to be terribly difficult to comprehend. And, as good and ethical landlords, we should also do our best to make sure that the tenant understands the lease. Just handing it to them and asking them to sign is not due diligence. At the very least you should brush over every major point on the lease and explain their obligations.

Remind your tenants that a lease is a legal contract like a car loan or a mortgage. If you fell on hard times and couldn't make your car payments, the bank isn't going to be kind and forgiving. As a human being you can be a bit more compassionate than a corporate machine, but you are still running a business and this contract will be treated as such.

Hello. I live in Tampa Florida and I just bought a condominium [...] I can't afford to pay the rent and the mortage at the same time. I'm disabled and I live on a second floor, can i use that as an excuse to move, since that was one of the reason I bought a first floor condo.
Know your rights. There are a great many laws out there designed to protect tenants, most of these are state-based, which makes them even more difficult to research and understand. But all landlords need to keep up on what tenants are and aren't allowed to do. For example, this tenant appears to have no legal ground to exit a lease under claims of disability. She might be able to convince a judge had she become disabled after signing the lease and was unable to use the premises, but it's unlikely that her current argument would stand in court. That she bought a condo without thinking about the lease she was in is a problem that is hers to deal with.

On the other hand, every state that I know of has a law in place to allow military personnel to break a lease without penalty if they are reassigned. The Virginia law (§ 55-248.21:1) requires that they give at least 30 days written notice.

When it comes to a private owner, they don't have the same legal standing as a company in that they often cannot run a credit check on you or send you to a collection agency for amounts due. If you are one of those people who have had bad rental histories or have aweful credit, they are the best places to check into first.
You ARE a company. If anyone read this and laughed, then I can't blame you. The very act of running a business makes you a company in the government's eyes. You may not have the resources or the legal departments of a major rental corporation, but you are legally allowed to do everything they are. That includes credit checks and turning bad debts over for collection. In fact, if there is anyone out there that isn't running credit checks on tenants, you deserve tenants like these. Credit checks might be intimidating, but they are simple once you learn how to use them.

I live alone and it is difficult just getting around now, so I have to move in with some family. However, I still have 2 months left on my lease, but cannot afford to pay now. Is it a binding law or if the apartment management is willing, can they let you out of the lease?
The lease is as binding as you make it. If someone leaves, nothing will happen to them unless you pursue it. This cuts both ways. If the man above did truly fall ill and needed to move in with relatives, you might allow him to break his lease without penalty out of sheer decency. But if a jackass moves out in the dead of winter without warning, nothing will come of it unless you file a claim against them.

A word of warning, I have heard if said many times that pursuing a deadbeat tenant once they have left your property is a waste of time. I have no personal experience with this subject, but be warned that most deadbeat tenants don't have the cash lying around just waiting to be seized. Trying to extract penalties from them post-tenancy can be a long, difficult and possibly expensive process. Often the best you can do is send a collection agency after them and mar their credit history.

hi... there is a sexual predator moving 2 blocks from us and we have a younger daughter.. he is actually a first degree sexual offender meaning the girl molested was under 13 years of age. I was wondering if this allows us to be able to break our lease if we feel unsafe... which we do.
Learn to talk to your tenants. Not everything has to be a fight. In this example explain to them that registered predators are allowed to live almost where ever they want, and that the other parents in the neighborhood who own their houses have no recourse (they can't force the previous owner to buy the house back just because the predator moved in). And who's to say that a predator wouldn't move into your new neighborhood too? You can only live in fear for so long. Form a neighborhood watch and take this opportunity to sit down with your daughter and explain the dangers of people she doesn't know. Work together with your community to actively prevent bad situations from occuring.

In the lease it says that if you break the lease you have to pay equal to 3 months rent. I can not afford rent let alone 3 months of it at one time. Is there anything I can do?
Don't be a dick. Sure, as landlords we hate broken leases. Broken leases lead to all sorts of expenses for us, from advertising for new tenants to vacancies. But don't go overboard in fixing penalties for breaking a lease because sometimes life happens and your tenant gets a new job in another state. Biff and I ask for 30 days notice and then a 1-month's rent penalty. That gives us (in essence) a 60-day window to find a new tenant form the moment we know about the vacancy. I think that is a very reasonable period of time to find someone to fill the place, and very few people ever need to move on less than 30 days notice.

An added bonus of making penalties more reasonable is that the probability of the penalty being paid goes up tremendously. Let's face it, if your tenant gets a new job in Paris, he's going one way or another. If you are asking for his first-born son he's more likely to try to dodge the bill. But asking for something practical (like a penalty equal to one month's rent) means you are much more likely to get that money.

