Signing a business or partnership agreement is usually a time for celebration. The alliance has been thoroughly discussed, you understand the value each party contributes, and you’re excited to have a new partner for your manufacturing company. But in the process of creating an exciting new venture, entrepreneurs often fail to examine the specifics of the agreement. The details in a business agreement don’t seem important, until they are.
It doesn’t matter — until it does.
Think of a business agreement like a prenuptial agreement in a marriage. When a promising business idea turns out to have a lot less promise, or one party just wants to move on, you’ll need both flexibility and formality to get a “business divorce.”
No time or money should be invested in the business before an agreement is finalized. To understand the economic and tax consequences of a legal agreement, make sure to review the document with your accountant as well as your attorney.
Consider the following what-if scenarios so you can avoid these 10 potential pitfalls.
- Vague Language — Imagine your widget manufacturing company enters into a partnership with someone who owns his own corporation, a distribution company. The agreement says that his corporation pays all expenses, and then allocates expenses “on a reasonable basis” to the partnership. That phrase may seem sufficient – until you see you’re being allocated his entire storage expense, bookkeeping costs and even costs for non-widget inventory. Is the agreement clear enough to resolve this dispute? Use an exhibit to list those expenses or other items to be allocated. Make sure to use specific language that won’t be left open to interpretation.
- Percentage of Ownership and Expected Contributions — Typically the amount that each partner contributes to the partnership at the start is used as the basis for ownership percentage, but there are other factors to consider. For example, one partner may have invested 70 percent of the cash but has no plans to work in the business, while another partner only invests 30 percent of the cash, but spends 60 hours a week, making sales calls, ordering supplies, supervising production, coordinating deliveries and otherwise running operations to make the widget manufacturing business a success. You need to determine how much time and capital each partner is expected to contribute and, accordingly, what percent of the company he or she will own. Time invested can often be subjective. You may want to consider identifying key performance indicators (KPIs) to be achieved based on the individual’s role and responsibilities. These may be based on sales, margin/profitability, prompt payment of receivables, inventory turns and more. Sales are always tricky, because the “rainmaker” usually feels that his or her contributions are worth more.
- Additional Partners — What if your partner wants to bring someone else into the business? Do you have the right to approve the new partner? What is the value of the shares he or she will own? Can shares be gifted, or must he or she invest? Whose shares are diluted in such a transaction? Your attorney can draft terms for expanding the partnership, but it’s best to have an accountant show you how a few scenarios would impact you economically.
- Distributions — What if, over years in business together, your partner takes more distributions from your manufacturing business? One year he needed a special distribution for college tuition, later he needed funds to settle his divorce. What are the annual tax implications for each of you? Will the excess distributions dilute one’s partnership or member’s interest? Your accountant can help you understand how distributions will affect your tax liability.
- Tax Implications of Business Structure — What are the tax implications when the business is dissolved? Depending on the type of entity chosen at the start, it might be taxed at regular rates or capital gains rates. Which do you prefer? Which does your business agreement dictate? Make sure you fully understand the differences between the various types of business structures so you can choose the right one for your manufacturing company and your accountant can advise on you tax planning accordingly.
- Valuing the Business — This is another area that can be controversial upon dissolution of the business. Include valuation methodologies in the agreement so it’s more objective than subjective. You don’t want to have dueling experts on dissolution. You may want to incorporate a penalty for the party who initiates the dissolution. And if there has to be an appraisal of the business who pays? Who pays for the legal fees?
- Selling the Business — What if your partner wants to sell and you don’t? Does your agreement give you the right of first refusal? What if he dies? Does the agreement include your right to buy out his estate, or must you stay in business with his heirs? You need a buy-sell agreement to establish a method to value to partnership interest and the interest purchased by the partnership or individual partners.
- Dispute Resolution — If you and your partners become deadlocked on a big business decision, such as whether to outsource or insource production, how will you move forward? If there are two partners who each own 50 percent of the company, a major dispute could potentially lead to end of the business. Heading to court is costly, both in terms of time and money. To avoid a crippling impasse, include a mediation clause in your agreement that outlines a procedure for resolving major conflicts.
- Joint Authority — Any individual partner can usually bind the business to a contract or other business deal without consent from the other partners. For example, if your partner signs a contract with a supplier to buy materials at a price your business can't afford, you can be held responsible for the money owed under the contract. Such a liability could be a risk to the financial stability of the business as well as to the individual partners, who are each personally liable for all business debts and obligations. It’s important to clarify any limits that you want to place on each other’s authority and what type of consent a partner needs to obtain before he or she can enter into a business deal and obligate your company.
- Allocation of Profits and Losses — Will profits and losses be allocated in proportion to a partner’s ownership interest in the company? Generally, this is the way it is handled, unless otherwise specified in the business agreement. The IRS considers partnerships to be “pass-through” tax entities, which means the business is not separate from its owners for tax purposes. All of the profits and losses of the partnership "pass through" the business to the partners, who pay taxes on their share of the profits (or deduct their share of the losses) on their individual income tax returns. Therefore it’s important to clarify each partner’s share of profits and losses in the written agreement.
Get the right advice up front.
Don’t just sign a standard business agreement with your buddy and think you’ve got a solid deal. Enlist both legal and accounting professionals to help make sure it’s the right deal for all parties involved. A well-constructed agreement means fewer surprises, less conflict and less expense, so you can get your manufacturing company off to a great start.
Robert A. Stone, CPA, ABV, CFF, is a senior client services principal in the Miami office of Kaufman, Rossin & Co., one of the top CPA firms in the country. He can be reached at firstname.lastname@example.org.