Few things are more rewarding, valuable and sought after than a good business partnership. The quality of a partnership depends not only on the partners’ individual character, but also their synergy, their readiness to be good partners and the structure of the partnership itself. Like a marriage, a good partnership can bring fulfillment, as well as a sense of security and common purpose. It enables partners to accomplish far greater things than they could alone. On the flip side, an ill-suited partnership can lead to resentment, unforeseen collateral damage, and the loss of faith, time and money.
Good partnerships can be created and nurtured with foresight, planning and attention to fundamental rules.
Business partners should know with whom they are joining forces. The cornerstone is the relationship between principals: how well they know and complement each other, their familiarity with each other’s strengths and weaknesses, and their respective problem-solving styles. Accordingly, successful partnerships often are founded by individuals who come to know each other in the trenches at one company, only to decide to forge another path together.
More commonly, two or more entrepreneurially minded individuals meet for the first time, engage in a seemingly destined conversation, and part ways having struck a deal to build a business together. While these circumstances may be intoxicating, more often than not the absence of a meaningful “dating” period masks a poor match. As a general rule, prospective partners should learn as much as possible about one another from business associates, clients and customers before progressing too far.
Having decided to work together, partners should unequivocally define how the partnership, most often a limited liability company, will be operated. To facilitate the conversation, and avoid confusion in the near and long term, each partnership should have a written operating agreement detailing the structural fundamentals of the enterprise, including contributions, roles and responsibilities, allocation of profits and losses, and exit parameters.
An operating agreement should define what each partner is contributing to the company in exchange for his or her interest. Interests may be granted in exchange for cash, property, services, or any combination of them. Unless otherwise agreed, partners are presumed to be equal partners. Sometimes one partner will invest cash and another will contribute services. The partners should come to an understanding early on as to the relative value of such contributions. For instance, in a two-partner scenario, Partner A may provide 100 percent of the funding for the business, but remain relatively hands off, while Partner B may fully manage the company’s day-to-day operations. Partners A and B may agree that the relative value is equal and that a 50 percent interest in the business makes sense.
The partners also should define the nature of their interests. Failure to do so may cause unintended consequences. Interests in partnerships may be capital interests or profit interests. Using the simple scenario above, if the company is sold after one year in business and the partners have equal capital interests, they would split the proceeds 50/50. However, if the business is dissolved one day after the startup funding is deposited into the company’s bank account, Partner B, despite zero financial contribution, may be entitled to half of the money in the account, even if it is all Partner A’s contribution.
Alternatively, the partners may have decided to split only the profits equally. In that case, Partner A would be entitled to recoup his investment amount first, and the remaining spoils would be divided equally.
Suppose a business is off to a fortunate and profitable start. The partners’ expectations regarding how and when to distribute cash should align. In certain circumstances, a growing business should reinvest all of its cash flow to fuel its expansion, thus compounding its growth and potential for larger returns down the road. In other cases, for convenience or necessity, some partners may see the regular distribution of cash flow of the business as a primary driver for being in the business in the first place. These entrepreneurs should keep in mind that unless the business elects to be taxed as a corporation, any income would be attributed to them regardless of whether the company distributed any cash at all. Unfortunately, without proper planning, this could lead to a personal tax obligation without having the means to pay it. In most cases, partners should consider agreeing to distribute at least enough money to pay estimated taxes.
For innumerable reasons, one or more partners may want to exit the business. This poses a number of questions that should be anticipated in advance. For example, is the interest freely transferable with no procedure or restrictions? If so, the departing partner may sell to anyone—be it the next Warren Buffet or an inexperienced businessman. To add some semblance of control, partnerships often employ varying degrees of Rights of First Refusal to buy partners’ interests. Other devices, such as tag-along and drag-along rights, may help ensure a minority partner is not left behind if others sell, or compel minority partners to sell along with the majority if they choose to monetize.
In some cases, closely held partnerships implement the ultimate in pre-packaged divorce provisions: the “shotgun buy-sell” agreement. In that instance, Partner A makes an offer to purchase another’s interest, and the other partner has the option to either accept the offer, and sell, or to buy Partner A’s interest on the same terms.
A successful partnership needs more than a great underlying business idea. It needs to be ushered into the world by partners with chemistry, and it should be built from the ground up to anticipate and withstand the issues it will inevitably face.
Christopher Rogers is an associate at Phoenix-based Jennings, Strouss & Salmon P.L.C. For more information, email email@example.com.