Dragonfly Corporation

On December 20, 2011, with the close of the Christmas season less than a week away, Janet and Michael Thompson received yet another call from their attorney: it was time to make some difficult decision s about their fledgling business. For the past three years, the couple had been operating their Dragonfly teenage clothing stores in Seattle, trying to earn a living and keep the business alive despite continuing losses. Now their angry landlord is threatening legal action if Dragonfly did not deliver on its overdue lease payments. The Thompsons attorney was pushing them for an answer: what did they want to do?

The financial picture was not rosy. Dragonfly had lost money since it opened, with the accumulated deficit from both stores at the start of 2011 reaching nearly $140, 000. (See Exhibit 1 for the balance sheets and Exhibit 2 for the income statements.) While the owners believed the business had gone more smoothly this past year, the numbers were ambiguous. And the Thompsons best calculations to date still showed Dragonfly losing money. (See Exhibit 3 for Dragonflys financial condition.) But the couple believed they were managing the business more wisely and felt they had corrected many of their early operating problems. They weren't sure why her dream child still wasnt profitable. Was it their location? Was there still something wrong with the way they were running the business?

The Thompsons felt they had several possible courses of action. They could try to buy time with the landlord and hope the economy and their business turned around. They could turn to Janets parents for additional financial help to see them through this crisis. Or they could admit the project wasnt working and begin bankruptcy proceedings.

The Thompsons felt their decision was complicated by the substantial investment Janets parents had already made in the business. Could they admit defeat to their family and close up the stores? Even worse, could they ask the family to increase their investment in an endeavor that might fail sooner or later?

There was also the problem of timing. While the Thompsons knew that Christmas was the peak sales season for retail operations, they also knew that January was the peak season for refunds. How were inclined to think the entire situation was somehow unfair. Just when they felt the stores were turning around, the issue of the lease payments was raising the specter of bankruptcy and forcing them to make a decision about Dragonfly before all the facts were in.

Background

Janet Hepburn and Michael Thompson met in Seattle as assistant buyers for Macys , a full - line department store chain, and were married in 1999 . Three years later, they quit their jobs Michael took a job as store manager for the Lerners department store chain and Janet decided to stay at home in anticipation of the birth of their first child. In 2004 the couple moved to Arizona , where Michael took a job working for Merrill Lynch in commercial sales. He hated the environment and found the work boring. He quit in 2005 to return to retailing with a job for a local women's clothing store. Meanwhile, the couples second child was born. In 2008, the Thompsons returned to Seattle and began looking into franchising a store with the Expecting Mother chain, a successful group of stores offering maternity clothes at the upper end of the pricing scale. Janet was tired of staying home and wanted to get back into the workforce. Both the Thompsons liked the lifestyle of retailing. They enjoyed going on buying trips, choosing inventory, and serving customers. With their combined experience in retailing, the couple believed they could make a serious attempt to run their own business.

In the process of investigating the Expecting Mother operation, the Thompsons became intrigued with what they perceived to be an obvious market niche for an upscale store serving Seattles teenage market. When vigorous research turned up few competitors in the local area, the Thompsons decided to abandon the Expecting Mother franchise idea and pursue opening up their own store instead, selling teenage clothes and accessories at fairly high price points. They developed pro forma cash flows which showed that the business would just break even in the first year of operation . (See Exhibit 4 for pro forma cash flows for Dragonflys first year.) Janet and Michael had friends who were successfully operating a chain of T - shirt shops. They liked the idea of opening one store now and using it later to leverage the venture into a thriving chain. Since they believed that most of the expenses involved in running retail stores were fixed on the corporate level, the Thompsons saw the long - term opportunity to generate a sizable income for themselves and a generous profit for their company . (See Exhibit 5 for pro forma income statements for 2009 2013.

Dragonfly

The Thompsons were not particularly worried about financing their new venture. Janets parents had expressed willingness earlier to finance their entry into the Expecting Mother enterprise, and the couple did not think starting up their own store would take a great deal more capital. They approached Janets older brother, Charles Hep burn , who was a corporate attorney in Chicago, and asked him to help them develop a plan to use in approaching the Hepburn's for money. Based on Charles Hepburn s knowledge of business and the Thompsons retail experience, it was determined that $165,000 would be sufficient to start up the new operation, which by now had been dubbed "Dragonfly"

Janet called her parents to discuss the prospect of underwriting the new store. She asked them for $125000. The Hepburn's offered little resistance to the idea. They were happy to see Janet so excited about the new business and felt that $125000 was a small investment to help their daughter reach financial independence. Janets father had recently retired from a successful career in real estate and preferred to give his children money now, rather than having them wait until after his death for an inheritance. He had only two concerns. First, the deal must be structured so that Michael was as responsible as Janet for the financial success of the venture and any obligations to the Hepburns. Second, the Hepburns must receive the tax benefits from any start - up losses with those caveats in mind, the family met on June 1, 2008, with Janet and Michaels attorney to set up the Dragonfly Corporation.

