All businesses start with either a single owner or a plurality of owners. If you are considering starting your own company, chances are you have considered bringing in a partner or two who can provide something to your business that you are unable to provide yourself. The success of this potential partnership depends greatly on properly structuring the ownership of the partnership. Things may work fine during good years, but economic stress will expose the weakness of your business structure.
A warning against being unequally yoked
Over the past few weeks, I have written about a couple of different verses found in the Book of Proverbs. In that same vein, this article discusses a command found in the Old Testament. It is found in Deuteronomy 22:10, “Thou shalt not plow with an ox and an ass together.” The wisdom of the verse is simple. An ox and a donkey are different. They are of different size and strength. They have different demeanors. Because of their differences, they will not work well together. So, how is this teaching applicable in business?
The real estate crisis of 2008
The real estate crisis of 2008 caught many real estate developers off guard. Most real estate development companies struggled through this real estate crisis. Many did not survive. Many projects from this bygone era remain unfinished here in eastern North Carolina. Of the companies that survived, many had large amounts of debt on their books. This debt was often secured by undeveloped real estate that had significantly decreased in value.
During the real estate development heyday, many partnerships were made where one individual provided funds for the development and another individual provided the expertise to build the development.
In these situations, the one providing the funds for the development saw an opportunity to earn a nice return on their investment in the real estate development market. But they needed a contractor who could actually perform the work. The contractor also saw an opportunity, but lacked sufficient capital to really leverage their expertise. Seems like a win-win situation, right? Not necessarily.
Partnerships such as these worked great prior to the housing crisis. But when the full effects of the crisis were felt, the weakness of these partnerships were fully exposed. The partnership could not continue to develop the real estate owned by the partnership to generate income. But the partnership had to continue to service the debt. And only one partner had the resources to service the debt. The partners were unequally yoked.
Understand what each potential partner brings to the table
Since the economic crisis of 2008, I have seen many partnership deal with situations such as the one above. Some of these partnerships still struggle with the effects of the crisis. Often, the partnership agreement lacked a mechanism for the financial partner to assume complete control of the entity. The lack of this mechanism often resulted in one partner making 100% of the capital contributions to service debt.
However, losses generated continued to be split based on the ownership percentages of the partnership. This continued despite the lack of material participation and basis of the non-financial partner.
So, before starting a partnership, consider what each partner is actually capable of bringing to the table when the next economic downturn occurs. Then, plan and structure accordingly. Perhaps a partnership is not best suited for your particular situation. Maybe the financial partner chooses to loan funds to the business instead of becoming an equity partner. Or perhaps the financial partner chooses to be the sole owner and hires the developer to work exclusively in the partnership.
Whatever structure you choose, be sure to address the ownership of any partner unable to meet their financial obligation to the partnership. And above all else, be absolutely certain to have an operating agreement in writing. Your success depends on it.