How to Expand Your Business with Partners and Investors

Done right, establishing a relationship with partners or investors can enrich your company with material resources and talented, effective human capital. Make the wrong choices, however, and the problems that result could be serious, even fatal, for your company.

WHAT TO EXPECT

No business remains static. Your market changes, competitors enter and leave the scene, new opportunities and challenges crop up. As your company grows and your market share increases, your company — and your business plan — must adapt. You need to plan and implement a strategy for growth. A well-honed plan will equip you to move ahead of your competition, and will also make sure your business is able to survive the inevitable tough times almost all companies face.

This document is intended to help you think through a critical part of the process of developing strategies for growing your company: how to expand your company by taking in partners or investors. As you will see, taking this step involves important issues of business strategy, finance and human relations. Done right, it can enrich your company with material resources and talented, effective human capital. Make the wrong choices, however, and the problems that result could be serious, even fatal, for your company.

BEFORE WE START

Because every company is different, the information on these pages cannot address all the issues and questions that may be appropriate to your circumstances. We can only present general information which you should regard as a starting point for your own thinking, and for conversations with your accountant, attorney, banker and other trusted business advisors. This document is designed for the entrepreneur who has succeeded in starting a business, has a viable product in a viable market, and has a business plan. (If you don't have a business plan, you should develop one.)

The Key Question

Let's get started with the key question: What are the objectives you hope to achieve by bringing partners and investors into your company?

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PROCESS FOR EXPANDING THROUGH PARTNERS AND INVESTORS

Define Your Needs

It is critical for you to develop a clear understanding of why you are thinking about bringing partners or investors into your company. Do you need money, or is something else lacking in your organization? You can raise money in ways other than bringing in a partner — through loans or selling equity in the business, for example. Partners can bring something other than money — new talents or productive capability.

Borrowing money can be costly, and selling equity involves some impact on your autonomy as the owner of your company. But bringing in a partner or partners will inevitably change the way you run your company. So there are costs — in dollars and in terms of the way you run your business — to any option.

If you first clarify your reasons for thinking about seeking investors or partners, you'll be far better equipped to manage the rest of the process.

Determine which of the following best describes your needs.

• * You need partners to:
• 
  
  • - Bring new, special skills (e.g., technical, marketing or financial) to the business
  • - Add new products, patents, property or production capability to the business
  • - Provide new capital to the business
  • 
    
• * You need money to:
• 
  
  • - Develop a new product line
  • - Increase your marketing
  • - Expand your facilities, equipment or inventory
  • - Hire additional employees
  • - Offer credit to your customers
  • - Other
  • 
    

Your Willingness to Accept a Partner

Entrepreneurs tend to be fairly self-reliant people. After all, they have the confidence to face the risks of starting up and managing a business. The motivation and self-reliance that enabled you to create a business can pose a problem when it comes to your ability to accept a partner, however. When you work with a partner, rather than as a sole owner, you will have to be able to accept losing some of the autonomy you now have. On the other hand, with a partner you will have someone to share ideas with and divide the day-to-day responsibilities, and ideally someone whose skills and interests complement yours, strengthening the company. Think long and hard about how ready you are in emotional terms to accept a partner.

What to Look for in a Partner

If you believe that you can work well with the right partner, the next step is to identify the qualities your partner should possess. You should be able to answer yes to the following questions.

• * Do you know your potential partner well?
• * Do you and he or she have experience working together?
• * If so, do you have a good fit of abilities?
• * Do you have confidence in your potential partner's abilities?
• * Do you and your potential partner communicate well?
• * Do your working styles complement each other?
• * Do you see a partnership as a positive step?

If you find the right potential partner, you will have to draw up a Partnership Agreement, as discussed below. This includes provisions which recognize that even a well-planned partnership may not work out — in effect, a sort of prenuptial agreement for the partnership. But even with a well-written agreement, dissolving a partnership can damage a business, so proceed with care.

Is Partnership Right for You?

There are advantages and disadvantages to each of the major forms of business structures: sole proprietorship, corporation, partnership and limited liability company. Another Business Builders document in this series, entitled How to Determine the Legal Structure of Your Business, covers these issues in detail. It analyzes these business structures in terms of: simplicity of operation and formation; liability for debts, taxes and other claims; federal income taxation of profits; deduction of losses by owners; and taxation of income received on investment.

