Creative Consensus, Inc. box 473, HCR 33, Spruce Head, ME 04859 phone: 207-596-6373 fax: 207-596-0538 email:
[email protected]
VIKING INVESTMENTS (Principals) Leonard Greenhalgh Dartmouth College
ROLE OF SANDY WOOD You live in Edgewater, a small town in Northern Illinois, where you have developed a substantial fine carpentry business, employing, in good times, up to 25 carpenters. (Fine carpentry involves such highly skilled finish work as doors, cabinet-making and wood trim, whereas rough carpentry involves putting up building frames.) You are one of only six such businesses in the local area and enjoy a strong reputation for quality, dependability and competitive prices. Your business has been chronically short of capital, and you have become overly dependent on Pat Olafson, the owner of Viking Investments. Viking has been a landlord (the company owns the building you have been leasing), a creditor (for years you have had a renewable loan), and a customer (you have just completed all the fine carpentry on a 100-unit condominium complex developed by Viking). Your dealings with Pat Olafson began several years ago. Pat’s Viking Investments Corporation loaned you the $200,000 that you used to capitalize WoodCrafters, Inc., of which you are the sole shareholder. It is a renewable loan that Pat can call due at any time. (Pat keeps reminding you that this could happen any day.) You wish you were not dependent on this source of cash, because at 10 percent, the interest rate is one percent higher than the going rate banks are charging business customers of your size. Since the economy turned sour, your profit margin is so low that the extra one percent really hurts. However, you have no choice. You have been at your credit li mit with t he banks for years, and the Viking loan is simply not replaceable. If it were not for the Viking loan, you would not be able to operate at your present level of business, so you keep
paying the interest every month, and thank your lucky stars that Pat hasn’t asked you to pay back the principal. You have also been leasing a building from Viking. You have been paying $5,000 a month in rent, high for the local area. The lease offers you the option of terminating or renewing at the end of each year, and you opted not to renew after this year, with Pat’s full approval. Before you gave your 90 days notice (60 days ago), you found a building closer to your other operations for only $4,000 per month, and you were anxious to move in because the $1,000 savings is important now that profits are so hard to come by. However, the deal for cheaper rental space has since fallen through because the current tenant (t he owner’s son) insists on continuing occupancy of that building. The intent to lease to you was put in writing, so you could sue the owner if you had the cash to pay for litigation, but you have no cash reserves at all. You need to ask Pat if you can renew the lease on your current building at the $4,000 market value. Local rental prices have decreased due to the poor business conditions, so you should have no trouble negotiating a renewal well below the old price of $5,000 a month. You heard through local gossip that Viking has no other potential renters, so you should be in a strong bargaining position. Your only other option is to rent a building much farther away at $7,500 per month, which is larger than you need and way above what you can afford, so you must negotiate a renewal of the Viking lease on favorable terms. (By the way, you are two months behind on rent because your bookkeeper prematurely took the building lease off your accounts payable list. You will pay the $10,000 you owe later this week after a
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Creative Consensus, Inc. customer’s check clears; if you wrote the check now, it would bounce!) Meanwhile, a potentially more serious problem has arisen involving WoodCrafters most recent subcontract work involving a condominium project being developed by Viking Investments. That deal has suddenly turned into a real mess and you need to sort it out right away.
WoodCrafters and Viking Investments Viking Investments has been an important client for the past nine years, and you have never before had any problems in dealing with them. The current problem is that Pat is refusing to pay you in full for the work you recently completed on Viking's new 100-unit condominium development in Edgewater. You need Pat to pay the entire amount due immediately because you bought lumber costing $700,000 on 30-day terms to use on Pat’s condominium project, and the deadline for payment is 15 days from today. You know from Fawn, Pat’s secretary, that Pat has the money sitting in a bank account; you need a cashiers’ check right away. You have only $10,000 in cash (or, more precisely, you will have, when a customer’s check clears later this week), and can't raise more, and you have been staring at the $700,000 lumber bill as the clock ticks. If you default on payment for these materials once the 30 days are up, you will immediately have to declare WoodCrafters insolvent, with the result that your reputation and credit rating will be permanently impaired. You are particularly anxious not to have any questions arise about your credit or reputation because you are stretched beyond the limit in the current inhospitable lending environment.
