How to form an equitable business partnership

November 4, 2009 10:44 PM

How to setup a business partnership in an old-school brick-and-mortar manufacturing business between four friends - two of whom will be the major investors (say A and B), one guy is partial investor who will work full time but is new to this business and doing business in general (C ie: me), and the last guy is the one (D) with the entire business knowledge. He is in the field for past 7 years, already running a profitable trading shop (buying in Saudi, selling in India) in this field and is interested in expanding by setting up 'our own' manufacturing facility in Saudi.

This is my first time venturing into a business setup after quitting my job. Some things which are different than the norm. We don't plan to take any debt. This is an all cash setup we are planning in Saudi and there would be no lawyer involved it's all mutual agreement and trust between us. Treat this as business amongst friends. There are no trust issues and nobody is fighting for the last margincal percentage. All of us are pretty ok with the plan being a bit flexible and we cover each others backs anyways. As long as it 'looks good and fair overall' it's game.

The investment capital ratio is :
A - 45%
B - 45%
C - 10% (ie me)

Entire capital is going to be invested upfront in setting up the business, visas, licence, machinery etc. There is no staggered investment. The only thing variable in the above plan is: B might decide to remain as just investor or investor + working full/half time based on the need.

D having the full business knowledge is going to do the initial work of sourcing raw materials, setting up shop and selling. He is the only one at this point with all contacts, knowledge the works. Apart from my 10% investment, the idea is I (and maybe B) be working full time alongside with him and learn the trade, eventually come to a position 6 months down the line where I (and B) be managing the Saudi shop and he'll concentrate on the selling side in India.

I will be working full time on this. But since I'm new to it, one way to look at this is also that I'm getting an opportunity to learn the trade. Same applies to B if he becomes a working partner.

All the working partners C, D (and B) are okay with not taking a salary for, say first 6 months or so.

How should we divide the stake in this setup between all of us and how much salary (or any other form of compensation - increased stake in lieu of agreeing to not take any salary) should C, D (and maybe B) get?

Thanks.

posted by forwebsites to work & money (10 answers total)

there would be no lawyer involved it's all mutual agreement and trust between us

…now. Even among friends, always start a business by having a partnership agreement drawn up by an experienced lawyer. Not only so that the equity distribution is decided in an orderly way, but so that you have a formal and recorded agreement as to what happens to the equity of a partner who decides to leave (or, let's say, dies).

I speak as a partner with old friends in two companies. For the sake of the company and of the friendships, lawyer up.
posted by nicwolff at 11:17 PM on November 4, 2009 [1 favorite]

As to how I'd split the equity in your situation: essentially, D has a going business and wants to fund expansion. He should make a straightforward pitch to A and B for investment, dividends, and potential exit; your minimal initial investment gives you a minimal role in that negotiation. You're really primarily an employee; put a cash value on 6 months of your work (at a discount, possibly, since you're not an expert in this business yet) and have that much equity vest at the end of 6 months, at the founders' price.
posted by nicwolff at 11:32 PM on November 4, 2009

it's all mutual agreement and trust between us.

That's a beautiful thing. It's worth hammering out an explicit agreement now, so that everybody is on the same page and mutual agreement and trust don't get lost along the way.

Treat this as business amongst friends.

Businesses amongst friends need extra care in initial setup, because friends are not something you should throw away lightly, and businesses among friends have an unfortunate history - the friendships tend to go first, and that often buggers the business.

There are no trust issues and nobody is fighting for the last margincal percentage.

Good. So you need to have an explicit, up-front, on-paper agreement that you've all put your signature to as well as your handshakes.

All the working partners C, D (and B) are okay with not taking a salary for, say first 6 months or so.

How should we divide the stake in this setup between all of us and how much salary (or any other form of compensation - increased stake in lieu of agreeing to not take any salary) should C, D (and maybe B) get?

I would strongly suggest that you get agreement between yourselves on what your relative pay scales will be, once the business is making enough money to pay salaries. These scales should not be set based on initial stake; they should be set on the basis of what similar skills can command when working for other businesses. So, each of you needs to figure out what you'd be making if you were doing your proposed set of jobs for somebody else; then you all need to vet those figures, and make sure you all agree they're reasonable; then convert them to percentages of the highest figure. Then, once the business starts making enough that paying salaries becomes feasible, start paying them at whatever rate the business can afford while still remaining solvent, but make sure the relative percentages are as agreed.

Once the business is prospering enough that it's able to pay you the actual salaries you decided on up front, it should pay that and no more as salary. At that point, the business is breaking even, and you can all have a little party.

Once the thing is beyond breaking even and is actually returning a yearly profit, you need to get together and work out how much of that profit should be ploughed back in to keep the thing going next year, or grow it, or whatever you want to do with it. And any left over on top of that amount should be split as pro-rata dividends according to initial stake.

You also need to agree on contingency plans in the event that one or more of you ends up wanting to pull out.

