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Before You Bring in an Equity Partner

Make Sure What You Give Up Is Worth What You Get

PartnersIf you’re looking for outside money to invest in your business, then you’re going to usually end up with one of two things: more debt or less equity. And make no mistake, no matter what you call your equity partner, he or she is a partner.

Some of the worst problems a business will experience happen when a partnership goes wrong. Before you bring in an equity partner, make sure what they bring to the table is worth what you are giving up.

When partnerships go wrong, they can go really wrong. It’s like a marriage gone bad, only worse. That’s because while there is a big body of law to determine how you break up a marriage, there isn’t for a partnership. This is also why it is so important to get a partnership agreement in writing, at the beginning of the relationship.

The most effective partner relationships are those where expectations are clearly spelled out. If you are considering bringing a partner into your business, either at the beginning or later on after the business is up and running, take the time (and possibly spend the money), to have a formal, legally-binding agreement prepared.

Set out how you will work together, and how you will resolve issues. The agreement will also set out how you can dissolve the partnership if you can’t resolve your differences. You need an exit strategy from the partner relationship, and it needs to be one that won’t break your company. That means thinking about things like:

(1)          Work. How do you make sure you both make a proportional contribution to the business, either financially, or through providing know-how?

(2)          Compensation. If you’ve got a money partner, this will look different from a “sweat equity” partner (that’s someone who works for their share). The money guy has far more at risk.

(3)          Death, Divorce, and Disability. These are commonly called the “3 D’s” in the legal world. How do you handle your partner’s death? Most assets are passed on to family members, meaning that your partner’s husband, wife, or children could become your new partner. Are you okay with that? The same question needs to be asked for divorce. If your partner leaves his wife and she gets half of his stuff, she becomes your third partner. Are you okay with that dynamic in your meeting rooms?

(4)          Disability is the third D, but it’s more of an internal issue. If your partner is injured or becomes seriously ill, and can’t contribute to the company, someone’s got to pick up the slack. That someone needs to be compensated for their efforts (ideally out of your partner’s share of the profits), right at a time when revenues may be down, or when your partner may need every cent she can get her hands on. With a long-term illness, it could be months or even years before someone recovers, if they recover at all. At what point do you make the decision to move on without that person?

(5)          The Buy-Out. The honeymoon is over, and you and your partner have decided to go your separate ways. Perhaps you want your partner out. Perhaps your partner wants you out. How are you going to do that? And, more importantly, how much is your company really worth?

(6)          This is the big one. There’s more litigation on this one point than all of the others, combined. How do you value a company that hasn’t made a dime, but you expect it to make millions one day? And you (or your partner) were an integral part of getting it there? Paying someone a buy-out fee based on projections can be a tough prospect. It also depends on what side of the table you are on. If you are the one being bought out, you’re looking for the highest possible dollar amount. The other side of the table is not.

(7)          Financing the Pay-Off. Assuming you make it through points 1-4, you’ve now got to figure out how you pay off a former partner, if it comes to that. Early stage companies don’t necessarily have deep pockets. There is often a profit share, or other form of payment schedule, that continues on long after the partnership is over. Looking for business financing is hard. Looking for business financing to pay off a partner is even harder.

And, of course, make sure you have an attorney drafting the details of your agreement, so that it clearly accomplishes what you want. It’s tempting to take money from anyone who is willing to give it to you when your business is new or going through a growth spurt, but if you’re bringing in a partner, make sure you’re following all the rules. It’s easy to get into a partnership, but can be very hard, and expensive, to get out of one.

Photo Credit: woodleywonderworks, Flickr. 

Author:

Diane Kennedy, CPA US Tax Aid. Diane Kennedy, CPA helps business owners legally pay less tax. She’s the New York Times best-selling author of “Loopholes of the Rich,” “Real Estate Loopholes,” and 7 other best-selling financial and tax books. She’s also a business owner and real estate investor. Her motto is “It’s Your Money. Keep More Of It.”