Small business owners understand that “small business” doesn’t equal “easy business.” A lot of resources, decision making, and legal and financial exposure go into creating a thriving enterprise. If all goes well the majority of the time, the return on investment can be significant. With their eyes on the upside, it’s entirely normal for egalitarian business owners to invite others into the ownership circle, as well as for those on the outside to request entrée. Despite everyone’s good intentions, my experience has been that many co-ownership situations are at best unnecessary and confusing and at worst divisive or even financially crippling.
Here are some questions to ask if you are considering bringing in new owners to your business:
- Does your potential co-owner understand the legal implications of owning a small business? Are they willing to engage and pay for their own legal counsel to review purchase agreements and other documents? Do they understand they could be sued as an owner?
- Does your potential co-owner understand the financial implications of owning a small business? If this is their first foray into business ownership, they’re likely accustomed to a steady paycheck that doesn’t represent the volatility of a small business’ cash flows. Is this person willing to go a month or more without receiving money from the business? Is this person willing to be a source of funding for the business during lean periods? This person may have never had any exposure to the financial side of running a business. Are they willing and able to learn about financial statements, cash flow management, budgeting, etc.?
- Does your potential co-owner understand the tax implications of owning a small business? Many small businesses are structured as so-called “passthrough” entities with the result being that an owner’s tax situation is at least a little more complicated than it was previously. Is this person willing to engage their own tax advisor for tax return preparation and year-round consultation?
- Just as important, do you understand the legal, financial, and tax implications of adding another owner to your business? Are you willing to finance their buy-in if necessary? Are you willing to share profit distributions pro rata in an S Corporation setting? Are you willing to give up some level of control over day-to-day and strategic operations?
- Would this person be better suited as a lender rather than an owner? Although these options aren’t mutually-exclusive, securing funding without giving up ownership may be a better fit for you and for them.
- Would this person be better suited as a highly-compensated employee rather than an owner? In many industries it’s common practice, even expected, for experienced employees to be offered ownership opportunities. Has this person already proven themselves as a potential owner or is ownership merely a reward for past performance? Sometimes, a situation similar to ownership is preferable such as one involving an elevated title and compensation that’s linked to business profits.
- Will this person add value to the business as an owner that they wouldn’t or couldn’t as an employee, contractor, strategic partner, or lender? Has every other relationship option been exhausted before offering ownership? Is this person being offered ownership because they are a friend or family member and it “seems like a good idea”? If your business has some amount of value and you’re looking at succession planning, is this person willing and able to buy in? Keep in mind that there can be a number of ways to cash out of a profitable business including winding down, selling to a competitor, selling to a third-party through a broker, etc.
It’s critical to understand the financial, tax, legal, and operational issues that can arise when bringing on another owner at any stage of your business’ life cycle. It’s quite possible that the ownership structure you envision could be unnecessary, with all parties better off under an alternative arrangement. Conversations with your business advisors about such a crucial decision will help you uncover answers to questions you may not have even known to ask.