Sunday, November 27, 2016

Partnerships?

Should you take on a partner?  Probably not!

A reader writes (a year ago!):
As usual, I've been reading with interest and joy your articles. However, recently I realized that there are some issues that you have not wrote about as much as others.

One of those is, for example, partnership. This came to my mind because I've been thinking about opportunities that emerge when people join forces (ok, money) on a business and how that could it work for me.

However, I've been reading some of my favourite writers about that issue and their view isn't very favourable. (I read two articles: Gabriel Zaid's El peor socio [The worst partner] and Mr. Money Mustache's big mistake. Both online, but the former in spanish only).

Anyway I will like to know about your experiences and thoughts about partnership. Maybe you could write about this theme sometime.

An Italian friend of mine runs a pizza restaurant in Florida.  He decided to expand to a new location near our home, which had us excited, as he had great pizza.   To do this, he took on a partner.   After a year of screwing around, in which the partner re-arranged the restaurant and re-painted the interior four times - without ever opening the doors for business, my friend finally got disgusted and bought them out.  The "partner" was supposed to bring all these business skills to the table, but in the end, never even bothered to apply for a liquor license.  He lost a lot of money by wasting a year building out the space, when he could have been open in three months.

"In Italy," he said, "We have a saying.   The best size for a partnership is an odd number of partners, less than three."

In other words, it was better to go it alone.

Partnerships are difficult arrangements at best.  The problem is, usually one person puts more effort into the partnership that another, and feels cheated because they get the same profit as the other partner.   Meanwhile, the lackadaisical partner gets the same profit with little or no effort.  And both parties feel cheated in the matter.  Even the lackadaisical partner will tell you he got "the short end of the stick."

The experience of Mr. Money Mustache happens more often than you think.   In fact, I would say it was typical.

Let me give you some real-life examples I know of to illustrate some problems with partnerships.


1.  Joe and Sam decide to start a cable television company in a small rural city in the midwest.   Each contributes $50,000 to cover the start-up costs and they get a franchise from the city.    Joe buys cable and runs buried lines through the city and suburbs and sets up headend units and handles all the paperwork.  Sam initially helps out, but loses interest in the venture and moves out of State.

Years go by  Joe and his three sons work like dogs to make the business a go.  It is hard, back-breaking work installing all that cable, but the company grows, and pretty soon they are hiring installers and have a fleet of trucks and start to make some real money.   Larger cable companies offer to buy them out.

Sam returns to the scene and now demands half of the proceeds of the cable company as he was a "50/50" partner in the deal.   Technically, he may be right, although their partnership agreement (if there even was one) was very vague.  Sam hires a broken-down lawyer to send a threatening letter to Joe.

Joe hires the largest law firm in his city and files suit against Sam.   Fortunately, Sam backs down and settles with Joe for a couple hundred thousand - a pretty good return on his investment, considering he did little in the way of real work.

The moral here is that partnership agreements can be sticky things.  Once you get into one, you are kind of stuck, as Joe was.  Joe couldn't just walk away from his cable company and lose his investment - and Sam knew that.  The Sam's of the world like to latch on to the Joe's of the world and demand half of everything just for showing up.

A more detailed partnership agreement ironically might have hurt more than helped.   After all, if it set forth explicit rights for both partners, Sam might have succeeded in his suit.


2.  Fred, Barney, Wilma, and Betty start a law firm.   They are all equal partners.  In the beginning it all goes pretty well, as each attorney has a small practice that is relatively the same size as the others.  By banding together, they each can market themselves as part of a larger firm and get more business.

Fred lands a big overseas client and starts doing pretty well.  He spends years flying overseas to meet with this client and has to hire a number of attorneys to handle the increasing amount of work.   Within a few years, more than half the firm's business originates with Fred.   Yet Fred has to split the firm profits equally with Barney, Wilma, and Betty.

The firm partnership agreement has one unique feature - the money that each partner attorney bills is earmarked for themselves.   Overall profits (from client reporting letters, associate attorneys, paralegals, copy fees) are divided equally among the partners.   So Fred has the clever idea that he should "pad" each bill to his client with an hour-and-a-half of his time, regardless of whether he worked on the case, and subtract the same amount from each associate.   This way he gets paid for "his" client's work.

