Five Ways to Keep from Screwing Up When Forming a Partnership

I get asked about this a lot. So, I thought I’d write down my answer.

I’m never going to be able to give all the details of starting a partnership in a single post, or even 100 of them, so I’ll have to keep it to an overview. Let me know your personal situation and I can give you more targeted advice.

1. Partner for the Right Reasons

Often I hear that two friends have decided to start a business together. Why? They’re friends! What a great thing to do together! Not a good reason. Partnership is about doing work and making tough decisions. Partners need to be able to have difficult conversations, even argue over things from time to time. It better be a strong friendship. If that’s the only reason, then avoid it.

Ask yourself why you even need a partner. The only good reasons are:

  1. You don’t have enough money to do the deal otherwise.
  2. You don’t have the time to do some necessary work in the business.
  3. You don’t have the expertise and can’t learn for some reason.

If none of these apply, then you shouldn’t partner.

2. Decide Who Does What Work

There are three types of partners – equity partners, labor partners, and experience partners. Equity partners are the people with the money. They typically don’t do much work, but they serve an important role – bringing the funding. They also might personally guarantee a loan, which is a big risk for them, and often they are compensated with equity in the deal. What I call labor partners are those who are willing to do work in exchange for equity. These guys will do things like manage the property or perform rehab. A property manager or general contractor might be someone who fits this bill.

An experience partner is someone who has done this multiple times before and can teach the others how to do it. This person might also have clout in the particular field and be able to open doors that otherwise are closed to the other partners.

Once you have decided, write it down! Ideally, this is going to be put in the operating agreement. But that’s not enough. Also write down what happens if a person fails to do their role and what measure decides whether they have failed. It’s a pain to do this, but it’s a bigger pain if things aren’t happening and the business starts to fail.

3. Decide Equity Amounts

Generally, the percentage stake in the company is the equity. Each partner will usually have a greater than zero percentage equity. Usually, this percentage is the percentage of vote that person gets when deciding important matters. Look at a hypothetical company with three partners each having 33 1/3 % equity. It’ll take two votes of ‘yes’ to pass, hence two partners will have to agree to make something happen.

What you don’t want is to ever have a situation where something gets 50% of the vote. To avoid this, no 1 or more partners’ equity can ever add up to 50%. That causes deadlock, and often needs to get resolved expensively, in a courtroom.

In a two-person deal, one should be 51% and the other 49%. There are other ways to do this, but this is the most simple. In a four person deal, each should not be 25% or you have the risk of deadlock again. If you must do this, then put in the operating agreement a way to break any deadlock.

There might be things that you want to be unanimous, such as selling substantially all property of the company. If that is so, it will need to be written into the operating agreement. For that, see the next paragraph.

4. Get an Attorney

This is often skipped. I’ll be the first to tell you that attorneys are expensive. But, they are valuable, and a good one is worth it. Don’t just get any attorney with a billboard. Do your research and find one with experience. Interview some of their clients.

The attorney has hopefully done this before and will know the right questions to ask to get you to put the things down on paper to protect you and your new business.

5. Decide Upfront How to End the Partnership

Hopefully you’ll make millions on your business deal. That’s great for you, but what happens with those billions tied up in a property and a couple partners don’t want to sell? For those that do, their equity is worth zero. When writing the operating agreement, decide now how people can get out of the deal. That might be a buyout clause or could be a sale or refinance at a certain range of times (which allows for market fluctuation).

I know this part seems tough. You just want to get started right now and worry about the details later. Trust me – take the time and do these steps. They will protect you later.

Dr. Equity