How to form an equitable business partnership

March 20, 2008 3:53 PM

How to structure a business partnership? Imagine this scenario: Two people want to go into business together. One person has the money to start the business, but no ability to actually run the business. The other person has the expertise to run the business, but no money to actually invest. How do they co-own the business in a way that is fair to both parties in respect to profits, debts, responsibilities and decision making?

If there are any books or resources that cover this sort of thing, let me know. I'm not making any business decisions based on this advice. I recently found myself in a conversation about the subject,and realized halfway through that I didn't know as much as i thought I did.

posted by billyfleetwood to work & money (18 comments total)

There are a ton of books and resources on this, just try googling for them. Or search here. This is probably the oldest business venture scenario in the world.

The best answer you can get is to find two lawyers to represent the two of you, or at least one lawyer who only represents the business (and not either of you two).
posted by MrZero at 4:22 PM on March 20, 2008

What you're describing is legally defined as a partnership, as you have already figured out. There are many, many books like this one that can get you started.
posted by Brian James at 4:49 PM on March 20, 2008

Just clarify a little. I googled the subject and there's TOO MUCH info. I'm hoping that maybe some simple layperson's level info can help narrow down where to even start. If this helps any, the question that started the conversation was this: At the beginning, the person who invested the money has made a greater investment, over time, the person who runs the business makes the greater investment(in terms of time and effort). How is this reconciled?
posted by billyfleetwood at 4:55 PM on March 20, 2008

Get a lawyer to draft a partnership agreement for you. Simple as it may sound, not everyone does this.

As for figuring out how to structure the partnership, it's something that you two will have to work out amongst yourselves. You'll probably want to talk to a management consultant who has a good reputation. A local business school may be able to help you out: often BCom or MBA students need to work on projects, and this could be one of them. If you need to find a management consultant, ask a faculty member in the entrepreneurship stream. As well, your local economic development agency may also be able to refer you to someone.

But remember, consultants only provide ideas - it's up to you and your partner to figure out how to structure the partnership.

And, like it or not, the person with the business savvy is typically going to get the short end of the stick, as the person with the capital is really acting as an investor, and, as such, is assuming most of the risk, and therefore, is entitled to most of the reward.

But talk to a lawyer.
posted by KokuRyu at 5:21 PM on March 20, 2008

My nickle's worth...

Don't form a partnership; it's simple, but it has no other advantages. I have historically used Subchapter S corporations, and would do a limited liability corporation if I set one up today. A little more complicated, but worth the minor headaches.

You get some insulation of your personal assets by virtue of the corporate shield. Formality is also a good thing to have in business. I'd marry people I wouldn't go into business with. It is a minefield, and being very formal helps keep things straight and level.

Google LLC. Consider Delaware or Nevada as states in which to incorporate. (Nevada, for instance, allows you to keep some anonymity and allows one person to hold all offices in a corporation. This is a little unusual, but worth thinking about.)

Good luck with your venture.
posted by FauxScot at 5:26 PM on March 20, 2008 [2 favorites]

You are asking how to balance the risk? Assuming this money goes towards capital, then money-man simply loans skills-man half the initial investment for the purchase of the capital good (e.g. the office building). In this way, skills-man and money-man each own 50% of the business's assets and the initial risk is equally distributed (i.e. if the venture fails both lose 50% of value of the initial investment as skills-man is liable to money-man).

After money-man has paid back his loan (presumably through the value generated by his work over time) both individuals will be half-owners of the assets of the business. Skills-man will continue to invest more into the business (through his work) and will presumably at that point be in a position to command a higher cut of the profits because money-man's 50% is less valuable without skills-man's use of it to generate value.

In terms of legal liability in this scenario I imagine both individuals would be equally liable, but I am no lawyer.
posted by norabarnacl3 at 5:27 PM on March 20, 2008 [2 favorites]

Yep, go for an LLC, and when you talk to your lawyer you will know why (basically it better protects your personal assets yet retains the informality of a partnership). The money man gets a share and the skills man gets a share. You can decide the percentage. They both get a say in operation based upon their ownership, but the skills man does the work. The alternative is a loan, but what is the collateral? This is done all the time and your lawyer will walk you through the process.
posted by caddis at 5:44 PM on March 20, 2008

You are asking how to balance the risk? Assuming this money goes towards capital, then money-man simply loans skills-man half the initial investment for the purchase of the capital good (e.g. the office building).

I think this is a bad idea, because you haven't really fixed anything, just made it more complicated.

