Saturday, March 8, 2008

The Partnership Paradox

To create a strong business partnership you want to be sure to choose as a partner someone you know and trust, right? But,too often partnerships formed by good friends can result those friends becoming bitter enemies, as well as financial calamity and bad feelings that may be with them the rest of their lives. Yet, obviously partnerships can and do work. Why do some partnerships thrive while others fail miserably? There is no single answer to that question, but you can greatly increase the probability of success by getting the structure right from the start. Here are some fundamental guidlelines. For specific legal language, consult an attorney.

The primary cause of enmity between partners is differing perceptions of what's expected of each other and what they "deserve". This is usually caused by trying to shortcut the process of aquiring equity in the partnership. There are three simple rules that can be employed to avoid this problem. First, the only thing that gets you equity in the partnership is CASH. Second, don't confuse compensation with income distribution. Third, every organization needs a captain, and there can be only one.

Rule one does not mean that one cannot gain equity through knowlege, labor, land or some other asset. It simply means that you should not skip a step in between. Each should be converted to cash first, then the cash used to acquire equity. In the case of knowledge, that knowlege needs to be applied on behalf of the company before it is of any value to it. Assuming the knowlege will be applied in some sort of management or consultation position, you first define the position, come up with a reasonable salary based on what you would pay a non-partner with the same qualifications and an agreed upon portion of the salary can be applied to equity. This can be done either in the form of repayment of a loan made by the company to the partner (for the purpose of buying in) or the partner can buy in over time as salary is earned. The same is true for labor. Pay a fair wage. The employee then pays for equity. This protects both the company and the employee. The employee is paid in full for work performed and earns equity based on actual cash investment. Again, this can be a paper transaction, but all the steps should be spelled out, so that there is no ambiguity. To illustrate the shortcomings of the alternative, consider this scenerio: You invest $10,000 cash (which at some point was a result of your own applied knowledge and ability). Your partner, gets half the company simply for having knowledge (as yet unapplied). Due to some unforeseen circumstance, the company has to be liquidated a month later, or maybe your partner decides to sell their portion. You just lost half your investment. What did you get in return? Your partner walks away with $5,000.

A contribution of assets should be handled in much the same way. First you agree on the market value of the assets, pay for them (even if only on paper), and invest the cash into the partnership.

The second rule is just as crucial. Compensation is compensation. Earnings distributions are earnings distributions. DON'T CROSS THE STREAMS! Compensation should be clearly defined and based on actual work performed, just as in any other job in which one is not a partner. Your percentage of ownership should not be a factor in determining your compensation. You may agree to take a below market salary to help out your company, but that does not entitle you to a larger share of equity. In fact, if your lower salary results in increased earnings, you'll only recover your share of the increase, the rest is divied up between the other partners. This can lead to serious resentment and is generally not a good idea. A work-around might be to include pre-distribution profit-sharing as part of your compensation. Income distribution should be based solely on your percentage of ownership in the partnership. Even if you do a lousy job and wind up getting fired, as long as you have equity, you're entitled to your full share of distributions.

This brings us to rule three: For a company to function effectively there needs to be a captain. One person who decides when input-taking is over and decision time is at hand, and who makes that decision. You don't have to be majority partner to be in this position. The position is commonly known as "managing partner" and is best given to the most qualified parnter, not necessarily the one with the most equity. Employees need oversight, direction, evaluation, encouragement and discipline whether they are partners or not. Performance standards should not be based on equity. All partners should fully understand this going in. If a partner needs to be demoted or fired for the good of the company, they should be ready and willing to accept that.

Business, like sports, can be a lot fun. Good friends coming together and achieving success can be very rewarding. To maximize your potential, make the ground rules very clear and easily understood. That way you can focus you energies on good ideas and implementation instead of spending all your time arguing about what constitutes a "foul".


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