Two entrepreneurs review their business partnership agreement to ensure they're protecting the business.

August 05, 2019

How to Structure a Business Partnership

No matter how successful they may be on their own, many entrepreneurs eventually reach the point where they decide to add a partner.

Perhaps they want to bring in additional investment, offer a piece of the company to a would-be successor, or find a leader who possesses skills or strengths the business needs to stay competitive.

Whatever the scenario, choosing a partner and structuring your business relationship with that person requires serious thought, homework and care.

What to Evaluate in a Strategic Partner

Before you start the search for potential partners, you'll need to evaluate yourself, your company and your needs.

"Know yourself. This is a step that a lot of people skip," said Alicia Goodrow, Houston-based partner in the virtual business law firm Culhane Meadows. "Know your strengths and weaknesses in terms of working with partners."

Everyone has different management and leadership styles and openness to learning and working with a team, she said, noting that many entrepreneurs in closely-held businesses make all crucial decisions themselves and are not accountable to anyone else. It's likely to require major change management for that kind of leader to take on a partner with whom they must share accountability and decision-making.

Almost all of Goodrow's successful clients work with business coaches to help them get the "10,000-foot view" of themselves and their companies, she said. Consulting with a coach can help you discern the type of partner you can best work with.

Once you've figured out what you need in a partner, only then should you begin evaluating prospects. It's vital that you thoroughly vet potential partners for their business and personal histories.

“Vetting a partner is a process much like dating and getting engaged," said Goodrow. She recommends running credit, criminal, tax and Better Business Bureau checks on your potential partner, and exploring the status of all businesses they've owned or served in as officers.

“Today it's easy to run these kinds of checks and you have to do it because your customers might do it," said Goodrow, noting how easily a Google search can turn up troubling information. “This is all public information and a lawyer can help you do this," she said.

While successful business owners often have at least one failed venture in their past, Goodrow noted, you'd want to identify those failures and understand why they happened — something that a dishonest player might cover up.

Natasha Davis, City National Bank senior wealth planner, noted that it's important to learn about any personal history a potential partner has that could pose a risk for your company. If your intended partner has a history of driving under the influence of alcohol, for example, “that's a liability that you are potentially taking on," she said. "Depending on their involvement and responsibilities, this is an important piece of information to know."

Even someone who's only investing in your company and taking a seat on the board, rather than actively managing your business, can easily elevate or damage your reputation, said Goodrow.

"There are successful entrepreneurs who I would not invest in and would not accept their money," she said.

It's also important to evaluate how a potential partner will mesh with you ⁠— and your senior managers ⁠— on a personal level. Even highly talented, hard-working, honest people may be a poor fit in terms of their soft skills.

Goodrow recalled a successful firm whose owner was grooming two key employees to take over the business. The chosen successors had "radically different personalities and risk tolerance and didn't like each other," she said.

After the owner got severely ill and then became incapacitated, the two successors wound up suing each other, the owner and the owner's spouse, eventually bankrupting the company.

“Always know yourself and know your partners. The owner didn't know these prospective partners very well. They had worked for him for a very long time but he had never taken a step back to think about how they would function as a team, as a partnership," Goodrow cautioned.

Clarify the Business Partnership Terms

Once you've selected a partner, it's important to define roles and responsibilities and work ethic, so that you have a shared set of expectations of your partner and vice versa, Davis said.

This can help avoid conflicts over day-to-day activities and visions for the company's long-term direction, especially if your new partner will actively work in the business.

Even work schedules warrant discussion, so you and your team aren't put off by a new partner who operates on a different timetable. Some people accomplish more in less time or have different responsibilities outside work, necessitating a different schedule, Davis noted.

It's best to start with a basic agreement on roles, responsibilities and control, and then plan to hash out other issues as they arise over time, she said.

If you're adding a partner because he or she offers something you lack, make that clear. Spell out your long-term goals as well, to make sure you're on the same page. You don't want to run into a situation where you're planning to retire in four years while your partner is expecting to join you long-term in building an empire.

“That expectation is probably going to conflict, so it's important to define goals for the business as well for you as personally, so you know when the other party is going to be getting out as well as how long they are expecting to stay," said Davis.

She outlined several points to consider and define when bringing in a partner:

  • Set a timeline for short- and long-term goals, including plans for passing control down the road.
  • Draw up a non-compete clause with any new partners so you avoid the fate of one business owner whose partners — his brother and a friend — poached customers when they left the company.
  • Determine whether the partner will be an investor only or play an active part in the business. Is the person really a new partner or a "mentee"? Make sure the partner understands your position on his or her status before formalizing any arrangements.
  • Clarify how the new partner's investment will occur. Will it be a one-time capital contribution, or will the partner acquire an interest over time?
  • If the partner is buying-in over a period of time, how will distributions occur? Will the partner receive shares, a salary or both?
  • Make sure that you have a contingency plan. If the partnership doesn't work out, will you have right of first refusal for a buyback?
  • Consider carving out real estate assets, intellectual property or other assets you may not want to share so they don't become part of the sale or partnership.
  • Purchase "key man insurance" to fund the buy-sell agreement in case of a partner's death.

Goodrow cited these additional decisions partners may need to make:

An investor-partner may want a seat on the board and veto rights over major decisions, such as bringing in new investors, buying capital equipment, merging or changing the business's purpose. He or she may ask to be involved in higher level long-range planning and budgets, and could seek minority-interest protections.

Partners brought in for technical expertise or sales brilliance, rather than financial contributions, may not expect to have that same seat at the table, but they may want a say on the company's strategic decisions involving their discipline, said Goodrow.

Bringing on a successor as a partner often takes place in stages, usually starting at least five years before the actual sale. In many cases, putting a bonus plan in place is the first step, shifting the partner's compensation to align economically with the business's success, she said. An owner may opt to allow a manager to buy a small piece of equity or provide equity as part of the manager's compensation over time.

Protect Yourself and the Partnership

Finally, it's absolutely crucial to put all agreements you reach with your new partner in writing.

"Too many times, companies rely on handshakes and promises when it comes to business partnerships and future planning. This will leave too many opportunities for things to fall apart. You may have been working together for the last 15 years and be best friends on the weekends, but business is business, and you should all treat it that way," Jason Burt, owner of Michigan-based business consulting firm Evolve Holdings.

Once you and your partner decide on the details of your arrangement, you need to formalize it either through a shareholder or partnership agreement or by forming an LLC or other corporate entity.

Davis advises that a sole proprietor bringing in a partner hire an attorney to draft documents for an LLC to provide liability protection and spell out what happens in case of a partner's death, divorce, dispute or disability. This will help protect against any potential events that could damage the partnership and the business.

Bringing on a partner can strengthen your business's financial footing, skill-sets or transition plan, but it's important to be diligent in the up-front work to make sure you've identified the right person and structured the business partnership properly so you can protect your business.

It's important to consult with professionals to evaluate your situation when selecting a strategic partner and structuring the relationship. City National Bank's wealth planners can help you weigh your options. To learn more, contact us.

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This article is for general information and education only. It is provided as a courtesy to the clients and friends of City National Bank (City National). City National does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors or persons quoted as of the date of the article with no obligation to update or notify of inaccuracy or change. This article may not be reproduced, distributed or further published by any person without the written consent of City National. Please cite source when quoting.

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