Buying into a partnership or selling a stake in a business to a new partner can be an exciting but serious undertaking for everyone involved. There is a lot you need to discuss, so this isn't a decision into which you should rush after a quick meeting or something to take for granted even if you know the person outside of business.
Types of partnership businesses can include two or more people in a state-registered partnership, a private corporation with only a small number of shareholders or a professional business consisting of lawyers, doctors or accountants. In fact, the only businesses you really can't call a partnership would be a business with only one owner, like a sole proprietorship.
Buying Into a Business as a Partner
A new business partnership comes with many opportunities for both parties as well as some serious risks. New partnership business advantages include the potential of expanding the business, attracting new opportunities, increasing contacts in the industry, increasing available capital and, of course, increasing revenue.
The biggest risk is that the people who work there may not be the best fit for the new partner. They may have a different vision for the company's future, for example, or a different work ethic. There is also the risk that the new partner's skills may not be the best fit for the company.
Rushing into a partnership is not a good idea for either party. You should discuss your plans thoroughly, look at each other's track record with other businesses and make sure that everyone involved understands each other's expectations before making the decision to work together or not.
Determining Compensation for a New Partner
There are two aspects to compensating a new partner that each need to be balanced. On one hand, you will need to ensure profits from the company are distributed fairly among all partners. On the other hand, you need to ensure the company has enough cash to meet its long-term goals.
In most small businesses, compensation usually includes a salary and a bonus. Bonuses can be a percentage of gross income or collected receivables. There are several issues you need to consider when it comes to compensation. You will need to decide:
- A level of compensation that is fair to both the new partner and the current partners.
- How much equity in the business the new partner should get.
- A buy-in price and whether it should be paid up front, in installments or through salary reduction.
- Whether or not the new partner will be responsible for company liabilities.
- Exit strategies for the new partner, including a buy/sell agreement and termination clause.
- A price to be paid to a departing partner.
- Whether or not to put a noncompete clause in a departing partner's contract.
Discussing Equity and Liabilities in a Partnership
Equity is more important to some people than others. Some partners aren't too concerned about equity, while others want equity in the company to have some control over the business.
A minority equity stake in a small business isn't worth very much unless a company is sold. It's unlikely you will be able to attract a partner with just a minority equity share. However, for those who truly want to be a part of a business, owning a minority stake in the company can make them feel that they truly have a vested interest in how the company succeeds.
Discussion of liabilities is just as important as equity. Before a new partner buys in, the current partners (or some of them) may already be liable for company debts. Everyone will need to be clear on whether the new partner will be responsible for any portion of the company's liabilities.
The Price for Buying Into a Partnership
If an incoming partner is given equity in the company, there must be a buy-in price established. Existing partners almost always want a high buy-in price from an incoming partner. Not only does it increase cash reserves but it can be used to pay outgoing partners. However, setting a low buy-in price also allows the company to set a low buy-out price should the new partner not be a good fit.
The value of the company can be established by adding assets, accounts receivable and goodwill all multiplied by an appropriate multiple:
Value = (hard assets + accounts receivable + goodwill) x (appropriate multiple)
A new partner can pay for equity in a number of different ways. Vesting is one way to do this, particularly if the company is a corporation with stocks. The new partner buys equity over time through the purchase of more equity. Salary reduction is another option that can be used along with vesting. The new partner takes a salary reduction, typically between three to eight years. This essentially works like installment payments using pretax dollars.
Discussing Exit Strategies in a Partnership
Exit strategies should be decided before the new partner is brought on board. Typically, an exit includes a termination of employment and a buy back of the partner's equity in the company. In professional partnerships, like doctors or lawyers, the loss of one's license means a termination of the partnership as well.
A buy/sell agreement is also important. It specifies events that will trigger a buy back, like employee termination, death or disability. For example, if a partner dies, the remaining partners could buy back equity from the estate or allow the partner's spouse or children to keep their share in the company.
A shotgun clause is also typically included in a buy/sell agreement. If there is a dispute between partners, partnership can be terminated immediately by one offering to buy out the other. The other partner can accept the buy-out offer or buy out the initiating partner for the same price.
Discussing Goals and Expectations
If an organization is going to thrive, the owners need to be going in the same direction while focused on the same goals. A business partnership can be just as important as a marriage, but the courtship is usually much shorter. Too often, after a short series of meetings, people listen to what they want to hear rather than asking direct questions and clarifying what is being said.
Imagine for a moment that two people decide to get married without knowing that one wants to buy a farm and have four children, while the other wants to get an apartment in the city and then travel for a few years. Chances are that the marriage will either be very short or unbearably long.
A similar situation happens in business partnerships when the partners' values and goals don't align. Imagine that you wanted your company to dominate the global market and become a household name, only to discover that your partner wants to sell the business as soon as possible for an early retirement. These sample questions will help to ensure you know each other's goals and values and lead to better insight on what a new partner will bring to a company and what the company may bring to that new partner.
- Have you been in a business partnership before?
- Where do you see the business being in five years?
- What is your financial situation?
- What motivates you?
- Are you a risk taker?
- What are your views on employee compensation?
- What is your definition of success?
- What is your definition of failure?
- What personal goals will this business help you achieve?
- How much time will you put into this business?
- Matt Dickstein: Bringing in a New Partner
- Fortune Builders: 15 Questions To Ask A Potential Business Partner
- American Express: Ready to Add Partners to Your Company? Here Are 5 Things to Consider
- Forbes: How To Structure And Finance Your Partnership Buyout
- U.S. Small Business Administration: Choose a Business Structure
A published author, David Weedmark has advised businesses on technology, media and marketing for more than 20 years and used to teach computer science at Algonquin College. He is currently the owner of Mad Hat Labs, a web design and media consultancy business. David has written hundreds of articles for newspapers, magazines and websites including American Express, Samsung, Re/Max and the New York Times' About.com.