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I. The Opportunity.

Samuel Watson burst into his partner's office and exclaimed, "I've found the perfect opportunity. It will make a boatload of money with no risk!"

Startled by his partner's exuberance at nine o'clock in the morning, Carl Houston just stared at him intently. Gathering himself he replied, "What opportunity?"

Without seeming to catch his breath Sam stated, "Jim, your least favorite attorney who does not return your phone calls, and I, met this fellow, Kip Alfred, at a reception that I had at my home last night. He is a guy about sixty years old who sold his company and is sitting on a few million dollars in cash. He told me about a company that our friend Jake Langford has just taken into bankruptcy, Chapter 11, for defaulting on a few hundred thousand in loans to his bank. The company is involved in imaging technology and can be purchased for the cost of its hard assets. Kip Alfred would like us to join with him in this transaction."

"I know this is 1983, but what the dickens in imaging technology and why would such a successful guy with millions laying about need us or our money, Sam?"

Thereupon Sam grew hostile and threw a two page summary on Carl's desk. Carl Houston began to read it. But before he could get past the first page of a rather technical description of imaging technology, Sam stated, "I am going to pursue this opportunity with Jim Sutton."

"Please let me understand this. You and Jim Sutton are going after this on your own. So why are you taking up my time if this is a personal thing, that you want to do on your own time, and with your own money," Carl asked.

"That's not the case at all, Carl. I want to pursue this as a business opportunity. I will keep you informed every step of the way. Carl, you may be CEO, but we are still equal partners."

"Sam, you're right, but I am not so sure this fits our Company's focus."

"There you go again. Every acquisition opportunity you come across fits our focus, and everything I find with my extensive social contacts, doesn't."

"That's not the case at all. What do we know about imaging or whatever it is called. We have re-capitalized companies, but never anything based on a single technology that we know nothing about."

"Carl, Kip Alfred is an engineer with excellent credentials in this field. He has worked for the NSA and the CIA and really knows his stuff."

"Great, another guy that I will have to talk to nondescript people sitting in a telephone booths to obtain character references. Maybe you don't remember the last guy like this you introduced. That fellow turned out to be an alleged former CIA Branch Chief. I say alleged because I think he never left the CIA and just wanted to use our Company as a cover for other activities; like importing tanks shaped like candy bars. Does Iran Contra ring a bell? Do you recall that all his job references had no last names? We were just instructed to call a number with no Company name."

"Carl, you are exaggerating."

"No, I am not. I was the one that had to check that fellow out because you were unwilling to do it. By the way, what do you really know about Kip Alfred?"

"He is a top flight successful guy."

"Sam, who says so?"

"Both Jim Sutton and Jake Langford speak highly of him"

"I understand Jake Langford's motivation, he wants to get his bank paid back. Let me guess, Kip Alfred is a client of Jim's. I'll bet that Kip Alfred owes Jim Sutton a few dollars, but Jim Sutton will be willing to forgo those fees if we do this transaction with Kip Alfred."

"Not exactly. Jim Sutton advised The Imaging Company on their lease facilities in Wheeling, West Virginia last January. He brought Kip Alfred, a client of his, into the picture because of his national reputation in the imaging field when the Company headed into bankruptcy in August. Jim Sutton has been working on a pro bono basis. He doesn't expect anything unless the transaction closes. I think he is looking for warrants in addition to cash fees."

"Sam, if you want this so bad, you can have it to pursue. All that I ask is that you thoroughly check out the reputation of Kip Alfred, keep Jim Sutton under control, and inform me as this thing progresses."

With that statement, Samuel grabs the analysis of Imaging Technology off Carl Houston's desk. He literally runs out of Carl Houston's office and walks briskly down the hallway into his own office with the door shutting swiftly behind him.

II. The Transaction

For the next six weeks, all Carl Houston saw of Sam was him leaving the office with Jim Sutton in tow. It clearly was the Jim Sutton and Sam Watson show. Carl Houston knew what to expect from experience. Eventually, Jim Sutton would come into his office because Sam couldn't ever reach a decision on his own. After he got through telling everyone at the bankrupt company how important he was, he would leave Jim Sutton holding the bag. The bag with the work in it, that is. Sam wanted the credit, but without the work and the responsibility that came with it.