Unfortunately, it is bill padding, which is illegal.  Worse yet, Fred put this in a memo to all his associates.   His partners were furious and his associates were none too happy.  One of them sends a copy of the memo to the State Bar, and an investigation ensues.

The firm breaks up - which works out better for Fred anyway.   He was getting screwed by his partners, some of whom were barely billing their take-home pay, much less making a profit for the firm.   Fred takes the best associates and his clients and moves to a new firm where an iron-clad partnership agreement (running over 200 pages) diverts more of the income from his client's work to him.

The remaining partners flounder.  Some find work at other firms.  Others retire.  A couple band together to form a new firm, but it doesn't go anywhere.   They realize now that Fred was the "whale" or "rainmaker" at the old firm, and that they should have reworked the partnership agreement rather than being greedy and taking all of Fred's money and forcing the breakup.

Of course, Fred's approach was equally as flawed.  He should have left the firm when he felt it was unfair to him, rather than trying back-door ways (illegal ways) of diverting cash.

Moral:  What starts out as a small enterprise where everyone is equal, can quickly morph into a larger enterprise where contributions by each partner are lopsided.   A partnership agreement should take into consideration that conditions can change.   And partners should realize that sticking together is probably a better idea than being greedy.  Alas, greed usually wins the day.


3.  Ricky decides to open his own law practice.   He has a couple of good clients and an office building, which he owns.  Business is doing well, and he is making a little money.  Ethel, who Rickey knew from a previous firm, comes in from out of town and tells Ricky she expects to be made full partner in the firm, right away.  Ricky balks.  He's invested hundreds of thousands of dollars in the firm, and thousands of man-hours.  Why should Ethel - who has no client base at all - get half of what he worked for?

Ethel's expectations are unrealistic - but they mirror the expectations of a lot of "salary slaves" who have no idea what a partnership means or how hard it is to run a business.  Ricky politely declines Ethel's offer and she now refuses to speak to him.

George, another old friend of Rickey's approaches him with a partnership proposition.   George has all sorts of "big connections" and big ideas and he will bring a lot to the table.  Again, he wants to be 50/50 partners in the deal (actually he wanted 60/40 in his favor, initially!).  When pressed for details about his big connections and big ideas, George gets awfully vague and says they are "confidential."

While George has nice expensive clothes and Italian loafers, Ricky realizes he is a bit of a con-man.  He is all talk and no action, which was why his last firm let him go.   Ricky politely refuses George's kind offer to take half his business.  George shows his true colors, letting loose a string of epithets and calling Ricky a "loser."

Moral:  Once you have established a business, there are all sorts of people who will invite themselves to be your "partner" and try to trick you into doing this, claiming they can increase the size of your business or whatnot.  The question you should ask yourself is, if they have so much freaking business and business sense, why don't they start their own enterprise?  And if you think about that question, the answer is pretty obvious.


4.  Jim and James decide to start a seed business.   They collect and sell seeds, and initially it seems to work out.  Jim has the seed know-how, James put up the capital.  Both think their contribution is greater than the other.

A big company offers to buy them out, and Jim refuses to sell, arguing that they will make more money in the long run if they stay independent.   James sees a very generous offer and that their seed business is somewhat marginal.  He would rather sell and take a nice profit.   However, since Jim refuses, they cannot sell the business to the big company.

And James was right.  The business was marginal and got even moreso after the big company went into direct competition with them.   Also, Jim made a lot of poor business decisions - overspending on things that were not necessary to the business - and did these behind James' back.

Within a couple of years, the business was broke and there was much acrimony as to whose fault it was.   James lost his investment.  Jim managed to make off with the seed stock and reopen a new business under a new name a year later.

Moral:  When everything is "50/50" it can be hard to get things done, as no one has a clear majority.  Two-person partnerships are a nightmare in this regard.   Three-person are no better, as it ends up being two-against-one, which sucks if you are the one.


