The lesson came in a deal I did in 1991 with a guy who wanted to buy a chain of franchised transmission shops out of bankruptcy. I put up the capital, about $100,000, with my usual understanding: I'd own 51% of the stock until he paid me back, whereupon my stake would drop to 25%. After that we'd split every dollar we took out of the business until I earned my 33% return for the year.
Everything went smoothly at first. We bought the company, contacted the franchisees, and started collecting the money. Within a few months we had 22 stores generating net pretax profits at a rate of $80,000 a year. It was a wonderfully simple business with one employee, no real estate, and virtually no debt.
Then the guy I financed came to me with a plan to leverage the business, expand rapidly, and do various things I considered reckless. I said no. He said, "You can't stop me. If I pay you back, I'll become the majority shareholder."
He was right, of course. There was nothing I could do. He borrowed the money to pay me back, reduced my stake to 25%, and started expanding. The company grew and--despite my misgivings--continued to be successful. I said, "OK, when are we going to start splitting the profits?"
He said, "What profits? We're reinvesting everything. There won't be any profits for a long, long time."
I received about $2,000 on my $100,000 investment over the next six years. I should have been earning more than $30,000 a year, but I had no way to force him to pay me. I couldn't make him declare dividends, and I had no control over what he paid himself in the form of a salary. I felt helpless. It was a very bad experience.
But I did learn a lesson. Now I make sure that the entrepreneur and I agree in advance on how each of us is going to get paid.
For openers, we settle on the entrepreneur's salary. Any other money that comes out of the business goes first toward paying back my initial investment. After I've been repaid, I continue to get a dollar for every dollar the entrepreneur takes out (beyond salary) until I've received my 33% annual return. What's more, I make sure I have a right to force the entrepreneur to take money out, up to an agreed-upon amount--say, $600 a week. That way I'm more or less protected if we have a falling-out.
Understand, I'd greatly prefer not to exercise that right. My hope is that just by having it, I'll reduce the chance that I'll ever have to use it.
There's one more rule I'm still working on. It concerns the perils of success. What do you do when the business takes off and the interests of the entrepreneur diverge from those of the investor?
That happened on my last deal, in which I backed a friend of mine who was privatizing a municipal golf course. It went so well that he decided he wanted to privatize golf courses all over the country. I could understand his enthusiasm, but his plan was too aggressive for me. Besides, under our agreement he was supposed to be focusing his time and attention on the first golf course. I complained enough that we eventually sat down and negotiated a buyout of my contract, which satisfied both of us. We're still good friends. We talk every week.
I'm not sure that I can draw a rule from that episode, but there certainly is a lesson here. It has to do with the importance of figuring out in advance how to tie up the loose ends of a deal--how to part company in a way that will leave all the parties feeling as though they've been treated fairly.
I never worried much about that when I was investing for the money. I just wanted to make as much as I could on every deal--and I wound up making nothing. Now I have different goals. I do these deals because they offer me the opportunity to teach other people some of the things I've learned over the years and to share with them the excitement of bringing a new business into existence.
But even though making money is not my primary objective, I can't ignore the financial aspects of the deal. Like everyone else, I have limited capital. I want to control what happens to it. I want to use it in ways that bring me satisfaction and happiness, and then I want to be compensated fairly for the results. When I don't earn a fair return, I feel as though I've been cheated, which ruins the whole experience for me. It spoils the reward I value most as an investor, namely, the good memories of all the fun and excitement we had along the way.
Sooner or later, David and I will have our own loose ends to tie up. I'm optimistic that if and when we do part ways, we'll be able to part as friends, taking with us some terrific memories. By then David should have some capital of his own that he may want to invest in future ventures. I hope he'll also have the confidence, the knowledge, and the experience to start businesses again and again.
And perhaps someday he, too, will flap his wings and become an angel, lending a hand to another generation of entrepreneurs. For all of us, that would be the greatest payoff of all.
The Player
NAME: David Schneider
AGE: 31
BACKGROUND: Born and raised in Greenwich Village
MARITAL STATUS: Married, one child
PRIOR EXPERIENCE: 12 years in the restaurant business, including stints at Copacabana and Museum Cafe. Previously owned a bar and was a partner in World Cafe, which he also managed
The Business
HARVEST RESTAURANT: 218 Court St., Cobble Hill, Brooklyn; 718-624-9267; subway F,G to Bergen St.
