It happens every day: friends go into business with one another, and invariably, one friend has more (if not all) startup capital than the other. In such a situation, equity is often distributed based on capital contribution and services performed. Unfortunately, the partnership agreement, operating agreement, bylaws or other operational documents rarely address what happens when a “services” partner fails to perform his or her services or performs these services at a level that is unsatisfactory to the other partners. Lack of funding or one partner feeling the financial burden more than others can put a strain on the business relationship if not properly structured at the inception of the business. Partners are bound to disagree at some point or another, which can lead to stressful posturing and expensive litigation.
The best way to avoid the unwanted partnership dispute is to plan properly on the front end in your organizational documents, before any money flows in or out of the company. Equity for services performed and raising money can be hot button issues for fledgling partnerships, so here are a few pointers to keep in mind:
Business relationships can go sour quickly if one or more partners are not performing as they should. Delegation of equity to service partners should be done in phases, meaning a certain portion of the service partners’ equity vests in quarterly or annual increments pursuant to the “vesting schedule,” set to expire after passage of a certain amount of time, usually 3 to 5 years.
The company should have the right to terminate the services arrangement prior to the expiration of the vesting schedule in the event the services are not being performed. This termination ideally should trigger a “buyout clause,” meaning the remaining partners are able to elect to buy out the service partners’ vested equity (to avoid having a “salty partner” lingering around). The equity which has not vested will be either redistributed or set aside to raise additional capital if needed. Which leads us to our next point.
Seeking Additional Capital
When corporations are first formed, it’s very difficult to predict how much capital will be needed – and, as with most things, anticipate going over budget. Be conservative when estimating your incoming revenue, be prepared to lose money, and have a plan for seeking additional capital in the event you need it.
The favored form of corporation is no doubt the LLC, but this entity can prove to be tricky when additional capital is needed. True corporations (think board of directors, shareholders, outstanding/treasury/issued stock) are able to sell stock to raise money. This is a distinct difference from an LLC, which presumes that all the equity is distributed at all times. For example, if you have an LLC and have three partners (or “members”) and the company wishes for each member to have 25%, one often makes the mistake in assuming the remaining 25% is unowned and is available for sale. Not true. The 25% would technically be distributed pro rata amongst all existing members, who then may each decide to sell 25% of the equity to a new member to raise money, and subsequently each member’s equity would be reduced pro rata or diluted. To avoid this complication or misunderstanding, the operating agreement should be very clear on issues surrounding capital raises, particularly in an LLC. Almost inevitably, one member will kick in money for the operation of the business while others are unable to. Does this entitle that member to additional equity? Is it a loan? If so, is the loan entitled to a priority payback? How does this effect voting rights?
These are common situations with endless creative solutions, which often need to be tailored to suit your business. So, time for the shameless “consult your attorney” plug. Spending a little money on the front end can save you a boatload on the back end… and please, avoid “legal template” websites if you can! No matter how simple your business, there is always some essence of a “needs analysis” that should be conducted, and your operational documents should always be custom tailored (and updated and amended) to suit your needs.