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Buying a Business Part I – ALWAYS have a Formal Partnership Agreement

By SueCanyon | August 24, 2007

One of my long-time clients sold one of his businesses last year to two gentlemen; one, a family member who was to run the operation side, and the other, a fellow who was very capable of running the business side.

Yet, even though I fairly insisted that they work out a partnership agreement between them, they came to sign the deal without one. That day, they were so anxious to get the purchase agreements signed that they were not to be stopped, so I knew that the day was not to be celebrated as an end to a long process of negotiation, but rather would be the beginning of a long and painful process of arguments and legal fees for both the partners and the seller of the business. And so it has been…

Rarely have I seen partnerships work at all. There have been cases, yes, but I must say that by the time the partners have invited me in, only about five percent of the partnerships were ultimately salvageable. By that time, the disagreements were too great and the hurt too deep to repair.

What partners often fail to realize is that they are, in effect, getting married to each other. Let’s explore this analogy a bit further. People who wish to get married do so after a long courtship and much discussion about all the facets of carrying on as one. Before they actually step in front of the pulpit, they have fretted over it, tried to think of every aspect that might go right or wrong, discussed money, logistics, home styles, children… everything. Yet, people often jump into business partnerships with reckless abandon.

Out of all the factors that apply to a marriage, the two that tend to contribute to divorce statistics more often than others are disagreements about money and jealousy. If we boil down the reasons that most people go into business, the two that top the list are money and power. And what two factors are most apt to contribute to jealousy? Money and power.

So, as it turns out, the most difficult aspects of marriage turn out to be the driving forces behind business, and the other, positive aspects about a marriage, don’t even apply to the business. So one would think that going into a business relationship should be thought about even more thoroughly than if one were thinking about marriage.

Many prospective marriage mates have adopted the concept of a prenuptial agreement to protect assets or attempt to influence behavior. In the case of a business partnership I’m going to go one step further and suggest that you need to work out your divorce decree.

The divorce decree should include fairly detailed job descriptions*… what each of you are expected to do, including measures of performance, and what each party is responsible for in the partnership. All too often, each partner believes they are responsible for the same things, like handling the money, and that will not only cause conflict, but it will open the door for something else very important to be left undone.

For instance, each partner often has a picture in mind as to how the business should be run. One partner may feel he can run the office and feels that the other can run the operation. The other partner may have an identical picture in his mind. He may feel that HE can run the business while the OTHER runs the operation. They go into business and each partner tries to run the business end while the operation crumbles for lack of attention. The business dies, as does the once strong friendship. Who is to blame?

On the other hand, let’s say that both partners agree that one will run the business while the other runs the operation. This happens often because one of the partners doesn’t want anything to do with the numbers end of the business. In this case, without performance measures and a strong reporting mechanism, the opportunity for theft and cost overruns is great.

For instance, while the operations partner is happily delivering product to customers, the partner who runs the business is buying expensive furniture for the office, taking customers to expensive lunches and golfing… generally doing what he believes a president ought to be doing. Soon, vendors aren’t getting paid, so the operation begins to falter. The business manager blames the operations manager for not producing enough, and the operations manager blames the business manager for spending too much money unnecessarily.

On the other hand, the business manager could be very tight with money while the operations manager runs an inefficient operation and begins to blame the business manager for mis-handling the money because he believes that the operation is running just as it should be. Without performance measures and a strong reporting mechanism, this partnership will crumble as well.

Reporting Mechanism

I’m assuming that you have a good bookkeeper posting your accounting. I’m also going to assume that you have some sort of job or product costing in place for your business. Without these in place, I’m going to suggest that your failure as a partnership and as a business is sealed, regardless of your partnership agreement.

The bookkeeper should have the month-end figures completed by the second week of the month. You and your staff should have a week or so to review the results of the indices for which each person is responsible. For instance, operations should be able to review all of the cost of goods sold figures, compare them to budget, look at the details of figures that have significant variances, and discover the reason for the over or under-runs.

Then, the following week, you attend a formal meeting with all department heads who are responsible for costs. Each department head stands up and presents his numbers to the group. He explains the reason for under or over-runs, what will be done about them, and predicts where his figures may hit in the following month, since the following month is now probably finished.

This creates an amazing focus on the score, without which you will not survive with your hair color in tact. It keeps all parties honest, and promotes team work rather than suspicion and jealousy.

