Adding a partner or shareholder is not simple. As with any agreement involving money, spending the time having difficult conversations up front is well worth your time and energy. A clear agreement avoids unnecessary conflicts that can sabotage or derail your business by taking energy from the business and focusing it on the conflict.
The typical scenarios for partnership are two:
One, we are newbies and we know we will always get along. We agree to be 50/50 and we will decide later if there are other things to work thru.
Two, I have owned my business for some time and to grow I take on a partner or new shareholder with a minority interest. I have always done things my own way and don’t consider that maybe now with someone else coming in, there are agreements needed.
Even more complex than a marriage, when individuals choose to do business as partners or shareholders, there is more than one relationship which is formed. Each one deserves your attention and a written agreement.
The purpose of this memo is not to give legal advice, that we leave to your attorney. Rather the purpose of this memo is to provide a blueprint for clear conversations and agreements prior to engaging an attorney to write the agreement as you have decided.
The levels of financial relationship in a business partnership or as joint shareholders involve three levels:
- Capital: Consider both initially and as capital may be needed to expand or keep the business continuing.
- Work: Each partner or shareholder may or may not work in their business and their work may or may not be worth the same value in the marketplace.
- Earnings and distributions: Earnings of a business may be in cash or as the business grows they may be tied up with items such as receivables, inventory and R&D costs. How will items like earnings, taxes and distributions be handled?
How will we own the business together? 50/50, 80/20, 55/45? Why? Capital contributed based on fair market value should be consistent with ownership percentages.
If you are considering a 50/50 split, realize that in a disagreement there is no majority shareholder with the power to decide. This could lead to no decision being the decision. If 50/50 is decided, who makes the final decision if there is a disagreement?
For a new business:
What will each partner(s) or shareholder contribute to the business to gain ownership? Will it be cash, existing tangible or intangible property or sweat equity? If it is sweat equity or intangibles, how will this be valued? What happens when the business has a hiccup and cash gets constrained? Will partners and shareholders add new capital in proportion to ownership?
For an existing business:
What is the fair market value of the business currently? How much will the new partner or shareholder own? Will it be cash, existing tangible or intangible property or sweat equity invested? If it is sweat equity or intangibles, how will this be valued? How will they buy in? Via payment to the existing partner or shareholder or as new capital directly to the business to fund growth? What happens when the business has a hiccup and cash gets constrained? Will partners and shareholders add new capital in proportion to ownership?
Write a job description for each partner or shareholder. Conduct market research to determine the market value for the job that each partner or shareholder will be performing.
What should each shareholder be paid for their work? Generally, this should be based on your market research for the value of the position. Often 50/50 partner or shareholders set their compensation equally even though their market based compensation is unequal. Think through that this leaves the underpaid partner or shareholder able to make more money outside the business than in, and unfairly rewards the overcompensated partner or shareholder for their work.
Earnings and distributions
Most businesses consume cash as they grow. You may have heard the saying, “Growth eats cash flow for breakfast, lunch and dinner.” In many businesses, this is true.
So, in the first year if you are lucky enough to make money, will you distribute it all to the shareholders? How will the business gain capital to grow? Typically, capital for an existing business is from earnings retained in the business. If the business distributes them all, there is nothing left to fund growth.
How will taxes be paid? Will each partner or shareholder be required to pay taxes out of their personal funds or will the business distribute funds for this? What if the business doesn’t have the funds?
What if one partner or shareholder is having a personal crisis? Will they be able to borrow from the business? At what interest rate? For what business purpose?
Your business is likely to be your largest asset. Strategically think through, what is a reasonable return on investment (ROI) for each partner or shareholder? How is this ROI achieved? What is the plan to build the business so this is realistic?
As always, we at Mackey Advisors are here to help you passionately pursue prosperity, whatever that may be for you. If we can help, reach out to us at Lisa@MackeyAdvisors.com or at 859–331-7755.