For your amusement

I think you'll really enjoy this best-of post that I came across on craigslist.

The kind of Landlord I am

1. Responsible for the weather
My building manager called to say one of the tenants wanted a discount for the days it was hot outside. Why? Because it was also hot inside. Their electricity is fine. They could run both air conditioners and fans and keep a supply of popsicles, just like I did in my apartment. My response: Will you pay extra if the weather is nice?

2. In charge of the animal kingdom
A tenant complained about mice. I sent over an exterminator several times. He stuffed steel wool in holes, baited traps, sprayed outside etc. Eventually he refused to go back because the tenant continued to leave open packages of food on the floor and counters. She insisted I was responsible for the problem. As if I commanded the mice to invade her house.

3. Menace to domesticated animals
One tenant was convinced I was poisoning her and her wooly mammoth dog with carbon monoxide. (What will I think of next?) Fire department went over there. Gas company went over there. City of Evanston sent an inspector. Everyone who tested got the same result. No discernable level. She tried to deduct $200 from her rent to pay for her vet bill. This woman also accused me of running a bicycle chop shop in the basement. And wanted me to compensate her for a parking ticket she got in front of my building.

4. Pet killer
I hired a carpenter to fix something. With the tenant’s permission, the carpenter went into the apartment. Apparently the act of opening the door scared the dog. The dog ran down a set of internal stairs, bumped his head and died six weeks later. This story was condensed to “Landlord killed my dog.” There are several neighbors who will not even say hi to me. One of whom made it his mission to make sure my landscaping is always in 100% compliance with arcane City ordinances.

5. Made of money
Tenant asked to break her lease because the price of her anti-depressants went up. No mention of the car she just purchased. Maybe she thought the hint of mental illness would scare or embarass me. She was three months into a twenty four month lease. 24 month lease she specifically asked for.

6. Heartless
Contrary to popular belief, I do not enjoy evicting single mothers at Christmas time. It takes months to evict and the landlord rarely recoups the back rent or court costs. FYI, I do not think it is more important to make your car payment. Thanks for asking.

Please pay your rent on time and remember, I am not omnipotent or an evil genius. A lease is a business arrangement.
And one more thing, why oh why wait until Sunday at 8pm to call and say your heat has been out since Friday afternoon? You call immediately if the microwave burns your popcorn.
Biff and I haven't had any incidents like the ones mentioned here... but it's only a matter of time.

The value of a home

You've probably heard it said before, "the value of a thing is equal to what ever you can convince a fool to pay for it."

It's never truer than in real estate. When you shop around for a new Xbox360, everyone is pretty much selling it for the same price. That's because the product is the exact same anywhere, so your incentive to shop around increases. In other words, it doesn't matter where you buy your Xbox360, they're all the same when you bring them home, therefore if you can find a lower price somewhere else there no reason for you to pay the higher price.

Real estate is different because no two products are exactly alike, making pricing more of a negotiation than a sale. You can't truly "value" a property, because it's worth is simply what you can convince someone else to pay for it.

There's a great post on The Landlord Blog that discusses the negotiation of a house purchase. Essentially the builder offered a "huge" reduction in price (about $75k), but when the blogger checked it against comparable sales, it was still too expensive. They made what they felt was a fair offer, and it was turned down.

So who was right? The builder or the blogger? The answer is neither. The builder obviously felt that the property could fetch a higher price than the blogger was offering, while the blogger obviously felt that the property was not a good value at that price. Only time can tell, but right now we can say that the blogger was 100% correct to walk away (good poker players know when to fold, and good investors know when to walk away from a bad deal). If the builder can find "a greater fool", then they made the right choice as well.

Brokers are NOT your friends

I came across this story today about how 7 mortgage brokers in Boston were shut down for using illegal and unethical practices:

Regulators have also gathered evidence of other abuses in the industry, including brokers discouraging homebuyers from hiring lawyers to scrutinize mortgage documents and persuading borrowers to sign blank loan applications. As a result, the division has adopted emergency, and permanent, regulations banning fraudulent practices, particularly scams that target poor consumers with limited English skills.
The funny thing is that while the target of these brokers were nailed for targeting people way over their heads, thousands of brokers are selling loans to middle class familes that really can't afford them. (Of course "can't afford them" is arguably subjective... which is why these brokers are still in business).