Work all this out between you. Put it in writing. All sign it. And then get on with enjoying each other's friendship as you build your business, secure in the knowledge that you're all clear on exactly where you stand.
posted by flabdablet at 11:34 PM on November 4, 2009 [3 favorites]

And yes - nicwolff's point about foregone salary being added onto initial stake equity is fair and correct, and is why it's important to agree on formal pay scales before you go any further.
posted by flabdablet at 11:39 PM on November 4, 2009

I'm sorry. Looks like I overstated the no-lawyer and friendly business clause which has taken this thread a little offtrack. I just wanted to indicate that it's not as if we are four big individuals with our own lawyers and month-long meetings and negotiations. It's just four fast friends, three of whom have previosly invested with each other at various levels. Ultimately yes, we'll hire a lawyer who'll make a formal legal agreement with all of us signing onto it.

nicwolff: what do you mean by vest in 6 months? Also, yes, I do realise that I am essentially an employee in this scenario. But here's the difference: I won't be working like an employee (fixed 8-10 hrs + overtime etc). I'll be working like one of the owners (whenever work demands 24x7). Apart from four of us, it will be basically a small 8-10 worker shop which I'll be managing. Along with learning from D, I'll also create my own channels, buyers, sellers the works. Right now we are estimating I'll be handling the shop and fully responsible for it within 6 months. As you realise this is slightly more than being a fixed salary employee. What I lose in not having the business knowledge, I put in terms of full management responsibility of operating the shop. That is why I asked how much salary should I (and maybe B) get for our fulltime work or if not salary what other way can we be recompensed for it? increased stake in business down the line, one time lumpsum bonus of our annual profits..? I've never done business but have vague ideas that that's how these things are done. So try to be as plain-englishy as possible.

It's my own idea to put in my own 10% stake as a way to force myself to act as a business owner and also it indicates to the other 3 friends that I'm pretty serious about it.

Without getting into our personal friendship details: In short, think of it this way. D wants to outgrow his current trading business. A and B and to some extent C (me) are initially using D's help to setup our (as in owned by all four of us) manufacturing shop. I'll learn the trade as D's apprentice in the initial 6 months or so after which I'll handle the sourcing/manufacturing/shipping part and D can concentrate solely on selling and increasing margins. The increased returns of this combined effort will be shared amongst the four of us.

How do we share that?

It would help if subsequent responders would focus on actualy facts and figures of our sharing agreement and delve not too much in our friendship details.
posted by forwebsites at 12:37 AM on November 5, 2009

How do we share that?

By starting from pre-agreed salary equivalent. If you like, work out the salaries as an hourly rate instead of a monthly rate; the rate should be what all of you agree you would pay a hypothetical somebody who was not one of you, to do the same mix of work with the same skills as the one of you you're figuring for, assuming you could already afford to do that.

Then, each of you works without that salary, but you account for it as if it were an additional contribution to your stake; and once the business is actually capable of paying you the salaries you've agreed on, those augmented amounts become the amounts you base the pro-rata split of withdrawn profits on.

As well as a lawyer to help you draw up the agreement, you're going to need a competent though probably part-time bookkeeper to keep track of all this stuff for you. If that's not one of you, it needs to be somebody you hire.
posted by flabdablet at 2:50 AM on November 5, 2009

Too many people get so bogged down in the initial contract that nothing ever happens. Personally, I start with a simple deal memo in ordinary English, could even be in the form of an email. You'll most likely find that you're not all on the exact same page already. Once that is in place, proceed until a few dollars are made. Then write a real contract with legal help. Perhaps not the most standard way to go, but that's how I do it.
posted by StickyCarpet at 7:07 AM on November 5, 2009

Super interesting question!

Ignore all the stuff above about using theoretical salaries as a basis for equity calculations. To reduce it to the absurd: if a primary school teacher and an IT contractor go into business to produce educational software for kids, they're not going to split the shares 20:80 just because the teacher earns so much less teaching kids than the contractor does writing VBA for banks.

It feels to me like for simplicity you should treat C and D as the founders and A and B as the investors. The founders will work full-time, and the investors will put money in. The founders need to decide what the investors' upfront capital is worth in terms of an equity stake, and agree with it the investors.

In terms of D: I'd be a bit worried about him not having any skin in the game. I can see that you have more to prove than him but I'd suggest he put in 2% and you put in 8%. You're both working full-time, he's got more experience but you're putting in more cash - I'd say you have a good claim to get the same equity stake as him; if he disagrees (and he will - but it's a negotiation right?) then talk to him and meet somewhere in the middle where you're both still motivated.

Finally, in terms of B possibly coming in and working full-time: you should agree that he has a window to do that in, and within that window if he does join then you will issue X shares to him which will dilute everybody's holdings.

In summary: don't overcomplicate it, and make sure that everybody has enough % to keep them motivated for the long term in whatever capacity you need to make the business a success.

Good luck!
posted by runkelfinker at 8:46 AM on November 5, 2009 [1 favorite]

Thanks everyone, especially flabdablet and thanks for your well wishes.

I showed this response to D, he's quite impressed about my ability to tap resources and get such thoughtful exchanges from the net.

I'm super excited about this venture and what it holds for in future in terms of changing my career trajectory! I'm sure I'll have a lot to ask and need more handholding from the hivemind in the future.
posted by forwebsites at 9:19 PM on November 5, 2009

The idea is that the contribution that each team member makes before the business can pay salaries as actual money should be rewarded with equity instead, and at a rate that reflects the relative values of all contributions.

To reduce it to the absurd: if a primary school teacher and an IT contractor go into business to produce educational software for kids, they're not going to split the shares 20:80 just because the teacher earns so much less teaching kids than the contractor does writing VBA for banks.

If a primary school teacher and an IT contractor go into business to produce educational software for kids, then on my proposed model above, the primary school teacher's role in the business would be as a consultant with teaching expertise, not as a teacher per se, and the proposed salary worked out accordingly.

The most important features of the proposed salaries are that (a) all parties agree, before anybody does anything, that they are fair and reasonable (b) they are all written down so that they can all be seen to have been agreed to. That way, anybody who feels hard done by at the end of the day can quite reasonably be told to suck it up by everybody else, and will in fact probably do so rather than prolong a business-eroding and friendship-threatening dispute.
posted by flabdablet at 11:18 PM on November 5, 2009