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.
Most people believe the owner owns the business and therefore owns what is in its bank account.
Here is what the evidence supports. Those are two claims joined by a therefore, and the second does not follow from the first. In most of the United States a distribution has to clear two tests on the day it is made: whether the company can still pay its debts as they come due, and whether its assets still exceed its liabilities. Those tests sit at section 6.40 of the Model Business Corporation Act, which thirty-six jurisdictions have adopted in whole or in part, and in Georgia at O.C.G.A. § 14-2-640(c) for corporations and § 14-11-407(a) for limited liability companies. The person who approved a distribution that failed them is personally liable for the excess, and a claim can be brought for two years afterward.
Getting this wrong runs both directions and only one of them is visible. Take too much and the seen cost is personal liability for the excess, for two years. Leave too much and the cost never appears on any statement at all, because capital sitting in a company that has no use for it looks exactly like prudence.
The owner's claim on that money is real. It is also last in line and conditional, and my paragraph gave the business a moral standing it does not have, which hid the part that is true and useful.
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.
Knight on profit
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, so the timing of that one payment is open in a way the timing of no other claim against the company is open.
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.
Where I was wrong
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 account that best supports my claim that the company holds its own assets is the same account that destroys my claim that nobody speaks for the company.
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 nothing would have been harder to meet and no covenant is in the way, the distribution is available. Available is not the same as advisable, and the two get collapsed constantly. Clearing the statute and the credit agreement establishes that the company may pay it. Whether the company should is a separate question, answered against working capital swings, contingent liabilities, planned spending, tax treatment and whatever the capital would earn inside the business rather than outside it.
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 and the one who has to justify the amount.