This is the second part of a two-part series on being ready for partnership. The first part looked at whether the principal is ready, and this part looks at whether the other party is.
The Thing About Partnerships
I view exploring a partnership as seeing a truck rolling toward you. Throw obstacles under the tires, and if the truck keeps moving after rolling over all of them, it’s maybe meant to be. I don’t mean that to be negative, at all, though. I think a strong partnership is a wonderful thing.
But partnerships are not as wonderful as the would-be partner might think, and there needs to be some careful evaluation. At the beginning of the exploration, the would-be partner is looking mainly at the pros, throwing the cons behind his back as he moves forward (that’s what the illustration is meant to depict). So a legitimate partnership discussion needs to bring both the pros and the cons into view so that everyone can make an informed decision.
When a would-be partner hears the downsides of partnership, they might want to keep moving forward, which is fantastic, because then you have a fully informed participant who still wants to do it. But if, after hearing the downsides, they start second guessing themselves about what they thought they wanted, we have the opportunity—as advisors—to redirect our efforts to a less involved…but still motivating…arrangement that everyone will be happier with.
Eight Downsides of Partnership
These are the harsh realities of being an equity partner, and it’s important that every would-be partner understands the risks and challenges:
- An equity shareholder will likely have a stronger, more enforceable non-compete than a key employee will. Under current law, a key employee can usually leave and start a competing firm across the hall, but owners have other fiduciary responsibilities that are more easily enforced.
- An equity shareholder’s non-participating spouse, or common-law partner, will need to be a party to an agreement. None of the existing partners will want an uninvolved shareholder with an antagonistic relationship with the firm, and so this eventuality will need to be addressed. This is the most common “call” on the ownership agreement and/or bylaws, too. So when a partner’s personal relationship goes bad, it will need to trigger two things: a price for those shares, and the terms under which they will be purchased over time (e.g., equal payments over five years at a specific interest rate). You may think this won’t apply, but you’d be wrong. Imagine a married employee who becomes a 30% partner. A year later they get a divorce, and that partner’s former spouse now owns 15% of your firm, and they almost always have an adversarial relationship with the other partners and the firm itself. This will always be true unless the uninvolved spouse is a party to the partnership agreement or has signed a prenuptial agreement that addresses this. The reason this is on the list of “cons” is because some partners can’t bring themselves to have this discussion and work out the agreement.
- An equity shareholder’s compensation will drop when the firm faces economic uncertainty, even when employee salaries are fully funded to retain their services during that difficult time.
- An equity shareholder might receive a “capital call,” requiring them to infuse an amount of capital that is proportional to their ownership position.
- An equity shareholder’s personal credit will be revealed…and could become an issue…when negotiating loan or lease agreements. A credit check will almost always be required at some point. Is the new partner comfortable with what that will reveal?
- Where required by a financial institution, a personal guarantee from all equity shareholders will be required, making them “jointly and severally” liable. That means that the bank can go after all personal assets until the loan is satisfied. Everybody is on the hook for everything, and not just whatever portion of the partnership they own.
- Bankruptcy can erase obligations, but two things are impervious to bankruptcy filings: student loans and taxes. When a company defaults on its taxes, or maybe a key employee doesn’t remit withheld taxes, or in the worst case scenario doesn’t pay them at all, the shareholders can be held responsible, even when they had no knowledge or involvement in the issue. Partners can indeed become responsible parties for any tax issues.
- Usually, the new equity shareholder must purchase equity, and that money will come from personal savings, home equity, a loan from a commercial entity, or friends and family. Or failing an actual buy in, a reversal (when the company buys it back) can be conducted with the same discount. The point is that equity ownership usually requires funds, and that point alone can make a transaction difficult.
Some would be partners are aware of all these things and are excited to continue. Others wonder if there’s a simpler, less risky way of achieving the end goal, and we will usually recommend one or two other alternatives, alone or together.
If you need help assembling a partnership, untangling one, or finding alternative methods to reward key employees, reach out and let us help.