Following is an abbreviated summary of this information, intended to give you an overview of the advantages and disadvantages of different business structures in terms of expansion. Reviewing this information may help you determine whether partnership is the right business structure for expanding your business. If you decide that it is, you will be ready to write your partnership agreement. If not, you can move on to other expansion strategies.

Sole Proprietorship — A business owned and operated by one person.

• * Advantages for expanding a business:
  • - The owner makes all decisions.
  • 
    

• * Disadvantages for expanding a business:
  • - The business is limited by the resources of the owner.
  • - Obtaining financing is more difficult than with other forms of business.
  • - The owner has personal liability for debts, taxes and other claims. Creditors can go after your personal holdings.
  • 
    
• * General Partnership — an association of two or more people who are co-owners of a business for profit.
• * Advantages for expanding a business:
  • - Multiple owners make it easier to borrow than sole proprietorship; a combined credit rating is likely to be stronger.
  • - The partners share responsibilities.
  • 
    
• * Disadvantages for expanding a business:
  
  • - Partners have personal liability for debts, taxes and other claims against the partnership; creditors can go after their personal holdings.
  • - Each partner is liable for the debts of any other partner.
  • - Any partner can commit the business to obligations.
  • - There is potential for disagreement and/or power struggles.
  • 
    

Limited Partnership — An arrangement where an investor's liability is limited to the amount of the investment. (There must be at least one general partner with full legal and financial responsibility; this would almost certainly be you, the entrepreneur.)

• * Advantages for expanding a business:
  • - You can raise money without losing control of decision making; limited partners cannot manage the business.
  • - You can tie repayment of investment to business profits, not interest rates.
  • 
    
• * Disadvantages for expanding a business:
  • - As the general partner, you have personal liability for debts, taxes and other claims against the partnership. Creditors can go after your personal holdings.
  • - Corporation — A distinct legal entity, separate from its owners. The owner's personal, non-business assets are protected from the debts of the corporation.
  • 
    
• * Advantages for expanding a business:
  • - It is easier to raise capital in larger amounts and from many investors through stock offerings.
  • - The owner's personal, non-business assets are protected from the debts of the corporation.
  • - Shareholders are only liable for they amount paid for their share of stock.
  • - There is transferability of interest.
  • 
    
• * Disadvantages for expanding a business:
  
  • - Power is limited by the charter and various laws. The charter dictates all decisions and activities of the business.
  • - Legal rules are stricter and more complex.
  • - Operating as a corporation is costlier and requires more documentation.
  • - There is double federal income taxation; the corporation is taxed on its earnings and then shareholders' profits are taxed as personal income.
  • 
    

S Corporation — Attributes of both corporation and partnership. It provides the same limited liability as the corporation. But like a partnership, an S corporation does not pay corporate taxes; profits pass directly to the owners, who are taxed at their individual rates.�

• * Advantages for expanding a business:
  
  • - An S corporation is treated for income tax purposes as if it were a partnership, while retaining corporate advantage of limited liability for shareholders.
  • - In situations where the corporation is expected to lose money in the initial year(s) of doing business, the shareholders can use these losses to shelter other sources of income.
  • 
    
• * Disadvantages for expanding a business:
  
  • - Shareholders are taxed on the S corporation's profits, even if this income is not actually distributed as cash. For this reason the S Corporation is not a good choice of business structure if the cash flow of the business is uneven or uncertain.
  • - Retirement and fringe benefits paid to shareholders are not deductible expenses.
  • 
    

Limited Liability Company (LLC) — Similar to and taxed like a partnership.

• 
  
• * Advantages for expanding a business:
  
  • - Treated for income tax purposes as if it were a partnership, while retaining corporate advantage of limited liability for shareholders.
  • 
    
• * Disadvantages for expanding a business:
  
  • - Not all states have adopted a limited liability company law. If you set an LLC in one state which allows LLCs and you do business in another state which does not, your LLC may not provide any limited liability from creditors in that state.
  • 
    

A Partnership Agreement

The best way to prevent misunderstandings and failure in a partnership is to write a partnership agreement. It is a tool that aims to protect your business from the adverse effects of future changes. You should have a lawyer experienced in this area of business law help draft your agreement, or at the very least review it after you have negotiated the terms.