Jim Sutton, on the other hand, was a brilliant real estate lawyer who wanted to be an investment banker. Unfortunately, his considerable technical real estate expertise and negotiating skill was not enough to overcome his lack of financial expertise and street smarts.

Suddenly, one afternoon Jim Sutton knocked on Carl Houston's door.

"Carl, have you got a few minutes?"

"Just passing through, Jim?"

"As you know, Sam and I have been evaluating the purchase of The Imaging Company."

"Is that what you call it?"

I think we have a handle on the hard assets thanks to the financial people within the company. Jake Langford has gotten the bank to agree to a purchase price of $1,500,000, which is equal to the net book value of the hard assets. I have started drafting a plan to submit to the court. My plan calls for the investors to put in $2,000,000 in exchange for the assets with a full release from the bank and the other creditors. Your company has committed to invest $500,000 and to help raise the remainder of the money. I think there may be one other bidder, but thanks to Jake Langford it is fairly certain we would win based on the terms I have just mentioned. We plan to form a Sub-Chapter S Corporation that will acquire the assets and assume approximately $500,000 in bank debt on a nonrecourse basis. The bank initially wanted personal guarantees because of the Sub-Chapter S Status. I knew you would never agree to sign a personal guarantee so I made it clear to the bank that is was nonrecourse or nothing. After a fair amount of yelling and bluffing to walk away, the bank agreed on a nonrecourse loan. This structure will allow for the flow-through of tax benefits from the amortization of leasehold improvements and the depreciation of other fixed assets with no personal risk to anyone."

"It seems to me that you have everything worked out, Jim. Why do you need me?"

"Come on, Carl. Listen to me. We are in a tough spot. Our reputation is on the line in this town."

"What's this 'we' stuff, Jim?"

"Please listen to me, Carl."

"Jim, I have to tell you that Sam has not made a single presentation to me or our Board of Directors regarding this transaction, much less discussed the $500,000 commitment from us and the raising of the rest of the money you mentioned. What do you expect from me?"

"Carl, I wonder if you would have the time to visit the company's facilities, meet with the management and review their numbers before anything gets put into a private placement memorandum. Also, I would appreciate it if you could review all the acquisition documents, a private placement memorandum draft, and the pricing of the selected assets."

"Jim, you have no due diligence document, projections, or anything real to support a private placement memorandum?"

"No. However, your partner has made positive representations to the bank and the Imaging Company. He has even begun talking to individual accredited investors without a book. I need your help before this goes much further."

"Jim, I was against this thing from the start. Not because it wasn't a great deal, but because we are not technology investors. Hell, I still know no more about this transaction today than I knew when I first heard about it. How can I be for or against anything that I know less than nothing about.

"Carl, please help me."

"Jim, I am not making any promises, but if you get everything together that you have, I will visit your office and try to get an understanding of what this thing is all about. I expect that you will make yourself available as well to answer any questions. In addition, I want you to put together a background memorandum chronicling every second of our involvement with this company, and a memorandum written by Kip Alfred summarizing this company's, and the technology's, history and potential."

"How about tomorrow at 2:00 PM?"

"OK, you're on."

"Thanks, Carl"

As Jim Sutton exited Carl Houston's office, Carl thought that this was another benchmark in his rather turbulent partnership with Sam. He could use his legal authority as CEO to end this expedition with The Imaging Company now and risk the break-up of his partnership with Sam. Alternatively, he could become involved and get Sam mad at him for forcing himself into his great deal. Ending his partnership with Sam was not an option at this time. However, he was not going to let Sam get the company involved in a transaction without being properly protected or damaging its or his reputation in town. Carl Houston decided to risk Sam's temporary rage for interjecting himself in his deal. He would try to stay in the background, but make sure the company's risk exposure was minimized if he could not dissuade Sam from doing this transaction.