Whenever you are entering into any contract or sale, remember that you have no friends in business. Your mortgage broker isn't really looking for the best deal for you, he's looking for the best deal for himself that he can convince you to take. Your real estate agent isn't trying to get you the best possible price, he's trying to get the easiest commission he can. Remember that the majority of his commissions is set by the general market, not how well he sells your house. An extra $10,000 for you is only worth a couple of hundred to him. All of the moral hazards I wrote about earlier still apply.

Case in point, the shirt house Biff and I bought we purchased with $19,400 equity (10% down). We brought just over $22,000 to the closing table. The second house we went with a less typical broker and purchased with $9,995 equity (5% down) but ended up bringing (after fees and other garbage) about $18,000 to the table. I don't know how that slipped past us, we didn't buy any points, but it did and I regret it each day.

I'm not saying that everyone is out to screw you. I'm saying that there's a fair number of people out to screw you and the only way to tell the difference between them and the good people is to do your own research.

Protecting your interests in a group investment (Part 3)

Note: This post is part of a series of posts on the fundamentals of partnership agreements and investing as part of a group. See the introduction to the series here.

Figuring out the management

Since the point of your partnership agreement is to protect you against inappropriate acts by your partners (such as taking all the money and running off to Aruba), we have to take some time to expressly define how the company is going to be run. You need to define your leadership, set boundaries on your management and make sure that any situation not covered in your plan is brought to the attention of the ownership.

Did you get all of that? If not, don't worry, we'll walk throu
gh each of them.

The difference between leadership and management is that leaders figure out the path and goals for the company, while the managers make sure that path is followed and that the goals are reached.

Your leadership is obviously going to consist of your owners, because they make the final decisions. Your managers can also be owners, or you could use a third party (such as an employee or, in real estate, a property management company).

So we defined who our leaders were when we figured out what the ownership interest were. The next step is to determine how decisions amongst the leadership will be made. Most often this is by a majority vote, but that leaves a lot of questions unanswered. Specifically you need to answer the following questions:

  • Who can vote?
  • How many votes does each owner get?
  • Does every owner need to be included in every decision? (For example, if there are 4 owners with 25% each, and three of them decide they want to buy something, does the fourth have to be asked since the majority was already achieved?)
  • Who can call a vote?
  • How do you bring an issue to a vote?
  • What happens if one (or more) of the owners is unavailable at the time of the vote?
  • Can an owner designate a representative to cast his votes during times of absence?
That's a lot of questions to deal with, but it sets a very strong foundation for the future operation of the company. Even issues such as a simple majority vote can be negotiated. In our Subway franchise example, I own 55% of the company while Uncle Joe owns 45%. But to preserve the partnership we can reach an agreement that for a vote to pass it must receive at least 60% of the vote. That way, for now, I can't force any decisions on Uncle Joe. But if we accept other investors in the future, I'll still be in a very strong position.

Once we've defined the leadership we have to set boundaries on the management. Whether the business is being managed by an owner or by a third party, strong rules need to exist to allow the manger to deal with simple daily problems, while raising major issues to the leadership.

A simple way to achieve this is to define Ordinary Business Activities.
In the Agreement between Biff and I, I defined Ordinary Business Activities as:
"the normal day-to-day business activities of the Partnership and excludes activities involving decisions that could potentially have a substantial current or future impact on the Partnership's assets, debts, income or expenses".
This list should mostly cover everything you think should be accomplished without needing a vote. Looking at our fictional Subway franchise a list of Ordinary Business Activities could include:
  • Opening and closing the store
  • Making and selling sandwiches and other foodstuffs (restricted to the menu)
  • Ordering supplies (within certain limits)
  • Accepting job applications
  • Building maintenance
Actions that aren't included within Ordinary Business Activities, and thus would require a vote to execute could include:
  • Hiring or firing employees
  • Giving raises
  • Purchasing equipment
  • Menu changes
In addition you probably want to define certain exceptions to the OBA rules, where certain events always require a vote, such as entering a contract with an annual cost of over $1,000 (say, with a cleaning and maintenance company).

The last thing you need is to have a manager be hamstrung by overly restrictive rules that make him require a vote on every possible activity. But at the same time you don't want the manager to be making unilateral decisions that significantly impact the future of the company. In other words, you don't want the manager to be allowed to do whatever he likes.

These rules and boundaries are extremely important to record and update whether you are participating in management or not. If you are managing an aspect of the company, then this will give certain decisions to you and you alone. If other owners object to your choices, you can easily provide them with the evidence that the decision was yours to make. If you aren't involved in the management of the company, then this is a way of ensuring a level of accountability.

