According to Inc. Magazine, over 80% of partnerships fail. You might ask, why that may be? When you step back and think about it, realistically, how many people can survive the changes that happen during a lifetime? A partner may get a divorce, a partner may have a family need to move to another location, a partner may get sick, a partner may die, a partner may have different financial objectives that change as they mature. Craig discusses the pros and cons you should consider before jumping into a partnership.
1. Create a partnership by meeting often and doing activities outside of business to create a relationship that is founded on a personal relationship that allows you to communicate openly and directly.
2. When choosing a legal entity, it’s not good enough to fill out some minor required forms by the state. You need to spend time looking at an LLC, an operating agreement or in a partnership, the partnership agreement and spell out the roles, the responsibilities and what is going to be contributed and how profits will be distributed.
3. Documenting what you agree to with your partner is of utmost importance. One partner may interpret something one way and the other another way. This will allow your partnership to be more successful if terms are properly documented.
4. Take the time to step back and look at what you and your potential partner are going to contribute and what value that might be before moving forward.
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From his first job flipping burgers at McDonald’s and delivering The Washington Post, Craig Willett counts only one and a half years of his adult life working for someone else. Welcome to The Biz Sherpa podcast with your host, Craig Willett. Founder of several multimillion-dollar businesses and trusted advisor to other business owners, he’s giving back to help business owners and aspiring entrepreneurs achieve fulfillment, enhance their lives, and create enduring wealth. The Biz Sherpa.
This is Craig Willett, The Biz Sherpa. I’m grateful you joined me today for this episode about partnering and not partnering. It’s a very interesting question and choosing the type of legal entity that you should use when you set up a business is an important decision. But let’s talk about partnerships for a minute.
According to Inc. Magazine, over 80% of partnerships fail. You might ask, why might that be? When you step back and think about it, realistically, how many people can survive the changes that happen during a lifetime? A partner may get a divorce, a partner may have a family need to move to another location, a partner may get sick, a partner may die, a partner may have different financial objectives that change as they mature. You have to consider the flexibility you need to build into a partnership arrangement before you do it.
Why do some partnerships work? Let’s look at sports. For instance, one of the greatest quarterbacks was Joe Montana. One of the greatest receivers was Jerry Rice. They won some Super Bowls. Why? They had a great partnership, but what made them great partners? They didn’t own the San Francisco 49ers, but they worked well together. Jerry had a very distinct role from Joe. Joe had to learn to read a defense and be able to call a play, drop back, be able to stay within the protection that he was provided by the frontline, and then complete a pass to Jerry Rice, who had a totally different role. Joe’s was to throw the ball, Jerry’s was to catch the ball.
But more importantly, Jerry also had to be able to listen to and understand the plays that Joe called. It wasn’t up to Jerry to call the audible, it was up to Joe. Jerry had to follow that pattern that was called so that Joe knew where Jerry would be when he threw the ball. It didn’t matter where the defenders were and it didn’t matter how much Jerry could read them, his job was to run that pattern as best he could and then when the ball was in the air, to get in position to catch it and to score a touchdown.
Think about it—very distinct and separate roles—but what worked for them is they each had their own contract and they each didn’t have to deal with ownership. But their synergy worked really well together, and I’m sure at the end of each season, Joe Montana wasn’t asking for Jerry Rice to be traded nor was Jerry Rice asking for a new quarterback to fill Joe Montana’s role.
Let’s talk about that, conflict. Partnerships tend to bring themselves to conflict. What are some ways to avoid the conflict? One way that comes to mind right away is to meet often. Maybe participate in activities outside of business so that you have a relationship that is founded not just solely on the business, but you build a personal relationship that allows you to communicate openly and directly. Certainly having regular meetings is one step to improving those communications.
But let’s step back for a minute and ask, why do people form partnerships or LLCs that act like partnerships? Sometimes, as a business owner, you may need additional money to fund your startup and you take on a financial partner. A financial partner other than a financial institution in the form of equity. That partner—do they own the business, and if they own the business, do they have a vote in who the management is and do they have a say in what goes on? Do they work in the business in addition to putting money in?
