Bringing In Your First Partner

A reader e-mailed me the following situation: "I'm about to give away 45 percent of my business in order to bring on an experienced business person who hopefully will take my (very) small online business to a higher level. Since he already has a successful strategic marketing/advertising/public relations firm billing several million dollars a year, he will be a valuable asset. I have been in business for three years and have invested $150,000 which has to be paid back in five years. This new partner is bringing experience and knowledge . . . no cash."

Here are the reader's questions, and my best responses:

If the business fails, should he be responsible for the debts I've incurred prior to his becoming a partner? This will depend on how your business is organized legally (i.e. as a corporation, partnership or limited liability company) because the rules are somewhat different for each. Assuming that your business is a sole proprietorship and will become a partnership once he signs on, he should not be liable (in most states) for the debts you have assumed prior to his becoming a partner. That doesn't mean, of course, that disgruntled creditors won't try to attach his assets in a legal proceeding and make you prove in court that the debt was incurred prior to his becoming a partner. Make sure you have a written agreement with your new partner that specifies the exact date on which he became a partner (make this the first day of a fiscal quarter, such as October 1--it will make things a lot easier come tax-time).

If the business succeeds, I assume he is responsible for just under one-half of the debt. Not true. Partners are "jointly and severally liable" for all debts incurred by the partnership. So if the partnership defaults on any of its debt, the creditor can go after either partner or both partners. In this case, since your partner is a "deep pocket," it's highly likely that a creditor will sue him for the entire debt owed. When preparing your partnership agreement, be sure to include an "indemnity" clause saying that if a partner is sued for more than his or her percentage share of a partnership debt, the other partner will reimburse him or her for any liability in excess of the correct percentage. So, in your example, if your 45-percent partner is forced to cough up 100 percent of a partnership debt, you would agree to reimburse him 55 percent of the judgment amount.

Since he is doing this under his name and not under the name of his business, how should it be set up if his business gets business from this new partnership? You should treat his business as you would any other supplier or customer--at arm's length, with a clear written agreement as to exactly what his business will do for your partnership and what his business will receive in return. Since your new partner is an "interested party," this agreement should be signed by you (or the two of you together), not by him alone. If he says "Oh, I was intending to use my 45 percent of partnership profits to reimburse my business for these expenses," point out to him that by doing so the partnership will not be able to deduct the payments--they will be treated as a "distribution" or dividend to him, which is not tax deductible.

Even though we're not merging our two businesses, he's planning to use his 12-person staff to do most of the work (such as programming and marketing). How will this work out tax-wise? Under no circumstances should any of his employees be treated as employees or independent contractors of your new partnership--your partner (or his business) should be 100 percent responsible for paying these people. If the agreement between your partnership and his business is properly drafted (see above), your partnership will be able to deduct any amounts paid to his business for services rendered.

What concerns should I have, since I am the one who founded the business and invested so much time and money? Your biggest concern is that your new partner turns out to be a bozo who doesn't deliver what he or she promises. Once someone becomes your business partner, there is only one way (legally) to get rid of them--you must buy out their partnership interest, at whatever price the two of you are willing to agree upon. In this case, we're probably talking about 45 percent of the business's average pretax earnings for the two or three years preceding the breakup. That's a lot of money for someone who did nothing to earn it.

Since you don't seem to know this person very well, I would recommend not giving him 45 percent of your business up front. Why not give him 15 percent instead, with a promise to give him an additional 15 percent next year and the year after that, if (and only if) the business achieves specific levels of operating revenue or pretax earnings? This is called an "earnout," and it gives your new partner an incentive to knock his socks off helping you build your business. At the same time, it gives you the chance to see if this person is really what you think he is, as well as the option to renegotiate the deal if someone better comes along with whom you'd rather do business.

One more thing: Few things are more stressful to a business owner than disputes with business partners. While no one enjoys "working out the terms of the divorce before the marriage has taken place," there's absolutely no substitute for a clear, written partnership agreement that states clearly who is entitled to what if the partnership doesn't work out. A qualified attorney can draft such an agreement for less than $1,000 in legal fees (unless your agreement gets really complicated). It's money well spent, and will save you many sleepless nights.

Cliff Ennico is host of the PBS television series MoneyHunt and a leading expert on managing growing companies. His advice for small businesses regularly appears on the "Protecting Your Business" channel on the Small Business Television Network at www.sbtv.com. E-mail him at cennico@legalcareer.com.