The beginning

The Thompson s thought it seemed like a very informal way to begin such a serious venture. Here they were, serving coffee in their living room to Janets parents, her older brother, and their attorney, Jeff Lawrence. When the meeting was over and the papers were signed , they would be the owners and managers of the Dragonfly Corporation. The family decided to give the company authorization to issue 50,000 shares of stock with a par value of $1. Initially, 27 , 2 00 shares were issued: 20 , 4 00 shares to the Hepburns for $20 , 4 00 in cash , and 6,8 00 shares to Janet and Michael for their 2004 Volvo, which had a fair market value of $6,8 00. Lawrence explained that they would designate Dragonfly as a Subchapter S corporation for income tax purposes and allow the Hepburns to take any tax benefits which might accrue from early losses. Later, when the corporation began to make money, this could be changed so that either Janet and Michael or the company paid any tax liabilities.

The remaining capitalization was undertaken in the form of debt. In order to be sure that Michael was financially tied into the project, the Hepburns loaned the young couple $102, 000 at an annual interest rate of 7.75%. The Thompsons, in return, loaned this money to Dragonfly, payable beginning July 1, 2008, in quarterly installments of $2,281.4 1, including the 7.75% annual interest. Charles Hepburn felt this capital structure had the additional advantage of giving the couple leverage in any financial adversity, because they would be the stores primary debt holder s. The corporation also borrowed $41 ,000 from Seattle Savings and Loan Bank for leasehold improvements, payable in monthly installments of $1,36 0, with interest at 10% per year. Confident that they had enough money to set up shop properly, the Thompsons began looking for a site for their store. They decided to lease a suite at the Crossroads s hopping c enter, near the major north/south road in that part of Seattle. Crossroads was in an old, open mall, which had recently been renovated. The Thompsons felt the emerging character of the shopping center would appeal to their upscale customer base. Also, because the renovation made it a slightly risky location, the rents at Crossroa ds were roughly half (i.e., $10 per foot vs. $20 to $25 per foot) of those in the more fashionable parts of town. Janet and Michael signed a lease on behalf of Dragonfly for 3,000 square feet at $2,550 /month or 6% of monthly sales, whichever is greater. The lease was for slightly over four and one - half years, ending March 1, 2013. They also agreed to pay some portion of common area maintenance costs, averaging about $ 578 /month.

Early Results

The results for Dragonflys first full year in business were not very good. Sales had been lower than expected, and much of the merchandise had been marked down significantly before it was sold. Thus, gross margins were considerably lower than the industry average. In addition, operating expenses were way out of line, bringing the annual loss at December 31, 2009 to $ 57,464. The next year brought problems as well. While sales were up slightly, and gross margins were up, Janet had clearly overbought, and inventory levels were up to $ 108, 800. Also, the Thompsons had managed to reduce Dragonflys expenses but had primarily done so by missing more payments to their Crossroads landlord and by reducing the amount of money they were taking out of the store. They were forced to borrow $ 20, 0 00 from Janets parents to make ends meet at home.

2011 A Tough Year

Thus, the Thompsons began 2011 in a precarious position. Their personal financial situation was very tight. (See Exhibit 9 for their personal balance sheet.) Janet had cut back on all the extras at home; the family was eating meat only twice a week. Drago fly was saddled with $ 108, 8 00 of inventory, and it looked as though only heavy markdowns would move the clothes. To make matters worse, the Crossroads M all was deteriorating rapidly. Already, 10 of the 60 tenants in the new part of the shopping center where Dragonfly was located had begun preparations to move out. It didnt look as though the renovated shopping center was going to make it. To counter the problems posed by the deterioration of Crossroads, the Thompsons decided to open a second Dragonfly store in one of the more prosperous sections of Seattle , five miles away and closer to their home . The new location, in the Bellevue s trip m all, was 1,450 square feet. The lease, beginning on July 1, 2011 , was for two years at $1,238 /month for the first year and $1,319 /month for the second, or 7% of gross sales, whichever was greater. Janet and Michael believed there were a number of reasons for opening a second store, despite their precarious financial condition. First, they hoped to recycle merchandise between the two stores, selling the clothing faster, and increasing gross margins by avoiding markdowns. Opening a second store provided other merchandising advantages, too. With a larger customer base, Janet felt there was a better chance of approaching a norm al curve in the distribution of sizes; she hoped this would lead to greater sales as customers began to rely on Dragonfly to have the sizes they needed. Janet also felt it was a good idea to send sale merchandise to a second location. She knew customers felt bad if they purchased an item at the regular price and then saw it on sale later. Dragonfly also had potential economies of scale in advertising. The Thompsons had developed a large mailing list of existing customers and felt they could spread this advertising cost among the possible revenues from two locations instead of just one. They were also looking for protection in case the situation at Crossroads did not improve. In a worse - case scenario, the Thompsons thought they could fold the first Dragonfly store on March 1, 2013 , when the lease was up, and move the merchandise to the Bellevue location. In the four months remaining on the Bellevue lease, they could either try to make the second store successful or use it to liquidate the inventory from both stores. Most important, with many of their significant expenses fixed, the Thompsons saw the second store as a chance to generate excess revenues for the incremental cost of the second set of lease payments. Despite the problems with the Crossroads store, they were pursuing their vision of a profitable multisite operation. Finally, near end of 2011 , the precarious financial situation forced the Hepburns to reclassify $40,8 00 of the debt they held as equity.

