Three inseperable friends want to start a business

How should they split the profits?

[vibgyor79]

Three very good friends want to start a business, say, a restaurant by pooling in their hard earned money. To avoid (ego and finance) problems, they need to decide on a compensation plan beforehand.

Tom is rich and invests 50% of the funds.
Dick invests 30% of the funds.
Harry invests 20% of the funds.

The restaurant is expected to break-even only after 6 months.

Question:

How do you structure the compensation plan for our three friends? Should it be based completely on the who has the highest stake in the business? That is, should they split the profits based on their individual investments? In this case, none of the three have any income for the first 6 months

Or, should they decide on a monthly salary based on their individual capabilites and plough profits back into their business? The monthly salary will take care of their family expenses for the 6 months.

Or should it be a combination of the two?

More Questions:

1) Has anybody been in this situation before?
2) What should one watch out for? Can a business partnership strain the friendship between Tom, Dick and Harry?
3) What if Harry wants to drop out and start his own restaurant after a couple of years? How should he be compensated?

[amoore]

One method is for Tom to make a couple of loans to Dick and Harry. Give them a year or something to pay it back. Make it seperate from the restarurant stuff altogether. Then, they're in equals on all profits and liabilities.

[fathom]

Well... first I'd say the initial investment really doesn't have much to do with this, sweat equity will easily make the investment mutual.

Regardless of what the business is a solid business and marketing plan should be the starting point.

An independent financial planner should be maintaining the books since most businesses rarely get by the first 1 - 3 years and neither Tom, Dick, or Harry will be objective when it comes to putting food on the table.

If indeed the business is at a breakeven point in 6 months, in my professional opinion tack on an additional 2.5 years before truly looking at compensation for anyone. If after three years and all three are still in the game and the game is florishing that's when you all can be justly rewarded and equally since all performed exceptionally to beat the odds.

Short term success is not long term fruition - there will be many highs and lows and the lows tend to outperform the highs.

A truism - adversity rarely has friends. Tom, Dick, & Harry may share a common bond (starting a business is a high) but the test of that bond is adversity.

If none of the three friends have marketing experience consider this the first adversity for you... before you start.

If you build it... they will come only works with baseball in a corn field.

[ukgimp]

You probably need to consider the effort put in also or the share of effort and whether the venture could go ahead without one of the others. For example your man Harry only put in 20% but he may be the Chef without whom the whole thing might slide. Chances are you are all in it for different reasons and abilities.

I was told to get everything down on paper, it may seem a ball ache bu will save troubel later on. Partnerships are known to be very easy to break down and with that a freindship may also breakdown.

I dont know where you are based but if you are UK it sounds like you would benefit from setting up a limited company. That would allow you to allocate shares quite easily depending on the initial investment along with all the other benefits of being ltd.

Cheers

[chris_f]

Don't forget to also take into account the time they spent on the business. One person might work 9-5 and another might spend all night staying up and working on stuff.

Chris

[gmoney]

I don’t have much experience in this one except that I have known a few friends who worked on a business together and the business ended up in trouble and so did the friendships. It took years before I was able to hang out in the same room with all of them together and even now things aren’t quite the same. However, time is a pretty good healer.

Obviously you will hope for the best but I would recommend that you plan for the worst. Provide outs for people in case of something like somebody or somebody’s spouse gets a really great job offer far away and make sure everybody knows what they will have to give up or get to keep ahead of time if they leave the business. Also make up contingency plans in case one or more partners have to cut back on hours worked in the business because they need another job to pay their bills. I would try to lay out as many rules and policies up front and make everybody sign it so if the stuff hits the fan you have something to turn to.

It gets difficult because up front investment is usually different and the “sweat” hours naturally seem to work out differently as well depending on individual skills and the needs of the business. I like the loan idea suggested above to balance out the initial investment but the sweat hours differences are usually difficult to handle when there is no money for salaries pouring in at the start - and there may never be. Equal up front investments and equal sweat hours would be ideal but if it is not then I believe there should be some form of mutually agreed upon way to deal with the imbalances in the boom times, the lean times, and perhaps the bust times.

