Let's Make a Deal
Four years after John Mautner started Nutty Bavarian, a Sanford (Fla.) seller of glazed nuts, he wanted to expand from 20 stores to 200. Mautner didn't have the cash to get there on his own, so in 1993 he sold a 50% stake for about $1 million. His new partner got an equal say in running the company. That, Mautner soon realized, was a terrible mistake. "With a 50-50 partnership, no one could make a call," he says. "We had conflict after conflict." After three years of locking horns on everything from strategy to store locations, he sold his half of the company to his partner.
Mautner has gone on to launch four other companies, and although he has brought in partners to help run them, he now insists on retaining majority ownership. Mautner's partner in his latest venture, Cycle of Success Institute, a $9 million, 10-employee Chicago company that offers online courses on small business growth, has a 25% stake. "I've talked to many people who are interested in investing in us," Mautner says. "But they want to take control. I refuse to do it."
Bringing a partner into your business can transform it, providing a much-needed cash infusion or connections leading to a huge boost in sales. A partner can share expenses or provide complementary skills to help you develop the company. And sometimes, giving valued employees an ownership stake is the only way to hold on to them.
But tread lightly. "Ownership is a precious commodity to be shared carefully," says David Doggett, an attorney with Strasburger & Price in San Antonio. Combining forces with the wrong person, as Mautner can attest, can be a nightmare. And although finding the right person, one who shares your goals for the business and with whom you get along personally, is crucial, it is only Step One. Even the most compatible partners can face trouble if the partnership itself is not set up right.
Before you turn over a single share, determine exactly how much control you are willing to give up and what corporate structure is best suited to your needs. Then map out how much voting power each person should have, how long it will take for the partner to achieve full ownership, and how profits will be divided. You'll also have to consider what will happen when the partnership ends, as it's far better to hammer out tricky issues when things are rosy, rather than when you're at each other's throats. And don't even think of closing the deal with a handshake. Everything you've hashed out needs to be nailed down, in nitty-gritty detail, in a buy-sell and ownership agreement before anyone moves into the office next door. "Small company owners are often so focused on running their operations that they overlook the importance of defining the details of their business relationships," says Mary O'Brien, a partner with Meagher & Geer, a law firm in Minneapolis. "That's a mistake."
EASY DOES IT
So you've found someone who is excited about your company and wants in. That's great, but don't let enthusiasm or dollar signs blind you. Instead, step back and determine if you are comfortable with the amount of the investment and what the investor expects in return. "A lot of times, that's determined by who's bringing what to the table," says Andrew Sherman, a partner at law firm Dickstein Shapiro in Washington. Anyone putting a lot of cash in your business will generally expect a good-sized chunk of equity, as well as decision-making authority. The most straightforward arrangement is to base the stake on the valuation of the company and what share of the company the investment represents.
Then there's your comfort level. That might rest on a range of issues, the most important of which will be how desperate you or your would-be investor is to make a deal. "If it's nice to have, that's one thing," says Chet Hosch, a partner with the Atlanta law firm Schreeder, Wheeler & Flint. "If it's a matter of survival, that's another." The comfort level of any existing partners matters, too. The first or second partner might well ask for as much as 50% or 33% of your company, while the 20th will necessarily get much less.
You might also want to give a large share to someone who invests little money—or nothing—but will be a rainmaker. Another option is to give a sizable amount of equity to someone who has other expertise that will benefit the business. That was the motivation behind Tommy Joyner and Jamie Lokoff's decision to offer their landlord and friend Paul Lichtman half of MilkBoy Coffee, a 25-person Ardmore (Pa.) company that has two coffee shops that feature live entertainment. Lichtman, 70, spent 40 years running an insurance firm. Joyner 36, and Lokoff, 41, had previously run a recording studio. They figured Lichtman could provide business savvy they lacked. The trio recapitalized the company, with Lichtman contributing 78% of the money and Joyner and Lokoff splitting the rest. Lichtman got 50%, and Joyner and Lokoff got 50%. For certain financial matters, such as major purchases or inventory decisions, Lichtman has the final authority. For all others, he has a one-third say. So far, all decisions have been made equally. "We want to maintain a spirit of partnership," says Joyner. "If anybody isn't comfortable with something, we sit down and have a conversation about it." Recently, to cut costs, one partner suggested that the cafés stop serving dinner. The others eventually agreed, but it took a few meetings before they were convinced. They've since opted to start meal service up again on weekends.