5.  Ricky decides that being a solo practitioner is no real fun, but can't find someone to partner with who has serious business acumen and their own portable practice.  So he interviews with a number of firms to take on a partnership position.   Most of them require that he have at least a million dollars in "portable" business before they will consider taking him on.   They are no fools - they want a partner with a business of his own, not someone who is taking but not giving.

The partnership arrangements are, to say the least, bizarre.

Firm A has a partnership that decides at the end of each year, to sit down and allocate profits to each partner based on an agreement reached after a marathon session in the conference room.   These meetings are legend and often go on for 12-18 hours at a time.  They argue, shout, cajole, and even scream at one another, until bloody and battered, they reach an agreement on how to split the partnership proceeds.   Ricky thinks this is a ridiculous arrangement.

Firm B has an even weirder arrangement.   Every month they total the accounts received from clients and then divide it up by how much each attorney billed for that month.   If Ricky gets paid $100,000 from a client that month, but is on vacation most of the month, the majority of the proceeds would go to the other partners, who billed more that month.   Ricky thinks this is also a ludicrous arrangement, as the income from a client is paid to an attorney who never even worked for that client.   What's more, it is readily apparent that the system could be easily abused or skewed to rip off Ricky by simply padding their "billing" for that month.

Firm C has a detailed partnership agreement that goes on for pages, listing types and levels of partnership, how much each person is paid, what percentage of their billing they get, how much they contribute to overhead, and even how much they are credited for pro bono work or giving legal lectures.   It is a very well-crafted agreement, but even then, some partners grouse it favors the older partners (who get more shares in the profits) over the younger ones who are actually bringing in the lion's share of the money.

The list goes on and on.   Some firms, trying to be "fair" have detailed agreements that would take an army of lawyers to untangle - and they are updated each year, as some new inequity is discovered.

The moral here is, there is no 100% "fair" partnership agreement.  At best, they are a rough approximation of how much each person contributes to the overall success of the enterprise.  And even if there could be a 100% "fair" agreement, every partner would feel, no doubt, that they are contributing more and getting less.  This is just human nature.

This experience also illustrates that a partnership agreement can be almost anything you want it to be.  You can make it anything from a verbal "handshake" agreement to a detailed contract going on for hundreds of pages - or anything in-between.

* * * 

So why do people form partnerships, and are there alternatives?

There are a multitude of reasons to form partnerships.   For a small company staring out, the partnership may be a better alternative to hiring someone to work for you.   If you are starting out a small retail store or a small electronics firm, you and your partner may have to put in long hours with little or no pay before the enterprise takes off.  Eventually, if it does pay off, you both reap the rewards of the enterprise.

On the other hand, if you owned the business as a solo practitioner and then hired someone to do half the work, you would have to have a lot of capital to pay that person, including benefits and taxes, in order to attract someone with sufficient talent and hard work to make the enterprise succeed.  And no matter how much you pay them in salary, they aren't going to put as much effort into the enterprise as a partner would.  Moreover, the money you spend on paying them would be better spent on building the business.   So a partnership has advantages.

As I noted in the law firm example, a partnership allows you to sell yourself as part of a greater concern, which helps attract clients and helps expand your business.  You also have resources, such as associates and paralegals, which come in handy when you want to bring in more business.   Sadly, despite the fact that attorneys are quite adept and drawing up contracts for other people, they fall down flat when it comes to their own partnership agreements.   The "partnership track" at most firms is based more on a verbal or even implied understanding than any written agreement.  And when partnership agreements are in writing, they are often poorly and awkwardly drafted.   There is a reason law firms are constantly shedding members, dividing up, merging, or simply falling apart.  It is the nature of partnership.

There are of course, alternatives, such as subchapter-S corporations (a subchapter-C corp is usually only appropriate if you plan on going public).   Again, you can try to structure a Subchapter-S corp so that each person has shares in the corporation, and you can even allocate the number of shares and voting rights and whatnot based on seniority, amount billed, how much contributed, or whatever other metric you wish to use.

In fact, a shareholder model can work well in a number of ways.  As the firm expands, you can issue more shares (but may be limited in the maximum number or number of shareholders, by law) which effectively dilutes the interest of older "partners" who may be on their way out.   They can also sell their shares to other partners (but generally not out of the firm) as a means of cashing out of the business. 