At 2 PM Carl Houston was lead into a formal dining room that serves as Jim's conference room by Jim's secretary. Jim's office is out of the downtown area situated in an old brownstone townhouse. While the townhouse is quite elegant, it lacks the formality of most attorneys' offices Carl Houston had visited. After-all, a dining room is still a dining room. Shortly after, Jim Sutton appears in the room carrying a large folder containing papers. "Carl, I thought I would initially go over with you the documents that I have on The Imaging Company. Afterwards, you can have as long as you want to read them. If you would like to take copies with you just use these yellow stick-ons to tab items to be copied."

"Jim, everything appears well organized and indexed so why don't you let me review the documents first. I will jot down my questions and if you have time we can cover them. Sam is aware that I am here. He was actually quite willing for me to get involved as long it was clearly his transaction. I have no problem with that at all."

Carl Houston spent almost two hours reviewing the documents and filled several pages with questions and follow-up items for discussion with Jim, Sam, Kip Alfred, Jake Langford, and company management. Some of the items he noted are excerpted below:

• The Imaging Company has undergone several ownership changes in its relatively brief three years existence. Each change seems to have been accompanied by high expectations of sales that never materialized and litigation by the former management and owners.

• The move to the Wheeling, West Virginia location in January accompanies the last ownership change that preceded bankruptcy.

• It was clear that the company used the free rent and advance cash payment for improvements from the new lease Jim Sutton had negotiated to capitalize the company and acquire new sophisticated equipment. The bank loans were use to cover ordinary operating costs. Once this money from the lease and the bank loans ran out, the company headed to bankruptcy. The owners did not appear to have invested more than a $1,000 of their own money in the company. Again, predicted sales to large government agencies did not materialize. In addition, difficulty in meeting certain government quality standards also appeared to play a major role in the company's failure.

• Kip Alfred appeared to have some role in prior companies, but it is unclear from the documents what that role was.

• The documents included lists of equipment securing the bank loans. The values placed on this equipment appeared to relate to their accounting basis. No liquidation analysis of this equipment's value was noted. The equipment was principally computer hardware and software, as well as the highly specialized testing equipment.

• It did not appear that Kip Alfred and his management group were investing any equity into the transaction. This was very puzzling for a person of his supposed wealth. Kip Alfred appeared to receive a twenty percent carry after the original investors received a return of their original investment. Kip Alfred was to be president of the company and given control over day to day activities and spending.

• The Board of Directors was to meet monthly. Sam was to be a member of the board and Jim Sutton was to be retained as general counsel. All Jim's legal fees were to be paid out of proceeds at the closing of the acquisition. The company's transaction fee was to be deferred and paid when the company reached certain levels of profitability. A very unusual arrangement.

• There were no financial projections or copies of patents, government bids or government contracts as part of this document package.

• Kip Alfred's memorandum on the history and potential of imaging technology indicated that this was a relatively new, but untried, technology with many possible competitors. An unknown opportunity appeared to exist in the commercial sector if one could convince non-governmental entities of the cost versus benefit of this technology.

Carl Houston bundled up the documents and walked upstairs to Jim's office and knocked on his door. "Jim, If you've got a minute, I have a number of comments to discuss, but maybe we should try to get Sam on the telephone so I can talk to you both at the same time."

Jim immediately called in his secretary and asked her to try to reach Sam. Within a few minutes Sam was on the speaker-phone in Jim's office and Carl started through his review notes.

"To begin with fellows, we need a realistic value for the fixed assets we are buying. Liquidation basis is the most reasonable approach to me which is probably less than half of the accounting net book value. Furthermore, someone needs to physically inspect each and every piece of this equipment to make sure it exists and is in working condition. Jake Langford is well aware of this issue, but I guess he was hoping to get all his principal and interest back."

After a lengthy discussion, Jim Sutton and Sam agreed to revisit the valuation and re-negotiate a value with Jake Langford.

Carl Houston continued, "we must prepare a three year non sugar-coated projection of future operating results, our financial position and our cash needs, that is assuming that there is anything to project. I do not see one thread of evidence that this company has any sales prospects."