Measures of Performance

Once you understand the reporting mechanisms that you want to put into place, it is easy to include measures of performance on your job descriptions. For the operations manager, some performance measures might be to ship enough product to meet the budget sales figures and do it at the cost of goods sold suggested in the budget. If your budget is flawed, the reporting mechanism will bring that to light in no time, allowing for the budget to be updated. On the other hand, if the budget is correct and inefficiencies are highlighted, then there will be pressure to get costs under control.

Similarly, the business manager may have measures that include Average Days Receivable and Payable*. If the company begins to run out of cash, it could be that decisions made by the business manager could be damaging the company’s ability to pay its bills.

For instance, if the business manager does not like to collect receivables, the business will begin to falter because small customers tend to pay only those vendors who actively collect. If the performance measure suggests an ADR of 50 or less, he will be encouraged to find a way to keep it in line, and therefore keep the cash of the business at a high level.

Why would he be so encouraged? I ask you, “Why do people stop at stop lights?” Most people answer me that it’s because, if you don’t, you’ll get a ticket, to which I reply, “Do you ever speed?” Most people answer “Yes.” “Will you get a ticket if you speed?” “Yes.” So that invalidates the ‘ticket’ answer as to why folks don’t run red lights. So, again, “Why do people stop at stop lights?”

Because the consequences are that they might die.

Consequences

In your partnership agreement, or divorce decree as it were, you must define what happens if each partner does NOT perform as you both expect. The performance measures must be reasonable, and the consequences clear.

For instance, if the business manager does not like to collect and therefore won’t do it, then the business is in danger. He must be encouraged, by the threat of consequences, to ‘manage’ his weakness by, perhaps, hiring a bookkeeper who loves to collect. The operations manager whose materials costs are running out of control may be encouraged to hire an aggressive purchasing assistant to help bring down those costs. Or he may want to bring in some outside help for a short time to help improve efficiencies on the production line to bring down the cost of materials.

The point is that without consequences, there may be no incentive to ‘color within the lines’. Overhead costs can be handled the same way. Spending on entertainment that, in the opinion of one partner, is excessive, will also show up in the reporting mechanism, and the consequences spelled out in the partnership agreement will encourage the business manager to control his spending.

So, the partnership agreement must define the expectations and what will happen if each partner does not perform as expected. How does one partner get out of the agreement if the other is not performing? How does one partner relieve the other of his job? Does relieving one partner of his job allow for him to keep his shares? How will he be paid for his shares should he be relieved of his job and want to sell his shares? Can he keep his shares? Can he sell his shares to someone else?

This list may sound a little morbid, as most prospective partners I know tell me that they will “never have any disagreements like that”. But the fact is that things will change, and I guarantee you that you will have disagreements. The proof? People who get married tend to do so because they think they will be able to last forever… today. But folks get divorced at an alarming rate in this country… and the rate of small business bankruptcy filings is much higher.

So, take at least a couple of weeks and think of all the things that might go wrong, and what you might or might not be willing to accept if they do. Then sit down with separate attorneys… SEPARATE attorneys… and write up the partnership agreement before you ever begin the process of buying or starting a business. Your business, your partner, and your families will thank you.

So What Happened to the clients I mentioned at the beginning?

This is an example of everything that could go wrong ─ did. The partners used a single attorney to negotiate the purchase. That means that neither partner could use that attorney when the breakup occurred. So, new attorneys who were not party to the original negotiations had to be brought up to speed to defend their respective parties.

The client who sold the business used an attorney who could not defend him in the state in which the purchase occurred, so he too had to hire and bring up to speed a new attorney.

The business manager fired the operations manager for failure to perform his duties. In this case, there were job descriptions, but because there was no partnership agreement, the operations manager didn’t feel that the job description he was given was what he needed to do. Therefore, the other partner, who needed that job done, fired him.

The operations manager then sued his partner and the corporation. Now they won’t, and can’t, speak to each other. Because there is a suit against the company, the business manager wasn’t able to get the loan to pay off the balloon payment that was due the seller. So the company went into default of the loan, and the business manager has been unable to find a suitable replacement to run the operations side.

The former owner has sufficient fears about the ability of the operation to continue to produce at a rate which will allow for payment of the purchase note, and with the company in default, he took it back and had to begin the sales process all over again. For lack of a partnership agreement, we are back to square one.

Forty-five employees are concerned, and rightly so, about whether their jobs are secure since the former owner has taken it back and operation continues to run without a manager.

Don’t make the same mistake. Always have a partnership agreement, and in it, focus on what can go wrong, not just how you will behave if everything goes as you expect, because I guarantee that it won’t.

*Explanations and examples of Average Days Receivable and Payable, and my unusual job description format can be found in the Profit Power Action Pack lessons.

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