The Dispute Your problem with Viking arose because Pat went on vacation when the condominium project was not yet completed. This led to problems of miscommunication within the Viking organization that Pat is now trying to pin on you. Last year, Viking saw an opportunity in the local real estate market to build condominiums in response to a local housing shortage. A site was selected, plans drawn up and approved by the town, and contracts were put out for bid. Because the recession seemed to be gaining momentum, you gave a bare bones bid only 7.5 percent above your projected direct costs.
You normally ask for 15-20 percent, to allow for contingencies such as price increases for raw materials, insurance increases, contribution to overhead, and other factors; you have never had a job come out costing less than anticipated, so the 15-20 percent markup has yielded a modest but reasonable profit. At 7.5 percent, you would at best break even, keep your crew of skilled workers intact, and pay some of your fixed costs. You didn't expect to get rich from the condominium project. Just after Viking had signed all the contracts and begun the foundation work, a rival developer began work on a 75-unit condominium project across town. Pat became very concerned because the rival condominium specifications were very similar to Viking’s, and it was not clear that the local housing market could support two large condominium projects. Pat talked to you about this concern, explaining the need to gain a marketing advantage over the other complex. Pat said that the Viking complex was going to be differentiated on the basis of a "quality" image, and urged you to pay particular attention to this dimension since fine carpentry is one of the most visible aspects of housing to the potential buyer. To emphasize the importance of the quality image, Pat explained that Viking had amended contracts with other suppliers. For example, appliances were being upgraded to top-of-the-line equipment, higher quality Andersen windows were being installed, and landscaping was to be more “upscale.” You personally assured Pat that your crew would turn out its very best work on this project. Just before your phase of the work began, Pat took off on an around-the-world vacation, saying that it was time "to get away from the rat race of real estate development in a dead market." You were envious because you, too, were feeling burned out from the continuing stress of making ends meet in an increasingly competitive market. A prominent source of stress concerns your work crew. You have a core group of five highly skilled carpenters who work as a team and who are largely responsible for your reputation for quality. Because of the slump in the housing market, finding work for them has become increasingly difficult, but you would hate to lay any of them off because they have been loyal workers, and you might lose them permanently. In the past, you have been able to keep this core group busy during slack times by having them work on your own house. You have made several additions to it, and although your purpose is to sell it as a high-
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Creative Consensus, Inc. end property when the opportunity arises, you and your family have enjoyed living in this wonderful house in the interim. It wouldn't be wise to sell it to raise revenues in the current depressed market, nor can you afford to pay the crew to keep making improvements to it. So these are stressful times, and you wish you were a big-bucks developer like Pat who can take round-the-world trips without worrying about money. Pat's obvious affluence relative to yours is particularly galling right now. Pat is trying to weasel out of paying for the quality improvements you made on Pat's behalf that were specifically authorized by the Viking Corporation. Here's what happened. Your lumber supplier called you shortly after Pat left town to advise you that a subcontractor in the next town had gone bankrupt, leaving the supplier with a large quantity of fine oak that could be bought at almost half the going rate. There was enough to do all the cabinets, banisters, front doors, and interior trim (baseboards, window and door moldings) in the Viking condominium project. This substitution would produce a large quality improvement at a very small increase in cost. But you had to act within the next 24 hours, or the bulk of these materials would be sold to another local subcontractor. Realizing that the fine oak could give Pat a very obvious quality advantage over the competing condominium complex, you telephoned Viking immediately. Pat's secretary, Fawn, told you that Pat was on a small Hebrides island off the coast of Scotland and wouldn't be able to call in for another week. In the past Fawn has approved changes in bid specifications that benefited Pat when you asked her to do so (with never a complaint from Pat), so you explained the situation to her. She agreed that upgrading to oak sounded like a good idea, but wanted to wait until Pat called in. You told her that you had a 24-hour deadline and that you would come in and see her the next day. When you visited Fawn the next day, you recounted Pat's parting words to you, "Fawn can handle any details that come up." You also shared your fear with her that the other subcontractor who was interested in buying the oak might be the one working on the competing condominium project. If that happened, Viking might lose both the marketing advantage of a quality image and Pat’s investment in upgraded appliances and landscaping. Fawn was reluctant to make a decision, even though it represented a small increase in total construction costs (probably less than three percent). On the back
