November 30, 2007 5:33 PM

I am investing in a start-up software company and there will be three partners. Some will invest significantly more $ than others into this, yet those not investing as much will be performing more of the work to build the company and manage and grow it once it is up and running.

Any formulas or ideas on how to set up the Partnership Agreement initially?

RG,

Assuming you are in the US, note that the IRS could care less about the work. To them, work is has no value. It is not capital.

As such, my understanding is this:

If 3 people are made equal partners and 2 of them put 50k in and the 3rd is just expected to work like a dog, the 3rd person is effectively being given 50k in "income", which is taxable. Because of this, my understanding is that you should make sure that the partnership ownership is solely related to the investment.

A lawyer+accountant could give you 6 more pages of details (accurate legal details, mind you...), but thats the bottom line as I understand it.

I am not a lawyer. This is not legal advice. I do not play a lawyer on TV.
Ditto for the accounting side.

Mark

November 30, 2007 5:46 PM

Great question. First of all, I would caution you about setting this up as a partnership as there are many legal ramifications to a partnership. Some sort of limited liability corporation might be a better way to go. Perhaps one of our moderators who is an attorney can fill you in on the exact pros-and-cons of the various legal structures or I'm sure that we have addressed the legal structure question in previous postings.

Getting back to the equity division and earning equity through "sweat labor". The way I've seen this happen best is for the parties to agree on a value to the "sweat equity". Some ways to structure the value of the sweat labor is the following:

1) for each month that a particular person is engaged full-time in the venture they earn $5K (or some number) of equity (in lieu of salary). If there is a payment based on time worked, there typically is some limit (e.g., up to $100K where $100K represents the dollar amount that the investor has anted up making the "sweat equity" person and the investor, in effect, equal partners).

2) for delivering a complete beta test version of the defined software (or some other deliverable), the particular person earns $50K of equity (or some number). Again typically you might make the deliverable value equal to the dollars invested by the investor so that the "sweat equity" person and the investor become, in effect, equal partners.

The above scheme becomes more complicated if the "sweat equity" person/people are also earning a reduced salary -- in effect you make it so the difference between the reduced salary and their value is "sweat equity" being earned. It also becomes more complicated if more than 2 people are involved.

One thorny issue is the equity percentage ownership and how it builds over time vs. the control issue over the fate of the enterprise. In the above scheme, the investor(s) basically begin with 100% of the equity and it decreases over time as the "sweat equity" person/people build equity. Once the intended end state of percentage ownership (and delivery of the product) the investor(s) and sweat equity person/people each have the same control. But you might want to structure it so that the investor(s) and the sweat equity person/people are fully committed until the intended end state is reached (e.g., initial launch of the product) so that an un-planned pull-out does not happen by either party and thus protecting both parties.

I know the above may sound a bit complicated. If you have any questions, please feel free to ask.

Hope that helps.

November 30, 2007 9:55 PM

Yes it is a US Corporation. I agree that the standard approach is to dole out shares for each dollar invested. But under your scenario, then the guy who works like a dog gets no ownership if we base owners equity and shares on their initial cash investment.

Correct. So you must find a different way.

So my concern is not so much an Accounting or legal issue, but rather a fairness issue between the partners.

I fully understand your concern. However, the IRS could give a flip about fairness. They wont care how lovely the paving stones are on the road to tax court are when they ring up the sweat equity partner.

The one who will be contributing the least (up-front investment-wise) will likely be putting in the most effort and adding the most value later down the road.

So how do we make sure he isn't discounted from an owners equity standpoint just because he doesn't have the initial cash to equal to the other Partners' investment? A year from now, he could be the primary driver of the success of this venture.

I would suggest that the other 2 partners each invest the sum that the sweat'r can put in. As work progresses, they can pay the sweat'r an equal amount for their share for the work whose combined total just happens to equal their next contribution to the partnership.

Im sure that isnt the only solution, but putting the sweat'r in the position of having a big tax bill every year isnt what Id recommend.