Sam became agitated and stated, "Carl, you just do not know what you are speaking about. I have personally participated in discussions that will lead to large orders for this company."

The remainder of the conversation went that way. Carl would bring up an issue and Sam and Jim Sutton would attempt to show how they have considered it. In some cases they had properly addressed the issue raised by Carl Houston, but in many instances it was clear that they were blind to the issues raised. Blinded by the supposed riches that Kip Alfred had convinced them existed just around the corner.

Finally, the meeting concluded with Sam and Jim Sutton inviting Carl Houston to visit the facility and meet the management group.

Carl Houston stated, " I would be pleased to visit the company and meet these guys. It is clear to me that this is no longer a $1,500,000 and above transaction, but closer to a $700,000 to $750,000 transaction. We can probably avoid raising money from outside people and limit participation to a very closed group that we know well. Our company's exposure should not exceed $250,000 in common stock with the take-back of a non-recourse note from Jake Langford's bank comprising a substantial portion of the company's new capital. In fact, I think we should ask him to convert the bank's note to entirely preferred stock at closing. In effect, the bank will be the largest equity holder."

Sam asked, "Who is going to do all this work and negotiate with Jake Langford? This really changes the deal."

Carl Houston stated, "It's your transaction, so the answer is obvious. You can take Jim Sutton with you to assist. Good Luck!"

III. The Conclusion

We have omitted and simplified substantial detail in the interest of presenting certain critical issues in the start-up of a company purchased out of bankruptcy. However, many of the same issues would occur if alternative approaches to starting a business were used, particularly if other owner/operators are to be involved.

Did this start-up succeed? The company struggled for more than a year. Additional money was contributed by the original investors to enable the company to secure its first government contracts. It never, however, seemed to have enough cash to fund its seemingly insatiable thirst for sophisticated equipment and to also meet operating requirements. This continuous cash squeeze was frustrating and puzzling to the members of the Board of Directors because operating results seemed to be improving. Puzzling until Kip Alfred had a sudden massive heart attack and died on the job.

Reading his rather impressive obituary in the local newspaper on their way out to the viewing, Sam and Jim noticed something curious. The company's name was misspelled in the obituary. Rather than the Imaging Company it read the Kip Alfred was President/CEO/Owner of The Imaging Companies.

Sam and Jim Sutton were late for the viewing that day. They decided to stop by The Imaging Company's office in West Virginia on the way to the viewing. Their inquiries of the distressed officers and examination of certain correspondence confirmed their worst fears. Kip Alfred was operating another company by a similar name within the office of The Imaging Company. This company, The Imaging Companies, was benefiting more than just from the goodwill and staff of the latter company; it was receiving a larger portion of the latest equipment, revenue, and cash flow. Unfortunately, Kip Alfred had drawn out most of the cash flow before he unexpectedly died so there was ultimately little left for Sam, Jim Sutton, and other investors.

The moral of the story is: (1) that nothing substitutes for the honesty and integrity of people; and (2) there are no short-cuts in performing a thorough due diligence. Remember, Carl Houston's words almost from the beginning: "All that I ask is that you thoroughly check out the reputation of Kip Alfred, keep Jim Sutton under control, and inform me as this thing progresses."

Did Sam and Jim Sutton properly consider the reputation of Kip Alfred? Even when Carl Houston raised a number of red flags in his preliminary due diligence review, did they thoroughly follow-up:

• The Imaging Company had undergone several ownership changes in its relatively brief three year existence.

• Kip Alfred appeared to have some role in the prior companies.

• Kip Alfred and his management group were (not) investing any equity into the transaction.

• There were no financial projections or copies of patents, government bids or government contracts as part of this document package.

If they had followed up with any prior owners, reviewed court documents, state filings, met with any government agency representatives, or reviewed patent office filings they would have most likely discovered that Kip Alfred had tried this scam before with some success. Finally, Kip Alfred and a number of the Company's officers had a long association with the CIA and other agencies which raises the possibility, that can never be proved, that they were not doing this for or by themselves.

Note: This case history is pure fiction. It was prepared for illustrative purposes only and any relationship with any persons living or dead is purely coincidental.

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