In short, like with a partnership, a Subchapter-S corp can be structured nearly any way want it to.   And there are some other interesting aspects of it as well.   You may be shielded from liability for some acts and maybe even acts of other "partners".   One firm I know of comprises a partnership of Subchapter-S corporations, with each "partner" in the firm being his own corporation.  The theory is, I guess, to shield the partnership from the actions of one partner, if they are sued.   It gets pretty crazy.

Of course, solo proprietor is the other alternative - going it alone.   The best thing about being a sole practitioner or sole proprietor is that you don't have to have endless meetings to argue about every decision made.   You can make all your own decisions - right or wrong.  Sometimes it is nice to bounce ideas off others.  But in large firms, decision-making can get bogged down, as people become more risk-averse.

The other nice thing about "owning it all" is that if you do build up a large business, it is all yours.  And there are many large companies in the USA today which are either owned by one person or one family.   The Chamberlain garage door company, for example, it a privately held concern and makes more than half the garage door openers in the country.   A good thing to be born with "Chamberlain" on your birth certificate, no doubt!

One downside, though, is that it can be hard to "cash out" a solo owned company, unless you decide to go public.   If you leave the company to your children, you've basically created a partnership - often a nightmare partnership that mixes money with family issues - that cannot agree on anything and usually ends up wrecking the business you built up.  Howard Johnson's, the restaurant, was victim to this sort of thing.

In my own life, I have formed two subchapter-S corporations, but in one of them, I was the sole shareholder.  Mark was co-owner of Hollin Hall Holdings, our Real Estate venture (which was far more profitable than Mr. Money Mustache's nightmare scenario!)   But even then, sometimes we would grate on each other's nerves.   I recall one night sheet rocking a kitchen in a duplex and wondering where the hell Mark was?   Here I was doing all the work and he was home watching television.  Words were exchanged.

So even if you are family members or spouses, there may still be friction in a business partnership - in fact perhaps even more so, as you bring relationship baggage into it.

I think if you are going to form a partnership, you need to sit down and think carefully about how it should be structured.   And you need to put it in writing and in great detail.   Odds are, your partner may balk at some or all of the terms, which may tell you volumes about your partner.  And bear in mind that you may have to go to court to enforce such an agreement.  So even with an "iron-clad" agreement, a partnership can still be a nightmare.

In reading the Mr. Money Mustache article above, I was chilled by some of the passages.  I was fortunate to see the warning signs of glad-handing and big-talking would-be partners (usually coke or meth is involved with those sorts) and walked away from such deals.   I feel sorry for the guy - $200,000 in debt, while his "partner" is drawing a salary from the partnership.   If you are going to be drawing salaries, you might as well just hire someone.   Why he let him buy new appliances using company money is beyond me.   But like he says, he was young and trusting.

Maybe sometimes it is a good thing to come from a dysfunctional family and have trust issues.   You tend to be able to spot these sort of things a mile away.  My bullshit detector is well-honed.

Are there successful business partnerships?  Well, sure.  "Business Insider" lists a few, although some of them, such as Jobs and Wozniack, really stopped being partners early on into the gig.   And it is only the monstrous pile of money they made together that kept them "friends" if not business partners later on in life.  I guess if your company becomes wildly profitable, your partnership will succeed.  In other words, success breeds success.  When things go South or at least get stressful, harsh words can be exchanged.

And of course, most of these partnerships end up selling out and going public.   Not many of them last forever.

I guess my takeaway is that if someone proposes a partnership agreement to you, be wary, particularly if it looks like you are doing all the heavy lifting (i.e., providing the money) while the other person is bringing nebulous things to the table like "skills" or "contacts" or "business acumen".   If that person was really such a hot-shot, why would they want your money?   After all, they could just get a business loan or grow their business organically.

The answer is, sadly, that in many cases, there are crooked people out there who know how to fleece the inexperienced and unsuspecting.   They know there are folks with stars in their eyes about "starting their own business" and "being your own boss" - and such folks have money to invest, but perhaps less common sense.

All I can say is, be careful.

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