Small Business Taxes & ManagementTM--Copyright 2015, A/N Group, Inc.
Taking on a partner (or shareholder, LLC member, etc.) should never be done casually. There are a host of factors to consider--can you get along with him or her on a daily basis? Will the extra business be worth the split of profits? The problems can easily outweigh the benefits. Before taking on a partner--or a shareholder, consider the following.
Everything changes. Taking on a partner or shareholder will require disclosure of some information you may prefer to keep quiet. Financial information, marketing plans, etc. A nondisclosure agreement may provide some protection, but it's not ironclad.
Material or minor interest? If the potential partner will have a material interest (10% or more) you need to be especially careful. But selling or giving even a small interest to another can be an issue. A partner or shareholder who thinks he's being shortchanged may bring suit. For example, your use of the company car for personal purposes. He may not win, but it could be costly and a distraction.
Make sure you're compatible. Sounds obvious, but you'll be surprised how many small business owners don't consider it. Chances are you'll be dealing with this individual on a daily basis, often in close contact. There's a good chance you'll spend more time with your partner than with your spouse. And entrepreneurs tend to be leaders and headstrong. That person who's such a good golfing buddy can show an entirely different side in a business relationship.
The new partner should be able to carry his own weight. Don't take on a person as a partner simply because you need another employee. Ideally, he or she should bring to the business complementary strengths. For example, you have technical expertise and he has strong business or marketing abilities. In many cases taking on a partner can improve your chances of securing a loan or being recognized as a business with more management depth. The latter could prove important if you're trying to work with larger companies. (See below if you're just looking for capital.)
No management interest. If all you're looking for is capital, or an employee with a "piece of the action", you may have other options. If it's just capital, you may be able to put a restriction that the individual have no managment powers except in certain circumstances such as when retained earnings is negative, a dividend is unpaid, etc. If an employee wants to be part of the action, you may be able to give him or her a bonus based on a percentage of the profits, a percentage of any increase in the net book value, etc.
True partnerships can be dangerous. In a partnership (as opposed to a corporation with two or more shareholders), each partner can be held jointly and severably liable for actions of the partnerships. Thus, you can be fully liable for all partnership debts, despite the fact that you might only have a small interest in the partnership, or that you had nothing to do with incurring the debts. Clearly, you don't want a reckless or risk taking individual as a partner.
Partnership agreements and LLCs. Some of the problems with a partnership can be alleviated with a well written partnership agreement. A limited liability company (LLC) can also be used to avoid the problems mentioned above. But be careful. Failure to have an operating or partnership agreement may mean you'll be governed by the default rules of state law. Get good legal advice. And make sure you abide by the operating agreement.
Personal responsibility in a corporation or LLC. Even in a corporation or LLC you can be personally responsible for the acts of another officer. Two of the prime examples are payroll taxes and sales taxes. But if the corporation or LLC isn't operated in a formal manner, it can lose some or all of the protection the law provides in other situations. For example, paying personal expenses from the business.
Consider a joint venture. While formal joint ventures are used more by large corporations, they can be attractive to a smaller business. In this case, each "partner" can be responsible for his or her own area. For example, you may manufacture the product while your joint venturer distributes it. Each of you has their own separate corporation, partnership, or LLC, and an agreement that binds the business entities. An advantage is that the joint venture agreement can be simpler than an operating agreement. And, should the venture fail, your primary business shouldn't be jeopardized.
Just looking for capital? If that's your only objective, you should explore other options. You could have a straight loan to the business or a loan with a feature allowing conversion of all or a part of the loan into equity capital or with a small equity investment at the time the loan is issued. Talk to your accountant or a corporate attorney for ideas.
Loss of control. More than one business founder has lost control to partners he or she has taken on. That's always a danger and it happens most frequently when the original owner sells too much of the business or is so involved in the day-to-day operations that he doesn't realize his partner(s) are taking over.
Think about the breakup. Personal and business relationships don't last forever. It could be as ugly as a falling out among partners or as innocent as the withdrawal of a partner for health or personal reasons. Or Mike (a 50%-shareholder) and Janice get divorced and Janice gets shares of stock in the corporation. You've got a new partner. Or Mike is forced to sell his interest in the business. You want to buy his share but don't have the capital to do so. You could end up with a new partner. There are plenty of ways to handle these situations, but you've generally got to plan ahead. Again, talk to a corporate attorney and your tax adviser since there can be tax implications. You should also have a mechanism to way to dissolve the partnership should you encounter irreconcilable differences. For example, a way for one partner to buy the other's interest or a way to split the business.
Taking on a partner or working shareholder, or even a capital contributor, can add materially to the business. But just don't rush into it. The consequences can be far reaching. Talk to your accountant and attorney.
Copyright 2015 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 11/02/15