Here is a checklist of items your partnership agreement should cover:

• * The name of your business.
• * The type of business and purpose(s) of the partnership.
• * The duration of the partnership. For example, this can be for a specific period of time, or it could be until the withdrawal, death or dissolution of a partner.
• * List the amount invested by each partner. Contributions may be in the form of cash, property, services, or intellectual property. Partners do not have to make equal contributions. Contributions can be made simultaneously, or one partner's can be deferred.
• * Detail the administrative responsibilities of each partner. Include the hours to be worked, skills to be contributed, vacation, sick leave, etc.
• * Detail the authority of each partner. Voting power may be equal or may be based on the amount of investment or other factors. Include a provision stating how much money each partner can borrow on behalf of the partnership without the approval of other partners.
• * List any restrictions on activities outside of the business. Remember that partners may be involved in other businesses.
• * Detail the division of profit or loss. Regardless of the amount of capital invested, general partners must share profit or loss equally unless otherwise specified in writing. Include a provision for periodic accounting.
• * Detail salaries and other compensation for each partner. Other compensation may include an expense account.
• * Detail how the assets of the company will be distributed in the event the partnership is dissolved. Regardless of the amount of capital invested, general partners must distribute assets equally unless otherwise specified in writing. Be sure to include trade secrets, patents, copyrights, trademarks, customer lists and the business name.
• * List the provisions for dissolution of the partnership. These normally include the death or disability of a partner, but there may be other reasons specific to your business.
• * Include a buy/sell clause and the method that will be used to value the business. This is critical for dealing with an unhappy partner who wants to sell out. It can prohibit the partner from selling his or her interest to a third party. It can also include a "shoot out," in which each partner sets a price at which he will buy another partner's interest or sell his own.
• * List the conditions for the admission of new partners.
• * Include a clause for settling disputes. This can be through arbitration (appointing someone who is given the power to decide a dispute), mediation (involving someone who attempts to facilitate a reconciliation), or both.
• * Specify how changes to the partnership agreement are to be made.
• * Detail provisions for settlement in case of death or disability of a partner. This may be handled through a buy-sell agreement funded by business life insurance.

A Limited Partnership Agreement

A limited partnership enables others to invest in a business without incorporating or selling stock. Limited partners are often friends or relatives. They do not manage the business. They share in the profits of the business, but their risk is limited; if the business fails, the limited partner loses their investment, but nothing more. A limited partnership agreement contains information different from that in a general partnership agreement.

Here is a checklist for a limited partnership agreement:

• * Names of the general partners and the limited partner(s).
• * Purpose of the limited partnership.
• * Duration of the limited partnership.
• * When each limited partner will be provided with the financial report of the business's activities.
• * The method of accounting and other record-keeping.
• * The contributions of the limited partners.
• * Conditions for returns to limited partners.
• * A buy-out clause. This may be the return of the original investment plus an agreed-upon amount of interest. This is very important; if your business booms, the return agreed upon in the original investment may be far greater than the limited partner's original investment justifies.
• * An assignments clause, which controls how your limited partner(s) can sell their interest to another investor. You may restrict the rights of the new limited partner(s) from reviewing your financial information.
• * A clause for settling disputes. This can be through arbitration, mediation, or both.
• * Provisions for dissolution and for events which do not cause dissolution. Examples include the death of a limited partner or the admission of a new limited partner.

The Appropriate Form of Investment

At this point you should have already determined how much money you need to raise and how you need to use it. The next step is to determine the type of money you want to raise.

• * Debt capital
• * Equity capital
• * both

Debt Capital — Money that is loaned to a company; principle and interest must be repaid.

• * Advantages for expanding a business:
  • - You can deduct interest paid as a valid business expense.
  • - Increases the company's financial leverage when earnings generated by the borrowed money exceed the cost of the debt.
  • - As long as you make the loan payments as agreed, you don't relinquish control of the business to investors.