of an envelope, you showed Fawn the following figures so she’d understand what a great opportunity this was:
Original bid (for pine and spruce) per unit Lumber:
$5,000
Labor:
$1,000
Other variable costs: Subtotal: 7.5% Markup:
WoodCrafters’ bid per unit:
$500 $6,500 $500
$7,000
Proposed amendment (upgrade to oak) per unit Lumber (Oak normally costs $12,500):
$7,000
Labor (oak is harder to work):
$1,340
Other variable costs: Subtotal: 7.5% Markup:
Revised unit cost per unit:
$500 $8,840 $660
$9,500
You then explained that based on your experience, the condominiums built to the original specifications would come out costing Viking a total of around $140,000-$145,000, and would be sold for at least $160,000. You then told her that it was up to Viking to make a decision. Instead of getting $160,000, Viking ought to be able to sell the condominiums for $175,000 with luxurious oak trim (an increase in selling price of $15,000 for an investment of only $2,500 per unit), so both Viking and WoodCrafters would benefit. You explained that you were basically trying to help Pat improve the quality image, as requested, but would be happy to stick with the original specifications. It was her choice. She said it made sense to her if the change involved only a three percent increase in costs. She confided that Pat had been working on a deal with a real estate speculator who was joining Pat on the first leg of the round-theworld-trip, and this "sweetener" might clinch the deal. With the decision made, you used Fawn’s telephone to call the lumber supplier. You exercised your option on the oak 15 minutes before your 24-
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Creative Consensus, Inc. hour deadline was up. You had already signed the paperwork and the supplier was simply waiting for confirmation.
2. This contract is final and binding. No amendments to this contract shall be effective unless in writing and signed by both parties.
Pat Returns
You contacted your lawyer who confirmed that these two clauses put you in a weak legal position.
Three weeks later, after your crew had completed its job, right on schedule, and you had mailed the invoice, Pat called you. Sounding very businesslike, but obviously angry, Pat said Viking couldn’t accept WoodCrafters’ cost overruns and read aloud a clause in the contract that said all amendments to the contract must be made in writing and signed by both parties. You were taken by surprise and became flustered as you tried to explain. Pat then said the condominiums had been sold to a speculator and that Viking wasn't going to take a loss because of your attempts to increase your profits at Viking's expense. You would be paid the contract amount, $7,000 per unit.
You then called your banker, who was no more encouraging. All the local banks have become very conservative in their lending policies in the current economic situation, and WoodCrafters -- like other subcontractors in the building industry -- has become viewed as a high-risk client. You have borrowed beyond your limit in order to provide working capital. Your house is mortgaged to the limit, your life insurance policy has no cash surrender value and you have no pension plan, so there is no possibility of further borrowing for WoodCrafters. In fact, if Pat were to call due Viking's $200,000 renewable loan, you wouldn't be able to take out a bank loan to repay it. You would have to sell your house.
Pat explained that Viking got no benefit from the higher-quality wood; the sales contract with the speculator was signed and was not re-negotiable. Pat then stated that "Fawn is typing a letter confirming the original deal, and it will be hand-delivered this afternoon. The net amount Viking will owe you is sitting in my bank account and will be released within 30 days of today, the date of receipt of WoodCrafters’ invoice."
Next, you called the lumber supplier to see if you could get an extension on the payment deadline. The supplier absolutely refused, citing his own economic problems. The reason that he had made the oak available at such a low cost was that he was desperate to raise cash. He had lost a lot of money when a big subcontractor in a nearby town had gone bankrupt. When you signed the contract to purchase the oak, you were also agreeing to a clause that said that you personally guarantee to pay--with your own assets--if WoodCrafters defaults. The money you owe him, $700,000, is due in 15 days, and because of the supplier's predicament, you cannot be even a day late in paying the bill. If you are late, you will be immediately forced into bankruptcy and your house and equipment will be seized.
As the conversation continued, both of you lost your tempers and insulted each other. When both of you had vented your pent-up anger and frustration, you agreed that the two of you should meet to discuss the bill, as well as Pat’s loan to you and your lease of Pat’s building.
