Many people start businesses on their own. Eventually, they might meet someone who seems to share their interests and entrepreneurial drive, or they get to know a trusted employee who has demonstrated ownership traits. The business founder decides they want to add that person, or maybe the person decides the future they want is shared ownership. Whether the business form is a limited liability company (LLC), corporation or partnership, business co-owners are “partners.” Before you become a business partner, there are a host of issues to consider.
Business partnerships are much like being in a marriage. Everyone goes in believing they will work together harmoniously and be able to agree on how to do things. But if folding the towels the wrong way can create marital tension, imagine what could happen when views differ on business decisions. If you are considering bringing another owner on board, here are 5 top things to consider:
1. Will you retain a majority interest?
Will one person have a majority interest? Will two people each have a 50/50 interest? Or if there are more than two owners, will all have equal interests? Beyond how profits are split, the answer to this question can have a profound impact on how decisions are made and where the power lies. When partners are 50/50 owners, it can be great because no one person has decision making authority. 50/50 partners have to make all decisions together. The downside is that no one person has the decision making authority when there is a disagreement. Attorneys cringe a bit when a client proposes 50/50 ownership, because it is with 50/50 ownership that we often see disputes and consequently, deadlock. Unless the partners put in place an agreement in advance addressing how to break a deadlock (more on this later), tension, arguments and ultimately the demise of the business can result.
In one partner has a majority interest, there is a person with the ability to break through a deadlock and keep things moving. This can be good for the business, but maybe less so for the partner with the minority interest. If the business operates based on majority vote of ownership interests, a minority owner has little power. If the minority partner wants out, it may not be easy to get out unless the partners put in place an operating agreement or shareholders agreement which planned for this foreseeable possibility. For most companies where there are not a large number of owners, a partner who wants out will find it challenging if not impossible to find a third party buyer for their ownership interest. A partner who wants out but for whom there is no previous agreement, will probably be able to disengage from the business, retaining a financial interest only, but according to state statute, they will have almost no voting say. Thinking through these issues ahead of time and having an agreement in place beforehand is crucial.
2. Will you sell part of your interest, or have the company issue additional ownership interests?
Let’s say you started your business by having your company issue to you 100 shares of stock or 100 LLC Units. Or you simply indicate you have 100% ownership. Now, you want another person to own a 25% interest while you retain a 75% interest. You can sell the new owner 25% of your shares or Units, which means they pay you. You will need to report this transfer on your tax return and you may have to pay tax on any capital gain.
Alternatively, you can have the new owner can pay money to the company in exchange for the company issuing to them shares or units. But do the math first. If the company issues 25 new units, that will translate into your owning 100 units while the new owner gets 25 units, or an 80/20 ownership arrangement when 75/25 was intended. The caution is: it is important to determine how the new owner will acquire their interest, check the tax impacts, and make sure the documentation reflects exactly what is intended.
3. How will the new owner pay for their interest?
This is another area where the best of intentions can go awry. It is easy if the new partner pays cash for the full amount at the time they receive their ownership interest. But often, the new owner can pay only part of the “price” up front and needs to pay the rest over time. In this situation, a promissory note should be prepared so everyone knows exactly how much is owed, how it gets paid (payment amounts and payment dates), interest charged, and the pay-off date. While most promissory notes are relatively short contracts, there are key terms which make them enforceable and valuable. Attorneys are skilled at drafting promissory notes that are clear, enforceable and what the parties intended. An attorney can also help document that the ownership units the new owner purchases serve as collateral for the note until the note is paid off. A collateral pledge agreement provides for taking back the ownership units if the note is not paid.
Sometimes, the parties want the new owner to pay the price for their ownership unit through “sweat equity.” Sweat equity means gaining an ownership interest in exchange for effort and toil instead of a cash payment. Ownership units in exchange for sweat equity is do-able, but in addition to pricing the units to be acquired, the “sweat” (work or services to be provided) needs to be defined and its value determined in advance. Disputes arise when one party feels entitled to more because they put up more money while the other party feels entitled to more because they did the most work. It is better to hash that out and document it up front.
4. Do your documents need to be revised?
If you are a single owner LLC, you absolutely need a new operating agreement when another owner (or more) is added. Multiple owners need a document laying out for them as well as for third parties (like banks and title companies) how the multiple members make decisions and any restrictions. A well-drafted operating agreement will have comprehensive provisions addressing who makes the day-to-day operating decisions, if there is a “manager” for the LLC, whether they can act alone, and when majority, super majority or unanimous consent is needed.
If the company is a corporation, it is required to have bylaws and bylaws typically direct election by the shareholders of a board of directors and officers. The bylaws define the powers and authority of the officers and directors. Nevertheless, shareholders in a closely held company should have a shareholders agreement which plans ahead for foreseeable events and changes in ownership.
Working with an experienced attorney to navigate these issues may cost a little more at the beginning, but can save many times that amount later when circumstances, business fortunes or relationships take a turn.
5. How are disputes resolved?
While everyone hopes for healthy and harmonious relationships among partners, the fact is tensions often arise. There needs to be a process in place beforehand for resolving disputes when strong opposing positions arise. One goal is to avoid escalating to litigation too quickly. Multiple owners can agree in advance to commit to alternative dispute resolution mechanisms such as mediation. An attorney can help business partners establish before a serious dispute arises, commitments to try mediation or use arbitration stead of suing each other or the business.
With mediation, a neutral third party, often an uninvolved but knowledgeable-about-the-subject-matter attorney or a retired judge, acts as a go-between to help the parties try to find a compromise. Ideally, the sides commit a day or half-day to staying at one location with separate rooms, and working with the mediator to reach a compromise. If the parties can agree on a resolution, an agreement is drafted that day and signed. If no agreement is reached, the parties can end the mediation and pursue a lawsuit or arbitration.
Arbitration tends to be more streamlined than a lawsuit in court. The arbitrator, chosen by the parties, ultimately decides the issues and also directs how much process will go into hearing each side of the case (whether the rules of evidence will be applied, deadlines, etc.). While arbitrating a matter may go more quickly and be less costly than a lawsuit in court, there is no right to appeal an arbitration decision.