It’s important to step back and take time to look at a proposed partnership arrangement. What are the benefits? What’s going to be given in exchange for the ownership, and what’s going to be expected in return? If you look and align those responsibilities well, you avoid the conflict, much like my Jerry Rice, Joe Montana scenario that I painted for you.
Consider this. If you have someone putting in money in the business and really has no other business expertise—maybe they received an inheritance and is a family member and they just want to give it to you, but they want some ownership so they get some of the “upside”—then they can be what might be called a silent or limited partner and have no say in management roles. Now, there may be some things that they have quite a bit of say in as to what the money is to be used for, but they can say that upfront when they give the money to the company and can build that into the agreement—how it’s supposed to be used and what it’s supposed to be used for.
This will avoid some of the long-term implications once that money has been either returned in the form of a preferred return to that investor, or in the form of a profits interest and they’re comfortable. Then you don’t have as much to worry about. But look at it. When you sit down and think about all the changes that can happen in life, it’s important then to document what you say.
When you choose a legal entity, it’s not just good enough to fill out some minor forms that are required by the state to recognize them, but you have to spend time really looking at, in an LLC, an operating agreement, or in a partnership, the partnership agreement to spell out what are the roles, what are the responsibilities, what’s going to be contributed, and then how are profits going to be distributed and in what order, so that those that are contributing only money may get theirs back first over those who are contributing time and expertise and are maybe receiving compensation as they go. The silent partner may not get paid.
When you look at the varying roles that you play, a natural partnership agreement can be formed. As with any good partnership, you should spell out the terms of how you get it started, how it’s going to function, and then when things change, how to wind it up. There may be preferred distributions that can be made to buy out a partner at some point in time. You may have two partners who work in the business, and let’s say in the form of a CPA firm, for instance, when two CPAs combine, there may be a buy-sell agreement put in place that has, as its basis, a life insurance policy, so that if one of them dies, the family of the other gets bought out on a pre-determined valuation basis and that’s paid for through the payment of life insurance premiums on both partners. That’s one way to avoid having to deal with a non-professional partner down the road and gives immediate cash to the estate of the deceased partner.
Now, there are other ways to deal with this as well, but rather than delve into all of them, I would say that the partnership is the most complex and that it requires taking time to meet with attorneys to work out the agreement. I would say if you have two or three different partners, your interests are going to differ to some degree and you should probably seek separate legal counsel when you do it.
Now, let’s step back and go to probably the more pleasant form of doing business. If that many partnerships fail, then you may look at other structures that probably aren’t conducive to that. That would be corporations, which would be a C corporation and an S corporation—and we’ll talk about the distinguishing characteristics of the two—and you may look at an LLC or a limited partnership that puts people in a limited partnership role. The other one that’s a common form of a business entity is the sole proprietorship. It’s simple, right?
Let me give you the priorities to consider when you’re looking to form a business. It’s real easy upfront to be excited and to almost skip over some important steps, but one of them needs to be the simplicity of doing it, but not overly simple. The other thing to consider is the tax consequences of the entity. The other one is what kind of legal protections can you get for liability that may spill over outside the business enterprise onto your personal assets. Then the third—or the last, the fourth one that you really need to consider is what are the costs to set it up. I don’t put the costs as number one, because it’s important to properly document.
It’s nice when we all get together around the table and say, “Hey, we’re going to be partners and here’s what we’re going to do and here’s what you’re going to do. We’re going to make a lot of money and we’re going to be happy together,” but documenting what you agree to is really important. We forget over time, and sometimes we hear what someone else says differently than how they intended to say it. We may have our perspective, and so I think it’s very important to take the time. Because as you take the time, it will allow your partnership to be more successful if it’s properly documented, and it will allow you to unwind it in a least costly way.
Think about it, there’s a bunch of law firms that specialize in helping partners sue other partners and break up. This is a hotly contested area and can be very expensive, and therefore, the more time and effort you put in upfront to spell out how you get in and how you get out, will keep everybody more at bay and make it more orderly when it’s time for someone to exit the partnership.
