I wrote a paragraph in a book last year that I no longer think is true.
An owner who treats every dollar above the reserve line as personally theirs is quietly starving the one party in this whole arrangement that has no other advocate. Employees can leave for a better offer. Vendors can walk away from a bad contract. The business itself has no voice of its own.
Here is what is wrong with it, so nobody has to wait for it.
The owner's claim on that money is real. It is also last in line, and it is conditional, and the conditions are written down in statute. My paragraph gave the business a moral standing it does not have, and by doing that it hid the part that is true and useful.
This is for an owner of a closely held operating company who has cash sitting above his reserve line and has to decide what to do with it.
The word doing too much work
The word is owner.
In ordinary speech, the owner owns the business and therefore owns what is in its bank account. That is two claims joined by a "therefore," and the second does not follow from the first.
A company holds its own assets. An owner holds an interest in the company. Holding the assets and holding an interest in the company that holds them are not the same holding, and a reserve sits in the gap between the two.
What the older account gets right
Frank Knight, writing in 1921, described profit as what is left after the claims fixed by contract have been met. Wages, rent, invoices, interest. Each of those has a number and a due date attached to it before the year starts. The owner's income has neither.
That is a real asymmetry and it is the one worth keeping. The bank can demand its schedule. The vendor can demand its terms. Payroll gets demanded on a Friday. Nobody anywhere can demand that an owner take his residual, which means the timing of that one decision is open in a way it is open for no other claim the company owes.
What does not follow is that the residual is a debt the company owes him, payable on request.
The conditions nobody mentions
A distribution is not a withdrawal. It is a decision, and in most of the United States the decision has to pass two tests on the day it is made.
After the money leaves, can the company still pay its debts as they come due in the usual course of business. And after the money leaves, do the company's assets still exceed its liabilities.
Those two tests are the equity insolvency test and the balance sheet test. They appear in section 6.40 of the Model Business Corporation Act, which thirty-six jurisdictions have adopted in whole or in part, and they appear in Georgia at O.C.G.A. § 14-2-640(c) for corporations and § 14-11-407(a) for limited liability companies, in nearly identical words.
Three other things can restrict a distribution that clears both tests. A credit agreement will usually carry a restricted payments covenant, which is the clause that limits what an owner can take out while the loan is outstanding. A distribution made without reasonably equivalent value, by a company that was insolvent or left with unreasonably small capital for the business it was in, is reachable by creditors under Georgia's Uniform Voidable Transactions Act. And a minority owner in a close corporation can sue directly for breach of fiduciary duty, without going through the company first.
The part that should get an owner's attention is who pays. Under O.C.G.A. § 14-2-832 and § 14-11-408, the director or manager who approved a distribution that failed the test is personally liable for the excess, and a claim can be brought for two years afterward.
So a reserve is not a gift to an abstraction. A reserve is what is left in the account after somebody ran the two tests and decided not to take the money, knowing he is personally liable if he ran them wrong.
The part I had backwards
The obvious defense of my paragraph is that the business needs somebody to speak for it, and that the owner is the only person present. That is the natural thought and it is what I was reaching for.
It is also already answered, by the literature I went looking in for support.
Jensen and Meckling describe the firm as a legal fiction, a shorthand for a set of contracts among people. On that account the business has no interests, so nothing is being starved.
Blair and Stout argue the opposite emphasis, that the corporation holds its own assets and its directors sit between competing claims on them. That is the account closest to what I wrote, and it is the one that finishes my sentence off. If a body already exists whose job is to weigh the enterprise against the people pressing on it, then the business having no advocate is false.
So the best support for the first half of my sentence is the strongest refutation of the second half.
What the withdrawal did not reach
The withdrawal may have gone further than the argument required. Blair and Stout’s account, which I used to finish off my own sentence, is a minority position in corporate law. It describes public corporations with boards that mediate among competing claims. In a closely held company with one owner, there is no such body. The director weighing the enterprise against the people pressing on it and the person pressing hardest are the same man.
That is the situation my original paragraph described. The refutation I accepted may not reach it. What I withdrew as a moral claim about an abstraction may have been a structural observation about single-owner firms, stated badly. What replaced it is a legal analysis, which is a different kind of claim. The two statutory tests tell an owner when a distribution is unlawful. They do not tell him how much to leave in. The question I withdrew was the second one.
What a reserve actually says
An owner can starve a business by taking too much. He can also leave capital sitting in one that has no use for it, which is a real cost and not a virtue.
The balance sheet does not settle which of those he is doing. What the balance sheet settles is smaller. Cash in the company account did not become the owner's personal income on the day it became available.
What to do before the money moves
Three things, in this order.
Run the two tests as of the date the distribution would be made, not as of the last close. Read the credit agreement for a restricted payments covenant. Write down the answer to both before the transfer, because the liability runs to whoever approved it and a claim can be brought for two years.
If the honest answer is that the distribution would not make any existing obligation harder to meet and no covenant is in the way, take the distribution. Knowing where the owner's claim sits does not mean he should never be paid. It means every other claim on the company arrives with a due date attached and the owner's does not, so the owner is the one who has to put it on the calendar.