When first cousins Peter Guidi, 60, and JJ Mokarzel, 62, decided to launch a bourbon company, Joe Louis Spirits, in Old Orchard Beach, Maine, they each drew from experiences with prior partnerships to structure their business. Both men knew they needed to be equally committed to the venture’s success but bring complementary skills to the table.
Despite being 50-50 partners, they agreed that Mokarzel would have the final say on any split decisions. “A ship can only have one captain,” says Guidi. “It’s a waste of time and effort if all you’re going to do is struggle for control,” he says.
How to resolve an impasse is just one of many decisions you’ll want to agree on before establishing a business partnership. You should also discuss financing, business structure and location, other contributors, insurance and tax implications, valuing the company, and the possibility that one partner might want to step away from the business in the future. “It’s easier to get married than to get divorced,” says David Levi, senior managing director for CBIZ MHM, a national accounting and professional services firm. “Spelling stuff out upfront is just huge.”
That said, it’s impossible to predict everything that might come up, and hard to envision the scope and future of the business when you’re just at the starting gate. Although you will want to touch on all the key issues, don’t lock yourself into rigid policies or negotiate so fiercely that you kill a promising business venture before it launches. It’s a shame when people “try to negotiate too sharp a deal or too comprehensive a deal. There needs to be some trust and ambiguity,” says John Emory Jr., president of Emory & Co., a business valuation and investment banking firm in Milwaukee, Wis.
Plan for the Unexpected
Before launching a partnership, talk through your vision of the business, risk tolerance, timeline and what may need to evolve as the business grows. “It’s good to be aligned,” Emory says. “When they bring in someone like me, it’s often because one person wants to retire in the next couple years and the other wants to work for another 10 years.”
Conflicts often arise from feelings of unequal contribution and defensiveness about underperformance, says Ray Parsons, 59, chief executive of Transcepta, a procurement and accounts payable platform that he co-founded with three partners. “Feelings of unequal contribution are perhaps the toughest problem to face because they involve a lot of ego for all parties,” Parsons says.
That’s one reason partners should understand and mentally prepare for the division of labor and goals to shift over time. “These are living, breathing documents,” says Levi, who advises partners to have an open discussion as things change and restructure compensation if needed. He’s seen situations where one operating partner does most of the work but there’s no mechanism for buying the other partner out.
For example, if one partner has a health or personal issue that requires stepping back from the business for a year, the other partner should be compensated for pulling the extra load temporarily. “For that period while that difference exists, it’s got to be acknowledged,” Levi says.
Similarly, if one partner is much older and aims to retire sooner, the priority should be steering existing clients toward the younger partner to smooth the transition instead of drumming up new business.
Entrepreneurs often underestimate the capital needed for success, experts say. About 20% of new businesses fail during the first two years. Partners should agree on sources of financing and strategies for raising money in the future.
“I would really discourage going to the retirement funds, especially pre-age 59½ because you have a 10% penalty for premature distributions,” Levi says. “What people most often do is pound credit cards, because it’s the easiest thing to do, or home equity lines.”
Decide from now how you’ll finance the business. Do you both need to agree on taking out a business loan over a certain amount? If one partner has more liquid personal assets, is that person willing to lend to the business, and if so, on what terms would the loan be repaid?
“If you have banking or investment relationships, talk to those bankers about getting financing for the business,” Levi suggests. For businesses with substantial physical assets, a good option might be lease financing, in which a lender owns the assets but the partnership buys the rights to use them through ongoing lease payments. Or if your customers owe the business a large amount, you could sell those future accounts receivables to a factoring company that advances you a smaller amount of money now. “It’s kind of like a revolving credit line,” he says.
Of course, partners must also agree on the foundation of the business. Discuss questions like: Where should you incorporate and be headquartered? What business structure is best? How much insurance should we buy?
“Errors and omission insurance, liability, and property and casualty insurance are a must. Sometimes key person life insurance is important,” to account for the death or disability of one of the partners, Levi says. Many startups, though, may not be able to afford all these policies initially, so check your personal umbrella policy to see if it covers errors and omissions in your business. Make a plan to acquire coverage in the future, if you don’t have the budget now.
Investigate the differences among an LLC, S corporation and C corporation to decide which structure is best for you. An LLC generally offers the most flexibility, but profits are subject to self-employment tax (both sides of Medicare and Social Security taxes) if you also manage the company. If you anticipate reinvesting a significant amount of profits in the business, an S-corp provides the option of putting owners on a reasonable salary, so that profit isn’t subject to payroll taxes.
A C-corp functions as its own taxpayer. That means the owners don’t have to file tax returns in each state where the business operates, and the corporation may enjoy a lower tax rate. A C-corp, however, has the potential for double taxation when you do want to take out profits. Ask legal and tax experts which is best for your situation. “Don’t skimp on your organizing documents and don’t skimp on advice,” Levi says.
Another potentially thorny area is whether to allow the partners’ children to work in the business, which could have the unintended consequences of tilting the company’s center of gravity toward the partner with more kids. You don’t want to accidentally become a family business.
And don’t forget to discuss whether the business will offer a retirement plan. Although each partner may have different needs for sheltering income from tax, the business must treat both partners the same.
The Buck Stops Here
All the advance planning in the world won’t prevent conflict so decide early on how you will handle disagreements and avoid stalemates. Will one partner ultimately get the final say? “Many lawyers advise their clients never to enter a 50-50 partnership” because of a deadlock if the two partners disagree, Emory says. Nevertheless, “I’ve seen lots of 50-50 companies work very well.”
You might decide that one equal partner always breaks the tie, as Guidi and Mokarzel do. Or perhaps you divide up areas of expertise so that each person has the final say in their wheelhouse, with any major financial decisions made together.
In a service business, some partnerships are structured more like an office share, where expenses are shared equally but profits are divided based on the business each person brings in and manages. “If I’m billing 40 hours a week and you’re billing 20 hours a week, we’re going to contribute to the common expenses, but at the end of the day I don’t expect to support your lack of productivity,” Levi says.
Often, it helps to separate whether an idea is a good one from how resources will be allocated to make it happen. Parsons discovered this when his company’s operations and engineering leaders were split on whether to provide more automation for a possible new line of service. “It became clear that each was really concerned with the impact on their already fully committed teams,” he recalls. Once each leader acknowledged that the initiative would be good for the company, they could then address the division of labor. In the end, both divisions chipped in, and the company added resources to fill the gap.