Your costs for this project, per unit, are as follows:
Preparing for your Meeting
Actual Costs (per unit)
In preparing for your meeting, you wondered what might have given rise to this unusual behavior from Pat. Perhaps Viking is in financial trouble because of the depressed real estate market, and is trying to bleed money out of subcontractors. Getting nowhere trying to speculate about causes for the problem, you re-read the contract, which contained the following two clauses that seemed to you relevant to the matter (though hardly encouraging):
1. WoodCrafters shall be responsible for any cost overruns on labor or material. In no event shall Viking be obligated to reimburse WoodCrafters for any cost overruns not expressly agreed to by Viki ng.
Materials:
$7,000
Labor (overtime was needed):
$1,600
Other variable costs:
$500
Total actual cost:
$9,100
Invoice to Viking:
$9,500
Actual profit margin:
$400
You were dismayed to discover that your generosity in trying to help Pat resulted in less net revenue for
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Creative Consensus, Inc. you (less than 5%) than if you had stuck to the original specifications (you will net only $40,000; you originally expected to net $50,000). This lets you do little more than cover your overhead expenses and your own modest salary. You can’t believe Pat really expects to pay you only $7,000 per unit (the original bid, prior to Fawn’s agreeing to the changes). Your out-of-pocket costs are $9,100 per unit. A loss of $2,100 per unit ($210,000 for the total 100 units) would leave you in desperate financial straits. You have only $10,000 in cash; because you cannot borrow any more, you would have to sell your family’s beloved house.
Sources of Cash Cash on hand: Receivables (invoice to Viking):
Total cash available:
$ 10,000 700,000 - $950,000
$ 710,000 - $960,000
Commitments for cash (non-postponable obligations)
Telephone calls to your bank yielded the following information:
Invoice for oak:
$700,000
Payroll (workers already have their checks in hand):
$160,000
Market value of house in a good market:
$1.1 million
Construction materials invoiced:
$ 50,000
Past due rent:
$ 10,000
Expected sales price in present market:
$800,000
Loan (if called):
$200,000
Total obligations:
Net loss in equity for an immediate sale:
$300,000
Principal needed to pay off first mortgage:
$200,000
Principal needed to pay off second mortgage:
$175,000
Bank’s total claims on house sale revenues:
$375,000
Net proceeds from immediate sale ($800,000 minus $375,000 owed):
$425,000
The banker added that in today’s lending environment for high-end real estate, the house couldn’t be refinanced in a way that would yield any more than the $375,000 for which it is already mortgaged. So if Pat really insists on sticking to the written contract, you will have to sell the house, and in so doing, you will lose $300,000 in equity. Next, you called Janet Blair, a local real estate broker. She said that she had recently had a client who was willing to pay $800,000 for your house. She checked with her client, and called you back to confirm the offer. Finally, you went to see your accountant. She reviewed your cash position in preparation for the upcoming negotiation with Pat, and pointed out that you have very little flexibility:
$920,000 - $1,120,000
With so much at stake, the upcoming meeting is an important one for you. You must make final decisions at this meeting, rather than leaving decisions until later. In fact, an impasse might mean that your payment for the condominium work would be delayed, forcing you into bankruptcy. Your lawyer advised you that if you declare bankruptcy, the trustee in bankruptcy will take charge of all your assets except for your house, and will sell them all for the benefit of your creditors. Your house would be foreclosed on by the bank which would undoubtedly sell it. The bank would retain $375,000 of the proceeds, pay you $15,000 and any that remained would go to the trustee in bankruptcy. The proceeds of these sales will then be divided among your creditors in proportion to the amounts you owe them, with the result that Pat will receive considerably less than $210,000. Your lawyer further advised you that if Pat attempts to get around this situation by subtracting the $210,000 you owe Pat from the $700,000-$950,000 Pat owes you, the trustee in bankruptcy will treat that as an “improper preference in bankruptcy” (Pat getting paid in full when other creditors are not), and will recover the $210,000 from Pat. If Pat has used the $210,000 to buy property or other assets, the trustee in bankruptcy will seize and sell either those assets or Pat’s share of those assets.
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