Granting a partner fully half of your company can be risky, however. It can lead to gridlock and power struggles, as it did for Mautner. Still, plenty of company owners take this more egalitarian approach. Sandy Abalos recently brought in a third partner for Abalos & Associates, her 16-employee, $2 million Phoenix accounting firm. Abalos still owns the biggest share of the company she bought 15 years ago, but all three partners have equal voting rights. "You need collaboration among partners," says Abalos. "If one starts pulling rank, it's doomed to die. That's a dictatorship, not a partnership." Alicia Rockmore and Sarah Welch, who started Ann Arbor (Mich.)-based Buttoned Up, a company that makes products to help women get organized, have another twist on the formula. Rockmore's two sisters invested about $70,000 in the company. All four women have equal voting rights and hold weekly conference calls to discuss what's going on and any strategic issues, such as how to allocate resources and whether or not to move operations to China. But daily operating decisions are made by Rockmore and Welch, who write up a monthly summary in an effort to keep the other partners informed.
The next question is timing. You can allow for a gradual transfer of ownership to a partner or make the transition all at once. Cycle of Success' Mautner brought in Keith Kalbfleisch with the intention of making him a partner, but he wanted to make sure his recruit was working out before giving him an ownership stake. Mautner gradually increased Kalbfleisch's holding over a period of about four years until it reached 25%. Like many small business owners, Mautner tied the award of ownership to benchmarks such as a certain high level of customer satisfaction.
Your partners didn't invest in your company simply because they liked you or your idea. They expect a return on their investment. You can divide profits according to the size of each partner's stake, but that's just one option. Formulas for profit-sharing are highly varied, especially for professional services firms and other companies in which every partner is responsible for bringing in business. Jerry Mills, chief executive of B2BCFO, a $10 million company that provides temporary CFOs, has more than 50 partners, all of whom work as temporary CFOs—up from 6 in 2002. To distribute annual profits, Mills awards partners points based on how much revenue each person brought in that year. Other firms devise complex formulas that consider salaries, length of tenure, and other factors. Says Sherman: "It can get very granular and intricate."
Companies set up as limited liability corporations (LLCs) may have the greatest flexibility in parceling out profits. Unlike S or C Corporations, LLCs allow you to change your profit-sharing formula each year. Abalos, for example, gives all partners a guaranteed annual payment, and excess profits are shared according to the individual's book of business that year.
You may also want to make someone a partner who has not put any money into your company, perhaps someone who excels in areas in which you're weak. Mautner, for example, felt Kalbfleisch's detail-oriented approach would complement his own big-picture style. Other would-be partners might have industry contacts you lack or relationships with potential investors.
Another approach is to reward particularly valuable employees with ownership or to give shares as part of a succession plan. Deborah Johnson, founder of Taylor Johnson Associates, a $2.5 million, 15-employee public-relations firm in Chicago, started giving shares to her daughter three years after she began working in the company. Last year, her daughter became a one-third owner. Recently, as the 58-year-old began thinking she would like to retire in about five years, she decided to start giving another longtime employee one-third of the company. That employee will buy his shares over the next five years, even though he'll begin receiving one-third of the company's profits immediately.
If you're not sure you're ready to give up equity, you might be able to take an interim step. "Make sure there's not another alternative before going all the way," says Doggett. One option is phantom stock ownership, in which an employee receives a percentage of profits, based on the value of a certain number of shares, without actually owning any of the company.
KEEP EXITS CLEAR
No matter what stage in the life of your business you take on a partner, don't draft any agreement without thinking about what will happen if the partnership sours. That could lead to an unpleasant battle if you split up when your interests have started to diverge. "Discussing these issues early, while you're still getting along, is the better approach," says O'Brien.
Valuing the business, should the partnership end, is often one of the most contentious issues. In some cases, owners come up with a specific formula. In others, they agree to hire a third-party appraiser. You could even have an appraisal done annually, whether or not someone is leaving. A third way is to use a so-called agreed value—the value the partners themselves put on the company—to be updated annually. Appraisals are probably the most common route, says Hosch, "maybe for their impartiality, maybe due to laziness." The problem is that they're also costly, and the appraiser may have little experience in your particular industry. Using a formula is cheaper, but you have to take the time to make sure you get a formula that goes beyond a snapshot of the company and reflects long-term trends. As for the agreed-value approach, it can wind up causing problems if partners end up differing about the value down the line.
In addition, you'll need to make provisions so existing partners can't get stuck with a colleague they don't want. The last thing you need is for the departing partner to sell shares to someone the remaining owners don't like. That means giving them the right of first refusal.
You'll also want to protect yourself so that, in the case of a partner's unexpected death or disability, their family members can't inherit the shares, step in, and take over without your consent. Finally, think about just how money will be paid to the departing partner and whether you want to give it as a lump sum, which might hurt cash flow, or in payments over, say, three to five years. Remember: Setting up a partnership correctly is as much about the end of the relationship as it is about the beginning.
By Anne Field