Small Business Taxes & ManagementTM--Copyright 2023, 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? Can you trust them? The problems can easily outweigh the benefits. On the other hand, a good partner can give management depth to the business, take over if you're disabled or just want to take a vacation, and be more helpful and work harder than an employee. But 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 have kepy confidential. Depending on how the business is structured you may have to disclose Financial information, marketing plans, etc. A nondisclosure agreement may provide some protection from outsiders.
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, not to mention potential bad press.
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. The 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 or he's willing to put up some needed cash. (There are other ways to handle that.) 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.)
What's the objective of the business? Some business owners want to grow the business for as long as they can. Growth often means reinvesting earnings rather than paying them out. It can also involving looking for financing, taking on more risk, and running a more intensive business. On the other hand, some owners just want a nice living. Others want to increase the value and sell out for a profit then either retire or move on to the next venture. If you and and your partner can't agree on an approach you're bound to have disputes.
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 management 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 true partnership (as opposed to a corporation with two or more shareholders, or an LLC), each partner can be held jointly and severably liable for actions of the partnership. 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. You should keep in mind that if you and your buddy just go in business together without creating an LLC or corporation, you're in a de facto partnership.
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. Deviation from the agreement can result in you losing any protection it affords.
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, not indicating that you're doing business as an LLC or corporation such as signing agreements with your own name rather than Fred Flood, President, Madison Inc. One of the main reasons for operating as a corporation or LLC is that the owners aren't responsible for the debts of the entity. But that protection can be lost if you know the business is in trouble and you pay yourself excessive dividends, let the entity pay personal expenses, etc. And that often happens with a small corporation.
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 for a partnership. 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.
Capital call. How are you going to handle the business needing additional equity capital? Some partnerships allow for a capital call where each partner is required to put up additional funds. This could come at an inconvenient time financially. Make sure there are provisions in any agreement to handle such situations and what to do if a partner can't advance additional funds.
Define duties. You're the engineer, Fred's the market genius. You should discuss what each of you is planning, but you may not want the other party looking over your shoulder second guessing every move. Make sure you can both live under those rules.
Arbitration. Not formal arbitration, but a third party you both trust and respect who can mediate a dispute. This could easily stop a small disagreement from becoming a lawsuit where neither party will really win. As the business grows you should consider having a board of directors that can do the same thing but on a more consistent basis. A board should also be able to provide you guidance and hopefully unbiased guidance..
Audit. Not infrequently one party puts personal expenses on the business. Not only does part of that expense come out of your pocket, if you're examined by the IRS you're both liable for any additional tax and penalty. In some cases the occasional personal lunch becomes outright embezzlement. In one case a partner hired his son for marketing and he ran up over $50,000 in personal charges on a credit card during the year. That reduced the partnership's earnings by more than 20%.
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. You can also run into trouble if a partner gets divorced or dies. There should be some provision in the operating agreement or a side agreement. Talk to your attorney.
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 for financial reasons. 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 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 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. Again, discuss this issue with your attorney.
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 2023 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 06/27/23