17 Dec Partnership Agreements: Financial Matters
Over the past several posts I’ve talked about some of the large scale things partners need to discuss before going into a partnership arrangement. We talked about things such as communication skills, exit strategies, who is bringing what to the partnership in terms of money, skill, or assets. The last couple of issues that need to be addressed before you go into business with somebody is Financial Matters.
Division of Labor
Division of labor sounds like it would be pretty simple: one person takes care of a few things, the other person takes care of other things, and sometimes you meet in the middle to make sure all tasks are completed. The reality is not so simple. There are many important areas where each partner not only wants to know what is going on, but wants to have some or total control over all the activity. The most common area of disputes when it comes to dividing up the labor and tasks is that it is often best for one person to be responsible for financial matters, such as bill paying, bookkeeping, or accounting. These tasks, however, are very important to all partners. There could be other operational areas that are important to the partners but none so much as the money. If there is going to be one person handling the money then that person also has to have some sort of checks and balances in place so the other partners are aware of what is happening financially. Sometimes it can be as simple as a regular information update or continuous access to the books.
When it comes to company finances, there needs to be mechanisms in place to protect against fraud and embezzlement.
I want to take a particular look at embezzlement because it is different from what people often assume. Embezzlement is not necessarily a crime of greed (although that is sometimes the case), but often it is a crime of pressure and opportunity. Let’s say one partner is facing financial pressures such as medical bills or family obligations. It is very common for a partner to begin to crumble under this pressure and recognize that there are not a lot of financial controls in place. So they take just a little bit of money to address an immediate need, often with the intent to replace the money. What might start as $500 or a similar amount could very quickly escalate to tens or hundreds of thousands of dollars. As external financial pressure begins to build for that partner, they are not very likely to approach their partners and explain the situation. Rather, they let the circumstance escalate. Being able to communicate well about professional and personal burdens is a valuable tool to protect the business in more ways than one, embezzlement included.
The last real big subject to discuss before writing a partnership agreement is one of compensation. How are partners going to be compensated for their time and effort in the business?
If both partners are working on the business full-time, compensation usually isn’t much of an issue. A 50-50 split is an easy decision to make. Compensation plans get more difficult when there is a disproportionate workload that is being put in by each partner. Often times this leads to hurt feelings and demands for more salary by one partner.
Compensation generally can be a couple different forms:
- Partners pay themselves their salary (if you choose to be taxed as a corporation, partners will generally make a salary),
- A draw, which is a withdrawal of cash flow or profit from the business,
- A combination of salaries and draws, or
- Dividends on stock or x-corporation distributions, which are additional monies that would be paid out.
- There are some compensation structures that take advantage of some tax benefits, for example by loan repayments. But be sure to consult an attorney or tax advisor on these structures.
You have to be very careful when you deal with the taxation of compensation. If you are taking a draw from cash flow and your partnership is not taxed as a corporation, the partners have to be aware of the self-employment tax (an additional 15% tax on income). Partners must consult with an accountant who is qualified to advise you on taxation regulations.
Other forms of compensation might look different. For example, you could have company cars as part of a compensation package. You could have fringe benefits, of which health insurance is the most common. You may also see life insurance and disability insurance which allow partners to be more secure in their financial situation.
Compensation and financial matters obviously work very closely together. Before entering into a partnership, the partners really should have a clear understanding of what plan is in place for managing financial matters and what the compensation structure will be between the partners.
One important final note: all of this changes. Partnerships are fluid in terms of who is involved, their personalities, and how the business is developing, particularly at a start-up stage.