The Crossroads Situation In the meantime, faced with increasing cash flow problems, the Thompsons fell further behind on their lease payments for the Crossroads Dragonfly store. In February, they made arrangements with the landlord to begin paying off their previous balance at the rate of $1,190 /month. But this expense left little cash for regular monthly rental payments; these dropped off to $ 680 /month. Thus, the balance owed to Crossroads was still increasing at $1,258 /month. In late June, the Thompsons talked with the Crossroads landlord again and offered to pay rent of 6% of gross revenues, which at the time was considerably less than the $ 2,550 /month base fee. They would spend the differential in advertising for the store, in the hope of increasing Dragonflys sales, as well as the shopping centers traffic. In addition, they would still be obligated for the common area maintenance charges of about $578 /month. At the same time, the payments on the overdue balance would drop to $884 /month. ( See Exhibit 10 for a history of lease obligations and payments. ) The landlord agreed, but the Thompsons did not receive any documentation confirming the transaction. By early October, the Thompsons felt they had spent as much money on advertising as they could reasonably expect to be effective. Michael met with the Crossroads landlord and proposed that Dragon fly begin paying the full $3,128 /month towards the rent again, with the payments on the overdue balance remaining at $884 /month. He felt that the meeting went well and believed that his proposal had been accepted. Thus, the Thompsons were extremely surprised when Lawrence called on October 25, 2011 , to say that he had received a very inflammatory note from the Crossroads lawyers. The letter threatened to pursue further legal action if the Thompsons did not sign a confessed judgment for the entire amount overdue of $29 , 344.43

Section 14: Assignment or Sublease Lessee shall not assign, sublease or transfer this lease or any interest therein or in the premises, nor shall this lease or any interest thereunder be assignable or transferable by operation of law or by any process or proceeding of any court, or otherwise, without first obtaining the written consent of Lessor. No assignment of this lease by Lessee shall relieve Lessee of any of its duties or obligations hereunder. If Lessee is a corporation, then any merger, consolidation or liquidation to which it may be a party or any change in the ownership of or power to vote the majority of its outstanding voting stock shall constitute an assignment or transfer of this lease for the purposes of this section

Section 22: Defaults

Time is the essence hereof, and if Lessee violates or breaches or fails to keep or perform any covenant, agreement, term or condition of this lease, and if such default or viol action shall continue or shall not be remedied within ten (10) days (three (3) days in the case of non - payment of rent or other payments due hereunder) after notice in writing thereof given by Lessor to Lessee specifying the matter claimed to be in default, Lessor, at its option, may immediately declare Lessee s rights under this lease terminated, and reenter the premises, using such force as may be necessary, and repossess itself thereof, as of its former estate, removing all persons and effects therefrom. If upon the reentry of Lessor, there remains any personal property of Lessee or of any other person, firm or corporation upon the premises, Lessor may, but without the obligation to do so, remove said personal property and place the same in a public warehouse or garage, as may be reasonable, at the expense and risk of the owners thereof, and Lessee shall reimburse Lessor for any expense incurred by Lessor in connection with said removal and/or storage. Notwithstanding any such reentry, the liability of Les see for the full rent provided for herein shall not be extinguished for the balance of the term of this lease, and Lessee shall make good to Lessor each month during the balance of said term any deficiency arising from a reletting of the premises at a lesser rental than that herein agreed upon as the Minimum Rent, plus the cost of renovating the premises for the new tenant and reletting it.

Section 25: Attorneys Fees

Lessee agrees to pay, in addition to all other sums due hereunder, such expenses and attorneys fees as Lessor may incur in enforcing all obligations under terms of this lease, including those fees and expenses incurred at trial and on appeal, all of which shall be included in any judgment entered therein. Such covered fees and expenses shall include those incurred in suits instituted by third parties in which Lessor must participate to protect its rights hereunder and those incurred in suits to establish and enforce rights of indemnity hereunder.

Section 27: Other Stores

Lessee agrees that neither it, nor any subsidiary or affiliate of it, nor any other person, firm or corporation using any store or business name licensed or controlled by Lessee, shall, during the term of this lease, operate a store or business which is the same as or similar to that to be conducted on the premises, or which merchandises or sells the same or similar products, merchandise or services as that to be sold or furnished from the premises, at any location within a radius of four (4) miles from the Shopping Center without the written permission of Lessor. Lessee further agrees that it will not promote or encourage the operation of any such store or business within said radius by any person, firm or corporation. In addition to any and all other remedies otherwise available to Lessor for breach of this covenant, it is agreed that Lessor may at its election either (a) terminate this lease or (b) require that any and all sales made at, in, on or from any such other store be included in the computation of the percentage rent du e hereunder with the same force and effect as though such sales had actually been made at, in, on or from the premises.

Dragonfly question

Who are the stakeholders involved and how are they feeling about the situation? And What should Janet & Michael do to address the financial, operational and legal issues they face?

PLEASE WRITE AS MUCH AS YOU CAN

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Please write as much as you can.

Thank you