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Thread: Splitting profit with investor?? Starting new business.

  1. #1

    Question Splitting profit with investor?? Starting new business.

    Hi there, I am wanting to draw up an agreement for an investor/partner for a new business.

    I have a great idea for a website which could be a complete flop or huge success. I met with an associate who is interested to come on board. They would be bringing with them their industry contacts and part of the capital, I am bringing 'the idea,' the rest of the capital and also the clients.

    Ongoing they will deal with the IT side and I will do the majority of the work from research, advertising through to maintenance once up and running.

    They want to do an 80/20 split. This means they will own 20% of the company- is this the only way? In an ideal world I would like to retain 100% ownership of the company and pay them a percentage of profit up to a certain value or for a certain period. This way they get a decent profit if the company is successful while I retain ownership and can sell or easily pay them out to that value if the relationship goes sour. Does anything like that exist? Or does anyone have any advice.

    Don't get me wrong, I do want them involved and I want to be fair. We are only investing $5000 each so it's not a big risk for them and I'm pretty sure they will agree to what terms I set.

    I also want to know how this is paid out? Obviously if we both take our share of the profits there will be nothing left for the company to grow on and to live on. This will not be either of our main income streams.

    Hope you can shed some light for me. Many thanks in advance.

  2. #2

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    In many ways, having 80% control is "purt near" equivalent to owning 100%, since you'd be calling the shots as the majority owner. Their 20% piece of the company would just be very similar in practical effect to their being 0%-ownership employees who are on a bonus plan that gives them 20% of the net. (...as long as the biz in running in the black. One obvious and potentially important difference is the extent to which they shoulder the burden for 20% of any losses. How this is handled is a function of the terms of their equity, as detailed in the partnership agreement.)

    That said, though, there might be a psychological advantage as well as a practical downside, at least potentially, to the 20%-ownership structure vis-a-vis the employee-with-20%-bonus plan. Some people simply are more motivated and charged up when they feel like the "own" a piece of the thing; that extra octane boost in your partner's tank might translate into bigger profits in your pocket (as well as theirs). But, for certain events that might come your way (e.g., merging your company into another), getting any minority owners out of the way beforehand, while doable, might involve some administrative and legal time and effort.

    Your ability to buy them out down the road could be accomplished via a simple buyout option. It's a provision in the partnership agreement that gives you the right to purchase their 20% piece from them, under terms and conditions specified in the agreement. The contract would typically provide that if you choose to exercise that option, the first step would be to value the company at such time. The method by which this pricing is calculated would be spelled out, as would the terms of the buyout payment(s) (e.g., quarterly installments for X years, at Y% interest on the outstanding balance).

    If the company's situation is such that you have to retain some/all of the profits in the business (typical of a growing company), the partners are simply credited (in their capital accounts) for their individual profit shares which were retained rather than paid out. Presumably these capital balances would be distributed to the partners later, when and as the company gets into a cash-surplus situation. "OK, our net profit last month was $1,000. But we had to use all of that buying a new server. So my share of the profit ($800) gets added to my capital account, and your $200 gets added to yours. We'll start out paying out those capital accounts when we reach that point where we're not having to buy new equipment so often."

    However you set it up, Beji, I hope it really takes off for ya. Best of luck!

  3. #3
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    Taking money out of a business early on is a no-no. If it were MY company (and it is not), I would issue a dividend at the end of the tax year, up to 50% net profits, split up 80%-20%. The remaining 50% (minimum) is plowed back into the business. This is to ensure that the business grows its operating capital through the year, and to ensure that you have a good picture of the profitability of the business before taking any money out.

  4. #4

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    Thanks so much guys, I am feeling better about it already!

    To clarify; would we put in the agreement that the profit we take annually would be calculated from only 50% of the total profit with the remainder staying in the company? Also as I will be doing many more hours, would we pay ourselves a wage for the hours we each work throughout the year? I realise that in the first year we wouldn't be paying ourselves anything but is that the best way to work it?

    With the buy-out situation, do we put in the agreement that they can only sell to me and at current market value?

    Thanks so much. :-)

  5. #5

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    Yep to all three.

    With respect to making profit distributions in the face of a cash-retention / plowback need (you're having to grow your balance sheet with new equipment, etc.), it's usually handled by making a distinction in the partnership agreement between profits and cash flow. The agreement will provide that profits (as determined by the accounting / bookkeeping process) are to be credited to the partners' respective capital accounts, in accordance with the profit-sharing percentages.

    In a separate section of the agreement, some term like net positive cash flow will be defined as the cash flow of the biz (cash revenues less cash expenses), and less a provision for equipment expenditures and other cash needs for feeding the growing enterprise. The agreement will state that this NPCF will be distributed to the partners in accordance with their percentages.

    Hence profits technically aren't distributed, they're credited to the partners' capital accounts. NPCF is what gets distributed, and so the company's cash retention needs are accommodated automatically.

    In the long run, profits and NPCF will converge to equality, but in any given period they'll likely differ. When you're growing and buying stuff, profits > NPCF, and so you'll be distributing less than all the profits. When your growth plateaus (and/or you're tapping outside debt capital), profits < NPCF, and the partners will be getting cash distributions that actually exceed their share of the profits for such time intervals. (That is, for such periods they'll be receiving not only their share of the current period's profit, but also a piece of their prior years' profits which couldn't be distributed at the time due to growth needs.) Long run, everybody gets cash which, cumulatively, equals their cumulative share of the profits. By crediting the capital accounts for the profit shares, and charging the capital accounts for the cash distributions as they occur, everything gets tracked properly and everybody ultimately gets exactly the cash they're entitled to, long run.

    If you are working more hours than your partner, and the partner isn't making up that difference in some way (e.g., contributing some special and critical talent, such that his labor is just as valuable as yours despite the hours disparity) then yes, this should be taken into account in the partnership agreement's profit split. You could, for example, agree that the first X dollars of accounting profit each month are credited to your capital accounts as Y dollars to you, and Z dollars to your partner (where X = Y + Z, and the Y and Z amounts represent "salary" amounts for your hours), and then all remaining profit over X are credited to the capital accounts according to the regular allocation percentages.

    And yep, you want the agreement to specify that should your partner desire to sell his interest, the sale must either be to you or to a third party meeting your approval. By itself, though, that would likely be unacceptable to Partner, as you could theoretically keep his investment locked in the company indefinitely by simply refusing to buy. More than likely he'll want it to read that he must offer his interest to you first; if you decline then after the passage of some specified time he's free to shop it elsewhere. As you can imagine, there are many variations and compromises between these two positions, and where you land will depend on negotiations. Finally, it's important to be clear in the agreement on the exact method by which the value of his interest is to be determined.

  6. #6

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    Thanks ArcSine, that's a lot to get my head around but the pieces are coming together now. Thank you so much for your help.

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