The Risks and Rewards of Business Partnerships

Partnerships can be difficult, but if organized the right way they can also provide great benefits for your business

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Maybe you shared a faded futon as college roommates or a second-hand Chevy as brother and sister. Whatever the circumstances were that brought you together, at some point you were convinced that a business partnership was meant to be.

You have this grand vision of how your small business will succeed. You think, “I can make this work with this person. I’ll do this, and he’ll do that. This is going to be great!”

You hit the ground running. You form a limited liability company online and file your Articles of Incorporation. With a few more clicks, you apply for an Employer Identification Number. Everything is great, until the business gets rolling and you realize that your business partner isn’t someone you can do business with after all.

As this scenario shows, working with a business partner has its risks. A strained relationship with a family member or friend is just one of the risks of partnership. Partnerships carry financial and legal liabilities as well. But business owners can reduce the amount of risk they assume in a partnership.

The first level of protection is the business structure. Business partners who form a limited liability partnership, LLC or S corporation gain liability protections. Generally, only what they invest in the business is potentially what they can lose, along with any loans or other obligations they take on.

Sharing the financial risk is one benefit of a partnership. Sharing responsibilities is another. Before partners open a business or add a partner to an existing operation, a partnership agreement is essential. This document provides a framework for resolving issues and prevents problems that may otherwise result in court action.

Choose wisely

Dave Kaster, principal at Fidelis LLC, a certified business advisory service in Green Bay, Wisconsin, encourages partners to discuss every scenario they can imagine and how the decision-making process will play out.

“Put that into the partnership agreement. Everyone needs to agree upfront,” Kaster says.

He compares a partnership agreement to a prenuptial agreement drafted before a marriage. Business owners may feel uncomfortable drafting an operating agreement, but that agreement can save them a lot of misery and legal fees.

“The time for compromise is not while you’re negotiating the partnership agreement,” Kaster says. “The time for compromise is after, when you’re working together. If you compromise up front, you have to live with it forever.”

Choosing the right partner involves careful consideration.

“Any time you’re going to partner, first and foremost, you’re looking at what each partner brings to the table,” Kaster says. “If you’re bringing the same thing, then you may want to look deeper. By partnering are we able to pool our money? Are we able to cover 24 hours of the clock, rather than 12? That’s all good, from the logistical aspect.”   

Above all, business decisions, not personal feelings, should lay the foundation of a partnership.

A partnership agreement should outline a variety of things, including percentage of equity in the company, whether it’s 50-50, 60-40, 70-30 or something else.

“The important thing is that there’s a meeting of the minds to understand what distribution you have,” says Devin Shanley, attorney with Peterson, Berk & Cross. Partners agree to the investment of capital equity and/or sweat equity. They are also willing to accept the liability, profit/loss and leadership authority that their percentage represents.

A so-called silent partner typically is someone who puts up capital but doesn’t have voting rights. However, if a partnership is structured as an S Corp, it’s generally one share, one vote. Corporations can’t exclude shareholders from certain decisions. So, instead of adding partners to the corporation, business owners may choose to structure an investor’s contribution as a loan, categorized as a stock purchase.

“You’re just going to want clarity, so your documents are consistent — whether you’re talking about loan agreements, operating agreements or partnership agreements,” Shanley says. “A corporate attorney or business law attorney can talk you through that and draft documents.”

Partners also should clarify how the company will handle an expense the business can’t cover. Will partners be required to reinvest in the company? If so, what procedure will be established?

Additionally, what happens if partners decide to change the partnership agreement? A method to modify the agreement should be determined upfront and included in the document.

Exit strategy

Besides planning how to begin a partnership, business owners also should plan how to exit. A buyout strategy is a critical element of every partnership agreement. Maybe someone wants out of the business, or a partner wants someone out. Maybe there’s a significant life change that affects ownership, like a divorce or disability.

Placing a value on the business can be tricky. In the case of a death, the surviving partner may not see eye-to-eye with the heirs. Partners with the foresight to structure a buyout plan create a smooth leadership transition. They might agree to contact a disinterested third party or arbitrator to determine the value of the business.

The classic buyout scenario occurs when a partner dies, and the death triggers a buyout. The surviving partner or partners buy out the deceased person’s spouse and/or heirs. Although the surviving partners may be fond of the deceased’s family, that doesn’t necessarily mean they want to be in business with them. Perhaps the survivors have no interest or aptitude for running the business. They don’t want any responsibility in the business, including any business debt.

A clear-cut buyout plan allows the surviving partners to maintain ownership, continuity and authority to run the business in the event of a partner’s death.

Life insurance and “key worker” replacement insurance are policies partners can purchase to mitigate risk. When a business owner purchases life insurance on a partner, the owner has the means to buy out a deceased partner’s heirs. The survivors will receive a check for the value of the business and won’t become owners.

Life insurance also mitigates the risk of corporate debt if a partner dies and the bank doesn’t allow the surviving partner to maintain the current debt load.

Additionally, partners can purchase key worker insurance on people who are instrumental in the day-to-day operations of the business. This insurance provides the financial resources to replace these key people, including partners.

New partners

Another exit plan involves training and fostering new partners. Business owners can offer financial incentives to keep employees around and eventually add them as partners.

“You want to give them the taste of ‘The better the business does, the better you do, too,’” Shanley says.

Any business with a high personal connection between service provider and customers should carefully and deliberately introduce the new partner to customers.

“To maximize the value of the business, you need to be able to effectively transition leadership and turn that business over to them,” Shanley says.

Working with a partner has its share of risks, but also has many rewards. Partners share responsibility and liability. Best of all, a partnership developed with the appropriate planning brings the right people together. Collectively, they work toward the same goal of operating a successful business.


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