Why shouldn't I put money into this deal?

A General contractor, Charlie, knew a man who was a manufacturer’s rep. for building materials. One of the materials that was very popular in construction are wooden I-beams made out of a special grade 2x4’s and 2x6’s and special plywood in-between for the vertical portion. There was a patented process and machine which manufactured the equipment and met all the standards and building codes. There were two plants that served the Phoenix area one in the Seattle and one in the Salt Lake City area. For whatever reason the Salt Lake City plant went out of business and the special equipment for that plant was idle.

The manufacturer’s rep. had a great idea to buy that equipment move it to Phoenix and set up a production plant for wooden I-beams and save all the freight from Utah or the Seattle area. Charlie and the Rep set out to raise some money among their friends and acquaintances and set up the business to do just that. In the process, they accumulated 8-10 fellow investors with a total of approximately $250,000 to buy the equipment get it set up and running. That was about the time I met Charlie.

Unfortunately, it cost more than expected when they set up the equipment in Phoenix, there was quite a bit of deferred maintenance that had to be addressed and they attempted to set up the production line better than it had been before, all of which cost a little bit more money than originally expected. Also, this took longer than originally expected so cash was going out before sales began for a long period of time. Naturally, they ended up running short on cash and had a problem. None of them were particularly well heeled and able to put in additional money so they started recruiting other friends and acquaintances. The people that they brought in as additional investors were insurance agents, architects, etc., each bring their $25,000 or so to “the deal.”

Unfortunately, Charlie and his original partners had not done a very good job of planning how much money they were going to need and had not planned their project very well. So, as it proceeded, nothing went as planned and there was very little confidence developed for the investors in the management. Production did ultimately begin and sales proceeded. After six months the manufacturer’s rep. wanted his normal commission on the sales plus his share of the “profits.” Naturally, this had not never been discussed so it was quite a surprise for the investors of which the rep. was one.

While that issue was being thrashed out, no sales were being made and the plant basically set idle except that the employees had been trained and had to be kept on board so that they were ready to resume production, and other expenses continued.

Finally, sales began again but by this time there had been three general managers and there was an executive committee meeting once a week with the general manager to discuss progress. Unfortunately, all of the investors were so worried about every nickel and how it was being used and all the money that they decided to attend each of these meetings. These meeting quickly degraded into a weekly review of every check that was written for the week during the week and what it was for, etc. In other words, not management.

Ultimately, the business failed and was sold to an existing corporation, which had already resolved its management and investing structure. The now twenty five small investors who had put a half million dollars into the business were very fortunate to come out with half of their money back as a result of the sale. In its twenty-four months, the company had destroyed twenty-five friendships and business relationships and had lost ten thousand for each of those twenty-five investors. In truth, none of those investors should have been involved in this venture. This investment was far to risky for the financial standing of nearly all of these investors. Basically, they were not “qualified investors” in that this investment was not suitable for their financial position. Another words, they could not readily afford to lose their investment. It is because this was not a suitable investment for them that the fifty percent loss for each of them was so painful and it is because that loss was so painful that each investor became so intimately involved in the day to day operations in order to protect their precious investment.

The investors failed to delegate to management to its job impaired the operation of the business, as well as the gross undercapitalization at the outset. There are many lessons to be learned from this venture’s failure, including adequate planning of the financing required, appropriate selection of the sources of the financing, and finally the establishment of key business relationships in advance.

POINT: We wouldn’t go rafting the Grand Canyon without a guide, so why do we go into major investment risks without any counsel?