Now, let’s go back to the other entities. Clearly, one of the methods that you can do is a corporation. A lot of people hear about corporations, and unless you’re going to go really big and take on a lot of money and grow really quickly, I would not look at a C corporation. If you’re in the services business, say a doctor or a dentist, I would certainly look at the S corporation form of doing business. Why? Because you can then take a salary and the rest, beyond what your reasonable compensation is, can be the profits of the business you can take as an S corporation distribution taxed only once and not twice, as maybe a C corporation is. You need to be careful, a C corporation has double taxation.
A lot of companies in the early stages realize it might be a year or two before they’re profitable and they plan on growing really quickly. Sometimes that growth never happens, and so you want to be careful, especially if you’re putting in most of the money, to not put it in a C corporation where those losses get locked up in there. You want to have those available to you to use to offset any other income you have, or to have a loss carry forward for future profits—future profits outside of the business. I think it’s important to look at other entities.
I would say the thing that’s probably most common today—and we’ve all heard of it—is an LLC, a limited liability company. Those are established under the laws of the state to give limited liability to those who own the business, meaning unless you commit negligence or fraud, the liabilities that arise out of the company—unless you gave personal guarantees—don’t spill over to you and take claim on your personal assets. Now, I’m not a lawyer, but I did do a lot of estate planning and a lot of asset protection planning as a CPA, and that is a good thing to consider upfront. You don’t want to have somebody sue the business for something that happened that you weren’t negligent on, and your insurance policies in the business pay for it, but there’s a claim in excess of that. You don’t want to put yourself in a position to potentially lose your home unless you did something negligent. Of course, that will never be protected.
Now, I would also look at the LLC form of doing business because it’s very flexible. I think flexibility is the key to choosing an entity. You need to have the flexibility going in to have different percentages of ownership, different responsibilities, and different expectations. If someone’s putting in all of the money and going to work all of the time, I would think that they would want certain rates of return over and above for the capital that they put in, and so they can receive those. An LLC allows for that flexibility, but it takes hiring someone to be able to spell out what those terms are. As you spell out those terms, I think you can find that you can reach agreement. What you’re trying to avoid is the conflict at the end of each year as to how to distribute the profits.
Come back to my analogy on Jerry Rice and Joe Montana. They weren’t looking to have the other one traded at the end of each year. They realized the value of the other person, and that’s what’s important. When you’re trying to spell out a partnership or an LLC agreement, it really comes down to the value contributed. There are ways to not bring in certain people as partners. You may hire someone that might be key to the business and they want a partnership interest, but you and your partner have invested hundreds of thousands of dollars in the business and it may make sense to give them future profits interests. In other words, if they’re going to bring and add a lot of value as a key employee, you may give them a percentage of the future profits. That allows them to get rewarded for what they do, but doesn’t take away your ownership of the business should you sell it.
Now, I know these might be complex, for some—complex concepts—and I don’t want to overwhelm you with the complex concepts, but I really want you to consider why you need a lot of flexibility and why you want to slow down and take the time to document a limited liability company—unless there’s only going to be one owner, or a partnership—you want to document that very well. Not to say that you shouldn’t properly document the other forms of doing business, but you want to be careful that each year the instructions are clear as to how to divide the profits, how to retain the profits, who has what authority to bind the company. Those things need to be spelled out. The more you can anticipate what the future will bring, the fewer conflicts you will have because you will lay out the ground rules upfront.
That doesn’t mean that we don’t change. Our personalities change, we get in difficult circumstances and people react different ways. I think that’s probably what leads to partnerships failing often at such a high rate And so you need to anticipate that that may happen someday and there needs to be a fair way so that those who are going to stay and those that feel they need to go have an opportunity to be bought out properly and a mechanism in place potentially to finance that, whether it’s payments over time and a formula as to how to determine what that partnership is worth. It really brings reality back to the table when you have agreed upon upfront what that valuation might be so that someone doesn’t think the business is worth more than it is and thinks, “Hey, I’d rather go spend the rest of my life on the beach and so I want to force my partner to buy me out.” That can lead to a lot of legal costs. If you spell it out upfront, there are ways to come to those agreements.