I am really interested in this post because I am starting to work on some projects with friends and it is very enjoyable. I just don’t want to make the same mistakes I saw my other friends make.

[starec]

>1) Has anybody been in this situation before?

I went through this 3 years ago. (It worked out very well, we are still together, growing fast.)

> 2) What should one watch out for? Can a business partnership strain the friendship between Tom, Dick and Harry?

Very true. It can strain (or even destroy) the frienship. One should be as clear as possible in drafting the contracts and all the legal documents. Do not rely on the frienship - start the company as if you were total strangers. Specify the shares, the lock-in formulae (the minimum time each of the three must stay with the company), the priorities in potential buy-out etc.

We opted for equal shares of each of the partners. With very different shares Tom has much more to loose in case the idea does not work than the other two. It tends to result in his trying to dominate the decision-making process, which may create a lot of tension, not good for business, nor for the frienship.

> 3) What if Harry wants to drop out and start his own restaurant after a couple of years? How should he be compensated?

Normally, partners have buy-out priority in this type of situation, other things being equal. It may happen that neither the partners nor external buyers are interested in buying the share - in that case, there is no way to force the partners to buy Harry out... (The formula which I like in resolving partner/ownership conflict: each partner puts his valuation on the business, the one with the highest valuation keeps the business, pays the price of the second highest valuation).

[thayer]

From my experience the most important issue is how to GET OUT of the partnership. That needs to be very clear from the start- how to get out, buyout arrangements, agreements to sell, how to value the business, etc... firm policies about how this is to be done if one partner wishes to get out.

Being held hostage because you did not have such agreements is a nasty place to be in, and the most amicable of partnerships can become like this when adversity arises or it develops that that wonderful partner has now become someone you now cannot stand to be around.

[rogerd]

I've been in a few deals like this. There are two related but separate areas - ownership/equity and compensation. Ownership often reflects the financial investments made by the partners, and compensation reflects the time and effort they put into running the business.

When a business is not well funded, the owners may work long hours with no compensation or at lower compensation than the market value of their work. This is often called sweat equity, and it can break down the neat division in the preceding paragraph - the ownership/equity split now depends not just on cash invested, but also expected workload.

The first problem will be agreeing on how to value these inputs. Say one partner will put up 80% of the money but not work at all, another will put up 20% and work full time, and the third can put up nothing but also will work full time. Agreeing on an equitable split can be tricky, particularly if it's not clear when the business will be profitable enough to pay market-level salaries. (Working for free for three months is one thing, but for two years is another.)

Assuming that an agreement is reached, I think it's essential to spell out some performance measures for the sweat equity participants. I was involved in one three-way partnership where one of the partners lost interest after an initial flurry of activity. It was a messy negotiation to reduce his share of ownership, and he ended up with more than he merited. I would highly recommend a defined activity or performance targets, with shares, options, etc., being awarded as those milestones occur. If a partner ends up not pulling his weight, there's a protection mechanism built in.

I agree with Thayer that getting out needs to be discussed, too. A buy/sell agreement should be drafted, and the sale of shares should be restricted. If one partner gets short of cash or gets hit by a bus, you don't want to find yourself partners with Guido (his loan shark, who will want to discuss increasing owner pay immediately) or Bubbles (his spouse, who has no experience but plenty of great ideas on how to run the business better).

If you can afford it, it's best to have a lawyer draft up appropriate agreements. Save time up front by agreeing on exactly what you want to happen, so the lawyer can focus on writing it up, not on negotiation. If this is a small venture that's really tight for cash, consider using and modifying some of the legal forms you can download - your resulting documents might not be perfect, but it will be a lot better than nothing. I've had some of my cut & paste "legal work" stand up under the scrutiny of $350/hr law firms, but I'd still recommend a real lawyer if you can afford it. (Tweaking an old expression, "A client who represents himself has a fool for a lawyer." :))

[rodpuga]

You have to find a formula based not only on the money invested, but also on their work and productivity.

If all three work the same load, and produce equal results for the company, they should get the percentage of their stake in the company.

[aspdaddy]

Other things beside investment - A partner with good industry contacts is invaluable for a buisness start up, how would you measure this?

