Thursday, November 19, 2009

How to divide interest in new business!

I was consulted by two friends who wished to start a business. They wished to get legal advice on what is the best form of business (benefits of corporation versus sole proprietorship, etc.), lease issues, personal liability of individuals to the lenders in case of default on business loan, hiring and firing of employees, etc. I was impressed with these people. One client had all the questions on his iPhone- putting technology to use. Lot of thought seems to go in the process which is a great sign of business planning.

One of the questions which was most interesting was-how to divide the interest. Both partners were putting in equal amount of money but one partner was going to work in the business and take care of the technical side as well as day-to-day management related issues. The working partner wanted a higher interest as well as a monthly compensation once the business reached a certain level of revenue. The investing partner wanted to know if such division of business equity was fair and reasonable. Specific question was what is the norm?

There is no particular norm in the industry for division of equity or share. I feel it is all negotiable. It just depends on what value is placed on money invested, work done, product created or service rendered and result obtained.

However, it is a great idea to talk about these things before hand to avoid future problems. Someone who is going to work in the business will naturally take most of the credit as person is using his technical and management skills based on previous experience. The investing partner is bringing in the money.

It is interesting to note that even though the money is important to run any business, the things change drastically when someone starts to value his own skills more than the money. If money is not there, the business won't start, however, if the business person is not there to manage functions skillfully then the business will not continue. It is classic "chicken or the egg first?" kind of situation.

What I felt was that the partners had the following choices:

1.      Acknowledge that money is important. And that personal credit is being used to qualify for business loan. Bank is requiring personal guarantee. Question becomes how is providing such guarantee!
2.      The working partner is contributing his business, technical and management skills.
3.      Either divide equally and pay the working partner a certain reasonable monthly amount as Manager. Or give the working partner a little bit higher interest (share) based on his skill if the business can not afford to pay the monthly amount.
4.    Loan money the friend/wanna-be-working partner at a market interest rate and be satisfied with the return.

5.      And lastly, walk away from the venture. My logic was that working partner might adjust the interest currently based on business or financial need. However, if working partner already views his experience and skill as more valuable and worth higher interest plus monthly salary, then at later stage, once the business starts to flourish, it might create more problems and might lead to a rift and breakage in relationship and smooth functioning of business.

Good thing is that at least these people are talking about it and discussing it before hand. I am sure based on their relationship, they will be able to reach a happy medium and do well in the business. I certainly wish them well.