When to Make an Employee a Business Partnerby
Question: My apprentice of four years has proved to be a valuable asset and I like working with her, as we have the same business ethics. Should I make her a partner in my business? Would it be more reasonable to offer 20 percent of the profits this year and let her buy into the business the following year? —K.A., Marietta, Ga.
Answer: There are a number of ways to structure a partnership agreement, but first let’s think about why you would add this employee as a partner in your business rather than finding another way to reward her, like giving her stock options or establishing a profit-sharing arrangement.
Partners are typically added because they bring much-needed capital, outside connections, or new clients to a company, advantages that an apprentice may not be able to contribute. They might have strategic business experience or skills that complement the existing management team, or be positioned to someday buy the company if its owners are planning for retirement.
A full partner will get a say in your company’s future and strategy. Also, a partnership is more difficult to untangle legally than an employee relationship if things don’t work out, says John Gerber, a Philadelphia business attorney and owner of Ready.Set.Legal, a legal services site for entrepreneurs. “A partner may have the right not to be removed or to require an appraisal and buyout of her interest,” he says. “The paperwork for putting the employment relationship in place is much simpler, and therefore faster and cheaper” than adding a partner.
If you’re absolutely certain you want to take on a business partner—and this employee is the best person to fill that role—you should get a legal partnership drawn up. That may involve getting a professional valuation of your company, which can be costly, says Jennifer Reuting, founder and chief executive officer of DocRun, a Santa Monica (Calif.)-based provider of legal documents for small businesses. It may also require your partner to come up with cash to purchase equity, which could be a financial hardship for her.
If you want to give her an incentive to continue working with you without making her a full partner immediately, you could start with a profit-sharing arrangement, Reuting suggests. “The benefit is that no actual equity in the business is being given away. You can structure it so that, when the employee leaves, they no longer receive a share in the company profits,” she says.
Such an arrangement would give your employee a percentage-based share of the net profit, on an operating basis and in the event the company is sold. Her profits bonus would be taxed as ordinary income rather than as a capital gain, Gerber says. The drawbacks are that your employee will not get the same sense of ownership as if she bought equity in your business, and a chunk of your profits will be diverted rather than being reinvested in your company’s growth.
Another possibility is granting company stock to your employee outright or giving her stock options that vest over time, so she has an incentive to stay on. “Stock options are commonly used for large corporations; however, they can be equally useful for small businesses as a way to compensate their employees,” Reuting says. Talk to your attorney about all of these options, and their implications for your company, before you make a decision about the best way to reward your valuable employee.