Expert: Arthur Naman - 2/16/2009

Question
Mr. Brock paid $50K for a franchise that entitled him to market software programs in the countries of the European Union. Investors considered buying a franchise from Brock asked to see the financial statements of his business.
Believing the value of the franchise to be greater than $50K, Brock sought to capitalize his own franchise at $500K . The law firm of St. Michael's & La Pue helps Brock form a corporation chartered to issue 500K shares of common stock with par value of $1 per share. Attorneys suggested the following chain of transactions:

A. A 3rd party borrows 500K and purchases the franchise of Brock.

B. Brock pays the corp. $500k to acquire all its stock.

C. The corp. buys the franchise from the 3rd party who repays the loan.

In the final analysis, the 3rd party is debt-free and out of the picture. Brock owns all of the corporations stock, and the corporation own the franchise. The corporation's balance sheet list a franchise acquired at a cost of $500K. This balance sheet is Brock's most valuable marketing tool.

1. what is unethical about this situation?
2. Who can be harmed? How can they be harmed?
3. what role does accounting play?  

Answer
The phrase "to capitalize his own franchise at $500k means, to me, that Mr. Brock begins this series of transactions with a capital infusion of $500k and therefore $500k of stock. In effect that is your step "B" above -- Mr. Brock invests $500k in the corporation, then the corporation has a value of $500k.

Please note that, if a third party purchases the franchise from Mr. Brock, then Mr. Brock has an immediate taxable gain of $450k ($500 - $50). The 3rd party then owns the rights to the franchise. This would not be the case if Mr. Brock contributes the franchise to the corporation directly.

Regarding your question #2, the 3rd party has borrowed the money and therefore needs to repay the loan. The corporation has not borrowed the money and thus there is no need for the corporation to repay the loan. Perhaps that is the reason for your question #1 or #2 - although I am not sure I would call it "unethical" for the corporation to make a payment for the third party.

I am confused, what is the purpose of the third party.

If Mr. Brock feels that the franchise is worth $500k, then that is what he can request from the investors, regardless of the amount he paid for the franchise.

I am not sure I have phrased my responses correctly, so please ask additional questions if what I have written is not clear.