Now, I want to talk about something that I think is really important in business, and that is keeping it simple. The more you can narrow down the concepts of what’s important to you and what you want out of the business, the easier it will be to put together the right documents and the easier it will be to choose the entity. The nice thing about an LLC is it’s taxed only once, but you can compensate people who work in the business as well, and that can be approved in the operating agreement upfront. There are ways to handle those decisions.
What I like is to try to keep things as simple as possible. You want your business to succeed and you don’t want the distraction or the costs to drain your business and take your eye off the ball. Imagine Jerry Rice. If he’s worried about something other than receiving and catching the football, he’s going to be looking at whatever else it is that’s a distraction to him and miss the ball. As good as an athlete as he is and as good as a business owner as you might be, if you have those distractions and you get too many of them, you’ll take your eye off the ball and all of a sudden that revenue-generating and profit-producing formula that you’ve put together in your business will all of a sudden start to falter as well. Your employees will sense the conflict at the top. They’ll sense—and so might your customers. When your customers start to sense that, they’re going to look at alternative sources for services or products that you provide and sense that maybe things aren’t going well there. So you really want to work it out.
Now, you may say, “Well, gee, Craig. I think then I’m not even going to have a partner,” and that may be something that you have to decide to do. I have to admit, I don’t necessarily do well in partnership situations. I’ve had a few and I’ve been able to buy out those partners over time, but I would say that I function best when I’m on my own as the sole owner. That doesn’t mean that I can’t have key employees and that I don’t reward them with profits interests as they move forward, but I know I don’t function well under that situation. I’ve seen too many fail. Maybe it’s my fear of failure that may cause that, but I believe that you know in your own heart what’s best for you.
Step back and look at what you’re going to contribute and be realistic about that, and then step back and look at the potential partners and what they’re really going to contribute and what the value of that may be. You can’t put a price on it, but you can certainly figure out how to divide up the ownership percentages. It may be that one of you had the idea to start this business and have some experience in an area that the others do not and that therefore warrants a larger percentage. It may be that one of you has the money, and for the first several years, certain decisions need to be made by the person who’s contributing the money.
Those things can be worked out. All I’m saying is do as much as you can to think through to avoid that conflict. No one likes conflict. Well, I shouldn’t say that, maybe there are some people who like conflict, but I tend to like to avoid conflict as much as possible. You do need to stand up for yourself and hold your own ground—I’m not saying to be a walkover—but as you set up your business, look at the best way you can do to document that. Look at the simplicity, look at the flexibility, look at the tax consequences of what you’re setting up, and then look at the costs. I think people get it the other way around. They look at the costs and avoid doing the proper documentation, and therefore, a lot of people jump into as sole proprietors. This opens you up to a lot of personal liability and also is not the most sophisticated way to do business.
I’m not saying to make it sophisticated. I said simple, and there are a lot of simple ways to get that kind of protection and then move yourself forward by educating yourself with a good CPA who can help explain the tax ramifications of the entity you choose, and choose a good attorney to document that, especially if you’re going to have partners.
I think one of the greatest things in life in the United States is the ability to start and own a business. That freedom and that flexibility is one of the highest expressions and forms of our ability to own property, of our ability to express ourselves and be creative, and because of that, small businesses are the economic engine of the United States, creating the most jobs each year. I think that you owe it to yourself to give yourself a chance to be successful by choosing the right type of entity. Thinking it through and not setting yourself up for some pitfalls that will trip you up, that you end up in the heap of the failed business pile at the end of the year. I think you have more in you than that.
I hope this has been helpful. I hope you’re able to sit down and think it through and find people who are qualified to advise you in such an important decision. Again, remember, it’s important to figure out what your role is. Joe Montana was a great quarterback because he could read defenses and he knew how to call an audible. Jerry Rice was a great receiver because he followed the lead of Joe Montana and was able to get under that ball on the play that was called; he wasn’t out there freestyling it. I think it takes both to be successful. Think of who you are in your business and how you’re going to be the one calling the shots or following the game plan that you—as a partner—come up with, with the lead or managing partner. This is Craig Willett, The Biz Sherpa.
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