Sunday, April 25, 2010

That's Not Fair! The Perils of Sharing Profits Equally

When you and your partners start your business, it may be tempting to say that you’ll just split everything equally- it’s easy, it’s fair and it just seems right. While the egalitarian approach might seem like your best course of action, it is ripe with problems that run deep, and could sink any business. Unless you’ve known your partners for many years and would trust them with your life, you may wish to proceed with caution when trusting them with your livelihood.

So what are the negative effects of splitting profits equally among the partners? (In this article I don’t use the textbook accounting definition of the word “profit.” Instead, I use it to mean all of the money that partners earn from the business. I also use the word “partner” in lieu of “member,” “shareholder,” “unit-holder” and other more technical terms.) Worst of all, this arrangement can breed apathy. Imagine a new business with three partners, each splitting profits equally. The simplicity of this arrangement is undermined by the way it has disconnected each partner’s earnings from their productivity. Two partners are pounding the pavement, working nights and giving their all to the business and the third is giving literally nothing to the business. That third partner will still share equally come distribution time. Is that what you envision for your business? As if this situation weren’t bad enough, as time goes on it will become more difficult for the two other partners to keep up their hard work. Eventually, the business starts to really suffer because nobody’s giving a hundred percent. Before you know it, it’s time to liquidate, dissolve and hope your personal liability isn’t too deep. Of course, nobody thinks this is going to happen- they wouldn’t go into business with someone they know to be lazy. But it happens more than you’d like to think, and you may only get one chance to prevent it from ruining your career dreams.

Even if you and your partners continue to work hard and you grow a successful business, an equal profit sharing arrangement could leave your most productive partner (you, of course) feeling slighted. Whether you’re working harder, understand the business better, bring in more clients or are just better at what you do, you’ve done more for your partners than they’ve done for you and you should have the right to be compensated for that. Unfortunately, you probably won’t be able to count on your partners to realize your superior contributions. People can be pretty touchy when money is involved (and especially so when you’re telling them that you deserve more of it than they do).

Lastly, though this happens much less frequently than the underachiever and overachiever problems described on the previous page, splitting profits equally leaves much more wiggle room for a dishonest partner to steal from the business. This is because the dishonest partner will be stealing from a bigger “pot” of money. Let’s hope this will never be an issue for you.

So what terms can a good lawyer put in your partnership agreement to better align partners’ payouts with the value they bring to the business?

If your business has established a consistent cash flow, one simple way is to pay each partner an hourly wage. This will ensure that nobody can fully reap the benefits of the business without actually working for the business. You could be more specific, setting different wages for different types of work and setting a minimum number of hours each partner must work and a maximum numbers of hours each partner can be paid for, and even set minimums and maximums for each type of work. Remember, as a partner sharing in the profits of the business, you are considered management and your work and payment are outside the scope of state and federal employment laws.

Even if your business has not established a steady cash flow, you could put in wage provisions that will kick in after certain time or revenue milestones, and can even include provisions for back pay.

If you run a service business in which each dollar of revenue can be attributed directly to work performed by a partner, it makes sense to tie each partner’s share of profit to the work they complete. In this situation, you have to be careful to fairly distribute the risk of a client’s non-payment among the partners. Otherwise you may be basing a portion of each partner’s compensation on luck alone.

I recently organized an LLC in which each partner was paid 70% of the time they bill, with the remaining payments going 20% to the business to pay expenses and 10% as a finder’s fee to the member or members who brought in the work (even if it was the same member who did the work). This is a rather extreme example, but it works well for a group who view their business primarily as a synergy of their own individual services.

If your business requires multiple partners to work collaboratively on project or product development and you are averse to paying yourselves a wage, you and your partners can implement a “scoring system.” This arrangement asks each partner to rate each other’s contributions at intervals throughout the project. The advantage, of course, is that everyone continues to have a reason to impress their partners with their work. However, careful planning will be necessary to prevent alliances from forming and funneling profits to certain partners.

There are many ways to structure your partnership’s profit sharing, with different levels of risk and reward. It’s important that you and your attorney think hard about what will work for your business and discuss it at length. There are many important decisions to make in your partnership agreement, but this provision will almost definitely be the most important.

Wayne Business Law is happy to help you and your partners figure out what works best for you.

This article first printed in the Winter 2010 Wayne Business Law Quarterly "Think of Everything, Act Accordingly."

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