Article

Why investing in 'corporate governance' is key to restaurant survival

This will involve investing in legal counsel to prepare documents governing the relationships between your company's officers, directors, and shareholders; recording your company's business activities and financial transactions; and adhering to statutes that mandate how to appropriately take actions by or on behalf of the company.

May 13, 2016

By Adam M. Myron, Richman Greer

Pause for a moment to think about the best dish you ever created in the kitchen. Chances are it was not the first time you tried to prepare it. More likely, you achieved success only after several failed attempts. You had to find the freshest ingredients, determine the correct proportions, measure out the right seasonings, and take special care not to over or undercook anything. Patience and trial-and-error in the kitchen resulted in creativity, innovation and achievement.

Unfortunately, when it comes to building a successful business, an entrepreneur cannot afford a trial-and-error strategy. Each decision will have far-reaching consequences and could determine whether a business is a boom or a bust. Having a system of good corporate governance within your business is critical to giving your enterprise its best chance of survival. This will involve investing in legal counsel to prepare documents governing the relationships between your company's officers, directors, and shareholders; recording your company's business activities and financial transactions; and adhering to statutes that mandate how to appropriately take actions by or on behalf of the company. Frequently, however, businesspeople do not adhere to good corporate governance strategies and find out too late that, when it comes to dealing with financial and legal issues within their companies, an ounce of prevention is worth a pound of cure.

The fact that this seems to be particularly problematic in the restaurant and food services industry is not particularly surprising. It is a common fact that the majority of new restaurants fail within the first year of existence, and from the moment of grand opening (if not sooner), there is enormous pressure to prove that a restaurant's concept, menu and level of service are different and better than its competitors. Moreover, entrepreneurs need to keep costs low in order to survive. Considering those pressures, is it really any wonder that investing in legal services to ensure a system of good corporate governance is usually a low priority in the restaurant industry? Nevertheless, failing to invest early in legal services can be a costly mistake. Consider the following examples.

Example 1: Smith and Jones are co-owners of ABC Inc., the sole asset of which is the hottest new restaurant located in the trendiest part of the city. As 50-50 owners of ABC Inc, Smith and Jones equally split expenses and share in all the profits, and because business is good, they are making money hand over fist. When they decided to go into business together, Smith and Jones agreed that Smith would be in charge of marketing the restaurant and Jones would manage day-to-day operations. They formalized their agreement with a handshake. Neither Smith nor Jones hired an attorney to prepare bylaws, which would have governed the operations of the company and set forth the rights and powers of Smith and Jones as the company's sole shareholders, officers, and directors. 

One day, Smith learns from the executive chef that Jones has been sexually harassing several members of the kitchen staff, creating a hostile work environment. To make matters worse, Smith learns that Jones has been paying himself an exorbitant "managerial" salary that accounts for 30 percent of the company's monthly costs. Smith discusses these matters with Jones, but Jones continues to harass the staff and write enormous checks to himself. A few weeks later, a series of sexual harassment charges are filed with the Equal Employment Opportunity Commission. 

Privately, Smith consults an attorney to learn what she can do to remove Jones from management and minimize the company's exposure for Jones' misdeeds. Unfortunately, Smith learns that what could have been a relatively easy and inexpensive fix is now much more uncertain and costly. If ABC had bylaws that provided in writing that any manager of the company who engaged in conduct prohibited by equal employment opportunity laws or paid himself a salary greater than a certain amount could be immediately terminated for cause upon the vote of at least half the shareholders of the company, Smith might have been able to easily oust Jones from management. Instead, because Smith and Jones had no written bylaws or other corporate documents, Smith decides that her best option may be to file a lawsuit, and as litigation costs mount, the business suffers.  

Example 2: Davis and Miller, inspired by the hype surrounding the invention of the Cronut, decide to register XYZ, LLC and open a store dedicated solely to selling what they believe is going to be the next food craze: HotFrogs — hotdogs made from frog legs. For reasons no one can explain, the concept is a smash success and, business is literally hopping. 

In order to keep up with demand, Davis and Miller write several large checks from their personal accounts to the company's operating accounts, and after a disagreement arises over what percentage of the business each member owns, Davis seeks counsel from an attorney to establish that she and Miller each own 50 percent. After Davis explains that Miller is claiming ownership of 75 percent of the business and is entitled to 75 percent of the company's distributions, Davis promises to provide to the attorney documents demonstrating that the business is evenly split. However, after searching for proof of her ownership interest, Davis can only produce copies of a few cancelled checks written to the company, none of which describe what the funds were for. Because Davis cannot prove her ownership interest with hard evidence such as share certificates, annotated checks, and governing documents, she gets embroiled in an expensive "he said, she said" lawsuit to establish her ownership rights.

These cautionary tales are not so uncommon, and they demonstrate why seeking counsel early when starting a restaurant is critically important to its survival. Investing in good corporate governance helps ensure that when unexpected things happen, you can deal with them efficiently and cost effectively. Your business is worth it.

Adam Myron is a shareholder in the West Palm Beach office of law firm Richman Greer, where he focuses his practice in the areas of business and partnership law, professional malpractice liability, employment litigation, association law, and non-competition law.