Consider the case where the partnership never makes a dime, but skills-man does substantial work. Does skills-man get to reduce the amount he owes money-man? If he does, then skills-man was never really bearing the risk of loss with respect to the amount of the loan that was likely to be offset, regardless of the success of the partnership.

Plus, to the extent that the loan is not expected to be offset if the partnership fails, you're proposing a different business deal. Skills-man doesn't have the capital to invest, so I don't know why you assume he has the credit to borrow capital to invest. If he does have the credit, why doesn't he just borrow from a third party?

The cross borrowing between the partners just distorts the economics of the partnership allocations, because money-man is taking on (probably substantial) credit risk in addition to whatever business risks are inherent in the partnership.
posted by Mr. President Dr. Steve Elvis America at 5:53 PM on March 20, 2008

Here's a rough generalization of how to proceed:

Approach your future business as a corporation (instead of a 50/50 partnership) that pays out equity/stock, ie. % ownership of the company. You and your "partner" then become employees #1 and #2 in this company.

In return for your partner's investment in the company, he gets a certain % equity stake equal to the % of the company's arbitrary initial value. Assuming the entire investment isn't required at the outset, he can stagger his investment based on certain milestones. So if he has $25k to invest, he can put in $5,000 at the start in exchange for a certain %, then another $8k at the next stage, then more at the next stage, etc.

For you, your work translates into sweat equity, ie. a % of the company's value based on the value of your work. It's typical to determine the dollar value of sweat equity based on what you would be paid doing similar work elsewhere plus a bit of goodwill (bonus). The best way to lay out sweat equity is to tie it to certain agreed-upon milestones. So if it's a website, a mockup might be worth 10% equity, the alpha worth 10% more, beta worth 5%, and launch is worth 15% more. This ensures your partner that your compensation is tied to the work you've promised to do rather than you automatically getting 50% right in the beginning as a 50/50 partnership would dictate.

The milestones should correspond with the investment injections from your partner. This minimizes the risk for both you and your partner though it's likely he/she will be more exposed in the beginning (and his initial equity % should reflect that).

Since you're dealing with arbitrary percentages, you can use it to determine debts and voting rights. It doesn't need to add up to 100% in the beginning. Keep the remaining percentage in the company - you can always recalibrate as needed. Until you take on additional investors or employees, it's all just numbers. Deal with everything as if you were employees of the company to keep it clean and fair.

The key is to put everything down in writing that both of you agree upon and sign. Then when you can, get a lawyer to make everything official.
posted by junesix at 6:15 PM on March 20, 2008 [1 favorite]

Consider the case where the partnership never makes a dime, but skills-man does substantial work. Does skills-man get to reduce the amount he owes money-man? If he does, then skills-man was never really bearing the risk of loss with respect to the amount of the loan that was likely to be offset, regardless of the success of the partnership.

Skills-man gets to offset the loan to the amount of cash his effort brought in. He still bears the risk because he had to spend his own labor to offset that amount of the loan. Inasmuch as his labor is being accurately valued his loss is equivalent with money-man's.

Your point about credit is good, but I assumed since the original asker is seeking to equally distribute risk between himself and the partner that credit risk is negligible. I think the dynamics of credit risk are inherently different in personal relationship situations and the money-man would have to evaluate that as he sees fit.

I don't see any other way to smooth out the risk over time. In this situation money-man is just a basic capitalist who necessarily bears large initial risk but wants to pretend he is a 'partner'. Contracting shared exposure through the loan is the basic way to do it.
posted by norabarnacl3 at 6:37 PM on March 20, 2008

The structure of the company can be an LLC or S-Corp (in US).

As to how to make it fair, there are many ways. One is to make it a 50/50 split with the shares vesting over time (so if one of you drops out, the other doesn't get resentful that a non-participating partner gets just as much reward).
posted by zippy at 7:02 PM on March 20, 2008

Consider the case where the partnership never makes a dime, but skills-man does substantial work. Does skills-man get to reduce the amount he owes money-man?

That is why dividing up the equity is better than a loan. It puts the risk more on moneyman, but then if the risk plays out moneyman gets a big return. Workerman takes the risk of years of working for low pay rather than taking that cush job at a Fortune 500 corp. with benefits and all. Each puts up risk, each profits or loses with the business. With a loan only the workerman loses if the loaner can recover the loan. For that arrangement you get low interest rates.
posted by caddis at 7:09 PM on March 20, 2008

1. Lawyer

2. Corporation >> Partnership

I know it's what everyone else is saying but it's true.
posted by unSane at 7:26 PM on March 20, 2008

I was, and still am, the money guy. I like to keep things simple. At the onset I give the working partner 50% of the business and say "GO". At the end of the year we split profit 50-50.