Introduction - The basics of entering a group investment
Part 1 - What a partnership agreement is, and what you need to know about it
Part 2 - What is my interest and how do I determine it?
Part 3 - Figuring out the managment

Protecting your interests in a group investment (Part 2)

Note: This post is part of a series of posts on the fundamentals of partnership agreements and investing as part of a group. See the introduction to the series here.

What are my interests and how do I determine them?

So in our series here we've been dealing with a fictional Subway franchise start up. I'll freely admit right now that I know very little about terms and conditions relating to Subway franchises so some information I present here may be inaccurate depending on the paperwork you have to sign with Doctors Associates Inc (the owners of the Subway brand). However, in general the concepts here should pertain to most situations, especially companies that are wholly original (not beholden to any super-brand company).

So what are your interests in your new investment? Generally, if you are putting forward money to advance this business, you'll want to be paid back in one of two ways. If you loan the money to the new company you'll form a bond and want to dictate terms of interest and a repayment schedule. However that would make you a creditor, not a partner, so we'll over look that possibility for now.

The second way to be paid back is to own a portion of the company. In essence, you'll be a stock holder in a privately held company (though partnerships do not need an official issuance of certificates). How much of the company should you own? This is often the first, and most difficult, question to answer. The answer can only be found through long negotiation between all interested parties. When negotiating your share of ownership interest, here are a number of concepts that should be considered.

Capital Invested. Who is going to be fronting the money, and how much? In our hypothetical example let's pretend that Uncle Joe is starting the Subway franchise but he's asking you to front 70% of the capital. A good starting place for the ownership discussion would be starting the shares according to the monetary investment, giving us a launching point of owning 70% of the company.

Expertise. Is the company going to be relying on the expertise of any of the partners? Maybe Uncle Joe managed a successful Burger King for 15 years and has the know-how to hire the right people and run the day to day operations. In a real estate partnership maybe one of the investors is a lawyer who knows how to get property re-zoned according to the investment strategy. In both cases, the partners who bring expertise to a company have a stronger negotiating position.

Level of Effort. Are one or more of the partners going to be investing significantly more time into the company than the others? Maybe Uncle Joe intends to manage the Subway full-time, while you sit back and do very little in the day-to-day operations. This work can be compensated in two ways. He can be paid a regular salary, or he can be compensated through greater ownership. Most likely it will be a combination of the two, with him taking a lower-than-average salary to help the company through it's early times, but in return taking a slightly larger ownership interest.

Referring back to our other example, let's say that we intend to get some investment property re-zoned and one of the investors, the real estate lawyer, will be the one to do so. He expects it to take a couple of weeks to fill out and file all the paperwork. The partnership can either reward him for his effort with a larger share of the partnership, or it can offer to pay him for his work (leaving his ownership level the same). Note that if the partnership pays him he will earn money regardless of the success of the investment. Offering him a larger share will link the return on his effort to the success of his filing.

In the end though, determining the ownership shares for the individual investors lays entirely on the shoulders of the individuals. There is no simple formula that can be used, instead it's simply reliant upon the negotiation skills of those included, which is why mergers between companies can take months as professional negotiators debate every fine point.

Obviously the more important the partner is to the success of the business, the larger a share they can command. A good question you can ask yourself repeatedly during this stage is, "What are my odds of success if I found someone else to replace this partner? What would my partner's odds of success be?" Could he find someone else willing to finance the investment? Could you find someone else to replace the knowledge he provides?

In the case of Biff and I, we each brought certain advantages to the table (my accounting and financial skills and his proximity to the properties) and we agreed to split all expenses 50/50. So even though Biff had a slight advantage in our negotiations (it would probably be easier for him to find someone financially gifted, than it would be for me to find someone I trust who lives in an affordable area), he didn't push because he knew that we'd both be profiting from our joint venture. Many small group investments go the same route, splitting costs, workloads and ownership equally. But each situation is unique.

In our hypothetical example, we finally settle on giving Uncle Joe a 45% ownership share based on his 30% capital investment, his expertise in the field and his offer to take a small pay-cut until the business turns a profit for 3 consecutive months. The good news is that once we've reached this point we've already answered a large number of questions including:

  1. Who is going to invest in the company?
  2. How much does each partner contribute?
  3. What is the role of each partner in the company?
  4. How much of the company does each partner own?
We're now well on our way to collecting more of the information we'll need before we draft our partnership agreement.

Introduction - The basics of entering a group investment
Part 1 - What a partnership agreement is, and what you need to know about it
Part 2 - What is my interest and how do I determine it?
Part 3 - Figuring out the managment