• * Disadvantages for expanding a business:
  • - You are obligated to repay principal along with interest and/or other compensation.
  • - If you are unable to meet the repayment terms, you may be forced to yield temporary control of the business to creditors.
  • 
    

Equity Capital — Money that is invested in the business, with investor acquiring some ownership in the company.

• * Advantages for expanding a business:
  
  • - Equity capital is much safer than debt capital. There is no legal obligation to repay the principal or to pay interest on the principal.
  • 
    
• * Disadvantages for expanding a business:
  
  • - You cannot deduct interest paid.
  • - You may have to relinquish control of the business to investors.

Your Strategy for Attracting Investors

Developing a strategy for attracting investors involves three tasks:

• * Finding potential investors
• * Understanding their objectives
• * Developing your plan for meeting their concerns.

Finding Potential Investors:

There are many potential sources of capital. They include individual and family investors, your suppliers, private and corporate venture capitalists, institutional lenders such as banks, the Small Business Administration and other government funded entities. You should be able to come in contact with potential investors through resources such as your friends, your accountant, your lawyer, investment bankers, trade associates and other business associations.

Understand Your Potential Investors' Objectives:

Private Venture Capitalists — These are usually individuals or privately-owned companies. They are looking for a high return on investment (ROI), access to new technologies or markets, or combining expertise to produce new products. Venture capitalists will want a fast return on their investment and will likely want a strong voice in the management of the business.



Corporate Venture Capitalists — These investors are usually looking to access new technologies. An investment by a venture capital group is often seen as an endorsement of your company's management and future prospects. A VC firm will also help open doors to new business, strategic alliances and corporate partnering, and can help you find high quality directors and others to help your company grow. They have high expectations for growth and performance, and are not reluctant to change the management of one of their portfolio companies if they believe it is necessary.

Institutional Lenders — Besides looking for a return on investment, they are looking to build their clientele. They will invest in small business that will look to them in the future for additional investment. Compared to venture capital firms, institutional investors are willing to accept a slower, steady return on their investment. You likely will have to put up some collateral for the loan.

Small Business Administration — The SBA offers several government-backed programs which make direct loans or guarantee loans from banks or other conventional sources. The SBA may require that you also invest a percentage of equity.

Meeting Your Potential Investors' Expectations:

Once you know what your potential investor is looking for, position your business to meet their expectations. The single most important tool for accomplishing this is your business plan. A well-prepared business plan will show potential investors that you are serious, that you have carefully and thoroughly explored the opportunities and risks in your market, and that you have strategies in place to respond to them. If you don't have a business plan, refer to the Business Builder entitled How to Develop and Use a Business Plan.

Negotiate Your Terms

When you are negotiating the terms of an equity capital investment, the points you should consider are essentially the same as those outlined above in the checklist for a limited partnership agreement.

If you decide to seek debt capital, your lender will probably have a prepared list of requirements. These are primarily aimed at ensuring repayment. But these requirements may be negotiable. Items you should focus on include:

• * Length of the loan term and the schedule for repayment
• * Interest rate and other charges
• * Provisions for maintaining working capital
• * Restrictions on the payment of salaries or distribution of earnings during the life of the loan
• * Restrictions on other borrowing during the life of the loan
• * Description of assets used as collateral for the loan

REVIEW

When you have completed the steps outlined in the previous pages, you should have a general understanding of the following key elements:

• * The expansion needs of your business
• * Your willingness to take on partners
• * Your preferred business structure
• * Writing a general partnership or limited partnership agreement
• * The appropriate form of investment for your business
• * Your strategy for attracting investors and lenders
• * Terms to negotiate with investors and lenders

RESOURCES

The Partnership Book: How to Write a Partnership Agreement, 6th ed. by Denis Clifford and Ralph Warner. (Nolo Press, 2001).

Partnerships Step-By-Step by David Minars. (Barron's Educational Series, 1997).

Let's Go Into Business Together; 8 Secrets to Successful Business Partnering by Azriela L. Jaffe and Tony Alessandra. (Avon Books, 1998).

The Small Business Partnership Kit by Robert L. Davidson III. (John Wiley & Sons, 1992).

How to Form Your Own Partnership: With Forms by Edward A. Haman. (Sourcebooks Incorporated, 1998).

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This In-Depth Business Builder was originally published in 2000.