Skills and knowledge etc also count. Sometimes friends dont see these issues because the expect it off each other for free.

[Chronos]

A group to study while deciding how to handle this will surprise you. The music industry is actually very efficient in it's manner of monetizing it's businesses, we call them bands. There are several ways that the proceeds are split amongst the band members some very brutal others quite democratic. There is currently a major touring act that has a "fair and generous" split of equity. The band is the name of the lead singer so he takes half of everything and the band equally splits what remains. Other bands will spit equal portions with extra percentages given to the songwriters. Four piece band with two songwriters so the split was 20%, 20%, 30%, and 30%. That was considered a very fair deal. At the other end of the spectrum I've heard of musicians who worked for a session fee ($5000 US and he paid his own expenses) and created principal material for some of the most influential albums of all time making the main band member very rich for the rest of his life.

There are many models to study in the music industry and they're very attainable since large acts like to find ways to flaunt their fortunes. See which deals ended up best for all parties see who hates eachother.

[Shane]

The sweat equity is the most important part. So, consider valuing the money each puts up as a loan at a pre-agreed upon rate of interest solves one problem easily. Also, no withdrawl of funding for a minimum of two years. By then it will be clear that it will sink or swim.

Valuing the sweat equity part is much more difficult. Will each play a different role. A chef compared to a maitre'd compared to a general manager will all have different values to the business and therefore different salaries/draws.

So, we would need more information to value the sweat equity. The real problem is in the middle of it with shrinking revenue it will get nasty.

Also, how will decisions be made. One person may want to advertise heavily and another not. Three people can break tie votes but that does not mean they will bring a consistent and rational face to the marketplace.

..... Shane

[vibgyor79]

Thank you for all the replies. I'm sure these suggestions will help every Tom, Dick and Harry! ;)

One more question -

Our three friends are now doing very well. Tom gets a very bright idea - he decides to renovate the restaurant and hires an internal decorator for $10,000. The other two don't like the idea and are angry with Tom for signing such a huge check.

In this case, since all three are investors, they are allowed to sign checks and withdraw money from the corporate account for business purposes. Should there be a limit on how much an individual can withdraw and should it be put on the legal agreement? Should there be a rule - if the amount to be spent is more than $XXXXX, it would require the permission of all the stakeholders?

[ukgimp]

That is dangerous, it was the one thing that put me off a partnership a few years back. I had the fear that I would come back to a 2MB pipe on a leased line for 12months min.

Could you either set a limit that requires counter signing if above a certain ammount.

This sort of situation is the fearsome part of the deal. I may be wrong but when I was looking into this I was told that the limited liability was not all the limited. If one director went mad they would come after the other to a certain degree.

This is where proper legal advice will come in! Make sure you get some.

[Travoli]

Nobody should have 50%, so that 2 partners can always override the other. Checks of amounts greater than $XX need to be agreed upon by at least one other partner.

MAKE SURE TOM, DICK, and HARRY ARE ALL VERY HARD WORKERS. If anyone slacks off, the whole thing could go down.

[Shane]

On the cheque thing, in Canada I believe that it is fairly easy to get an account that requires two signatures.

Also consider that as time goes on the lives of the three partners will change and there should be an exit clause on how one member can leave. How is the share of the company valued. Who can he sell to. Does he have to offer the two remaining partners equal amounts of shares.

Good Luck,
Shane

[webdevsf]

If you want to remain friends, don't do this.

[Kimberly]

I have been in business with 2 other shareholders for years now, and I have learned:

An equal partnership almost never works. Parties eventually can't agree, and progress grinds to a halt. Some one needs to be in charge, and gets to have final say. A CEO, which may or may not be one of the three.

I equate the word "team" with "ain't nothing gonna get done", unless the team has a defined leader. Otherwise the debates just go on forever. And I think it's easier to right a mistake than to overcome the results of inaction.

Alternatively, it is established early-on who is in charge of what. Sales, Ops, Finance, etc.

But, I think if one peer on a team is writing $10000 checks without the blessing of the team, inaction may be the least of the partners' problems.