I let the working guy pull a salary each month so he can stay afloat. This has worked pretty well for me. I meet with them once a week or so to go over business matters. After that I stay out of it unless he needs me for advice. At the end of the year he provides me with financials and that is that. Sometimes I will pull in a business manager to over see some of my projects but often I try to let them run themselves.

You need not make this too complicated. If the money guy is solid, really has the cash to risk and believes in what you are doing, then it is not necessary to go any further than signing the paper work stating you are both owners. If you predict the situation could get dicey pay the lawyers to hammer out the finer details that spells out what happens in different scenarios. I have avoided this as I pick people that I trust and they trust me plus it saves some of the money needed for start up capital. Sure there is a risk but everything you are doing is a risk of some sort or another.

You can also pull more cash for the money guy by using him as the bank. Any leases or loans can be given to the money guy as he will act as the bank and receive payment on these advances each month. I have a bank set up just for that purpose... works well to keep money coming in on a regular basis through out the year.

I would run this by him and see what he thinks. Good luck!
posted by bkeene12 at 8:13 PM on March 20, 2008

Would this be a bricks and mortar business, billyfleetwood, or would it be a potential internet business?

To all those who answered above, would your answer have been different for one or the other?

Sorry for asking more questions here, but I can surely imagine some different answers here if we were talking about an internet business partnership.

Not sure if it is kosher to piggyback on an "AskME" question, but I would like to do that.

Let's assume for a minute that billyfleetwood was asking about an internet "partnership" that might result in both parties making or losing some money. Yes, one party loses dollars directly, (upfront expenses), while the other loses money with their sweat equity, (spending time on "this instead of that".)

It seems to me that things are alot less rigid here on the net, and a whole lot less litigious, but I would happily be informed otherwise, and be the wiser for it. Sorry if this is derailing your original question, billyfleetwood
posted by LiveLurker at 8:14 PM on March 20, 2008

I don't mind the piggybackiing LiveLurker, if noone else does...

My initial question was referencing a brick and mortar business, but I would assume an internet business would follow similar principles.

And thanks everyone for the input. very helpful. Also Allow me to reiterate. I am NOT making any actual business decisions based on what you say. I do know that Lawyering up is the proper move. This question came from a larger conversation that I tried to leave out so as not to get too speculative or chatfilter-y.

bkeene12 a followup question for you. Is the salary you pay an advance against profits? Also, if you don't mind me asking, do you have an over/under on the amount of time it takes you to make back your investment that factors into your decision to invest?
posted by billyfleetwood at 9:00 PM on March 20, 2008

Billy, something important to keep in mind about partnerships: Sweat man and moneyman are equally liable for debts incurred (At least, under the Uniform Partnership Act, a model code adopted by many states.) This is a far, far worse deal for sweat man than moneyman, though. Picture this: You go into business, the money guy puts up $50k, the sweat guy puts in his labor. After five years, let's say you have racked up debts of $50k. The business, if you sell it, is WORTH $50k. So you sell the business. Money guy gets back his $50k, because that's what he put in to it. You get the sweat equity back from the business, which isn't valued for these purposes. Then you jointly owe the $50k debt. Moneyguy owes $25k, you owe $25k. So, moneyguy pays the $25k out of his $50k investment and ends up with $25k at the end of the day. You, as the sweatguy, are left with a debt of $25k and nothing to show for your endeavors. :-)
posted by Happydaz at 9:27 PM on March 20, 2008

Sorry it took so long to get back on this one... no over or under on the time it takes to get my investment back- it is usually impossible to gauge this in a fair way and puts too much stress on the business- bad ideas usually get thrown in the mix because the working owner is under one more gun.

As I have seen it the working partner is more motivated to make it work as their livelihood is tied to the success. The salary is part of my risk, most of the time it is not a problem- my partners are highly motivated and I have done my due diligence to make sure their concept is sound. Besides, the working partner is in there day after day, night after night- sometimes all night. I am sitting on my ass typing in metafilter so their salary is the price I pay for such luxuries. Personally, I just see this as fair. Many will not- YMMV.

On the other side, since I am the bank, I have to be paid on the loans and leases before salaries are dole out so I am still highest on the income pecking order.
posted by bkeene12 at 7:40 PM on March 26, 2008