Mark

December 1, 2007 2:34 PM

Doug,

I (think I) understand your question. Here are some thoughts that come to mind:

[1] IP; Work; $s
The major ingredients in equity ownership - to address the fairness issues - has to do with three main components.
=> IP: The person with the idea (and therefore Intellectual Property) has 100% of the value associated with that IP (initially). Therefore, s/he has the right to sell some of it for either $s or work in lieu of $s. If more than one person is bringing in the essential IP, then they need to discuss relative value.
==> Work: The person who is taking a no/or reduced rate salary is effectively investing in the company. Legal, tax and accounting issues aside, the value of the deferred compensation* has two components: the $s being deferred (which should count as one $ for equity for every $ deferred, PLUS (!!) the risk associated with no, or little pay. There should be some sort of "factor" placed on this... that goes up as salary gets closer to zero. A factor of 3x base monthly salary isn't unreasonable, if the person is taking zero salary. It is SO easy for other people to not recognize the extensive risk that is being taken in a start-up by someone who cannot afford to put $s (vs someone who can afford it.)
==> Investment: The person (people, in your case) putting in the $s have a much simpler calculation: Although this question still needs to be answered: "What is the pre-money valuation?" Then work through the numbers to make sure it all plays out correctly.

You'll need to put together a small matrix of founders versus the type of contributions and work through the details on this one!

* Careful - Investors do NOT want someone's deferred compensation turned into a debt! The deferral needs to be thought of as eventual value extraction with a liquidity event. Nothing more. Or investors will run. If you will have no other investors, then debt is possible... but just be careful.

[2] Buy/sell
There will be bumps on the road, and investors (either $s or hours) may want out at some time. or someone who puts in the $s, who is also working in the company may want to not work at some point. Going through the exercise in [1], above (and valuing all contributions) helps set things up. But when the bump is hit, the partners will want to have already worked out how to deal with potential (probable?) splits in the future. That way, egos are somewhat subdued and the calm, well-thought-out assignment of equity and value at different points in time will help things go smoother in the future. Bottom line: Have, negotiate and deal with a Buy/Sell section in your agreement before moving forward in any substantive manner. (When I started Synergy Consulting Group with two other partners, this clause helped smooth a potentially contentious confrontation exactly one year later (when we asked one partner to leave - due to lack of focus and no follow-through), and also really helped 6 years later, when another partner bought a company and extricated himself from the consultancy.)

[3] Vesting
Something else to consider when putting together a company: Think in terms of vesting rights. Not only for the person getting equity in lieu of but also of the $-investors... especially if VC capital is to needed. Their term sheets will read something like: "You know that equity your *thought* you had? We'll get some of that back to you, if you meet your sales targets." Paraphrased, indeed... and not at all unreasonable. Clearly, ALL partners need some sort of "kick" of equity up front, so that all are truly invested to stick around. Usually 25% of whatever their total equity will be... then spread out the remaining equity over 2 to 4 years (longer, if VCs are to get involved). They'll like that you've already set it up. A bonus for doing this is, you'll already have part of the buy / sell sorted out... in terms of equity acquisition if someone bales out or is fired. Preferences go to the hard $s input, but you get the idea. (And yes, the devil is in the details!)

[4] % vs. stock
I'm not sure how you're setting up the structure of the company, but as long as you stay in a "percentage" mindset, the partners will forever be comparing ownership %s. And if additional investment is required (either in the form of $s, IP, or work), someone will always have to "give up" a percentage to make everything work out to 100%. If you create an "S" or "C" Corporation, and assign stock, then SHARES are issued as more investment, IP or work is added into the company. Assigning new shares does not require anyone to "give up" their shares, although % ownership decreases. It's a different mindset and will help you overcome this most basic human issue of not wanting to get taken advantage of. If you put together a stock structure (found in the download area of SoftwareCEO.com), that will go a long way in dealing with this highly-probable future issue.

[5] Bonus idea: Careful about "Work for hire"
Although this really falls under "Who owns the IP", if the person doing the work is the real idea-generator, then s/he already owns the IP, and it is very likely that s/he will develop more. This needs to be honored. Likewise, if someone new comes in, typically, it is under "work for hire rules" - where the company owns the IP. Sticky "tweeners" is where the company hires (or consults with) someone who BRINGS IN THEIR OWN IP. Since they already developed it - they already OWN it. If the new hire (or consultant) does not assign their IP to the company, then [a] the company does not own it and cannot claim it, and [b] all hell will break loose if a divorce occurs. Word to the wise (founders): Just because you bring someone in and pay them doesn't mean you automatically own what someone brings to the table. If they CREATE it (specifically with the company's $s),then that's a different matter.

OK... this was VERY long winded (I almost apologize ), but you asked a complex issues, and I wanted to add to the great advice you already received by touching on a few different areas. Also... once you've sorted out your agreement, make sure attorneys are involved to make sure it's done right.

All the best!

Regards,

Mark