May 20, 2014 by Aaron Scott Young
In the last thirteen years I have created over 11 partnerships, and in that time I’ve learned a lot about the necessary ingredients for creating a successful partnership that can lead to a successful business.
Strangely enough, the biggest mistake most business partners make is that they believe that their business will be successful if they simply execute on enough opportunities. They look out into the world and see an ocean of possibility and usually launch their business in multiple directions, hoping that something will eventually work. Often they design their partnership equity and compensation agreements such that rewards occur after the business has been proven to be successful.
What I have found is that it is actually much more important to design partnership compensation and equity structure to withstand multiple rounds of failure. These rounds of failure usually lead to finding an area of focus, and then maximizing opportunities within that focus to the exclusion of faux-opportunities (a/k/a distractions).
The Fallacy: “The business will be successful if we just take advantage of as much opportunity as possible. We will wait to pay ourselves now and will split the profits when we are successful.”
The Reality: “Finding a successful strategy for our business may take a long time. We may have to go through many types of opportunities until we find the right customer/product/service mix that works for us. We have to be intelligent about how we pay ourselves on the way to success and beyond.”
The dangerous decisions that business partners make as a result of the fallacy include decisions to pay themselves based on the profitability and the success of the products or services being sold and agreeing to profit-sharing as their primary method of compensation regardless of their respective contribution or operational responsibilities in the business (Many people just decide to split ownership 50/50 with no further justification). The reason this is dangerous is that many business partners get financially exhausted on the way to “Cash Distributability” (this is my term). Whether they serve as the capital partner, or as the operational partner (a fancy name for sweat equity partner), if the structure for compensation is not properly aligned with the realities of the business, it can spell disaster for the relationship and the effectiveness of the partners.
What we recommend in our proprietary methodology called the Fair Partner Equity FormulaTM, is that business owners take a modular approach to compensation. In an example where one partner is more active in the operation of the business and another partner is more passive and provides financial assets, it means that the partner compensation and equity structure need to reflect the respective levels of all types of past and ongoing contribution.
It is also crucial to design the compensation agreement to keep the operational partner focused on building the business to find success as quickly as possible. A tactic to accomplish this is paying the operational partner some kind of living stipend. The danger often is that the operational partner, if not compensated fairly while working during the initial stages of the business, may become financially exhausted and may have to choose between finding other ways to provide for themselves or working on the business partnership.
This may mean that the equity split between the partners should no longer be 50-50 but the total compensation for each partner is a lot more fair and in line with the different responsibilities and needs that each partner may have. It may be appropriate for the partner who is taking the financial risk by providing the capital for the operational partner to take a stipend, to value this risk and seek reimbursement in the form of a payable or additional equity. This is one way to make the deal more palatable to all parties involved: the operational partner stays focused on the building the business, and the capital partner is compensated appropriately for the risk of capital. It gets more complicated and involved when the types of contribution from each partner are more diverse (e.g. IP, real estate, credit, networks, licenses, etc), then it becomes even more important to distinctly compensate or at least consider each form of contribution when creating the equity and compensation agreement for the business.
This approach allows for all partners to receive compensation that is in line with their responsibilities and contribution and ultimately allows them a format to have an ongoing conversation about the fairness and the effectiveness of their overall compensation structure. Ultimately, an approach of this nature will provide an environment in which partners will be able to scale for growth, delegate responsibility, and create the business of their dreams, while still being able to have an amicable and productive relationship.
Hugh O. Stewart, MS
2504 Raeford Road, Ste 107
Fayetteville, NC 28305