[Question] A Couple of CC Questions Relating to Profit Sharing and Expenses

[rfnel]

Good Morning Everyone

To cut a long story short, a friend of mine recently approached me with an offer of partnership in his company (a CC). He approached me primarily because my skillset will prove beneficial to his company. He's been in business (alone) for around three years, and he's never employed anyone.

The vast majority of his work is done for a single client who pays him on a monthly basis. Through my involvement in the company, we hope to expand the customer-base.

The tricky bit comes into play with profit sharing and ownership of the company. Neither of us wants to bamboozle the other and we want our agreement to be fair for both parties. With regards to profit sharing, we've discussed an arrangement whereby whoever brings a contract, automatically gets 20% of the revenue from the contract while the other partner gets 10%. The remaining 70% is allocated based on the hours spent by each partner. Thus, if he brings in a contract and each of us does an equal amount of work, he gets 55% and I get 45%. Based on a discussion with his accountants, it looks like this approach will be viable.

As for ownership, we initially leaned towards 40%/60% in his favour. His accountants, however, advised him to reduce the size of my share to something like 30%, just in case I try to assimilate the company. I've thought about it, and I'm concerned about investing a lot of time and effort in a company which I don't even own a third of. In the long run, if the company does well, I think 30% would be an unfair divide if we both put in equal amounts of time and effort.

One of our other concerns relates to running expenses - how should money be allocated to expenses? Using the 30%/70% example, if one partner owns 30% and the other owns 70% of the company, should 30% of running expenses be paid from one partner's share of revenue and 70% from the other? Since it's an IT company and both of us work from home, we'd like the company to pay our monthly ADSL fees. However, since we're with different ISP's and our monthly ADSL fees differ, it isn't as simple as a 30%/70% split on the total ADSL fees paid by the company.

Apart from what I've mentioned, what else should we think about?

Cheers,
Riaan

[Mark Atkinson]

Hi Riaan,

First off, please bear in mind that a CC is different to a partnership in that it's a separate legal entity.

Regarding membership of a CC: I believe that if a member joins a CC after incorporation, that member is liable for a contribution in cash/assets. The contribution you make is usually proportionate to the share of the CC which you will acquire. Often the contribution is made in the form of a loan account to the CC - but either way, you are going to be paying money into the business. So you need to come to an agreement with the existing member as to what your contribution is going to be and what share of the CC you're going to acquire.

If you don't make a contribution to the CC, you can't be a member and you are then just an employee of the business.

Essentially you can come to whichever agreement you wish regarding share of revenue because the CC (remember, separate legal entity) pays you a salary/wages as determined by the members of the CC. Think of it as working for an employer and he pays you each month. Different to a partnership, where all the profits of the business are assumed by the partners in their personal capacities.

Expenses are much the same. They need to be paid by the CC first and foremost. I suggest you figure out a method of remuneration that is based on the profit of the CC as opposed to the revenue. Or perhaps a set rate per hour worked and a commission for bringing in the actual sale. You need to think of your salaries as just another expense to the business.

Whichever way you end up doing, I strongly suggest you put everything in writing, thinking of every possible little detail which could go into the agreement. It also seems to me that the situation is rather informal right now - which is okay when you only have one member. My suggestion is that both of you work at constructing a slightly more formal framework to the business as you start to grow and do things involving more than one member.

Hope that helps.

[Justloadit]

Do remember, your friend has 3 years of his life in the CC, and has built it to where it is now viable to bring a partner in, so what is his contribution worth in your grand scheme of things?

Basically he has laid the foundation, where the next step of expansion is so much easier than starting from scratch. Sometimes we forget these things especially when we think that we are now going to make this into a muti-national corporation.

One way I use of making a fair decision, is putting yourself in his shoes, and making the deal from his stand point as yourself, what would you be willing to give?

Once you have past this hurdle the final decision is easier to come to.

[rfnel]

@Mark
Thanks for your response. Thus far, he's been handling the legal rigmarole of bringing me in as a partner. From what I understand, it's possible to bring a partner into a CC with their skills/expertise as a contribution. That's the angle that he's been working from.

I'm still coming to grips with the terminology of it all, so feel free to correct me when I get it wrong. As long as everything is factored into the equation when it comes to remuneration, that's fine by me. In the same vein as the ADSL example, if the member remuneration is based strictly on profit after expenses - say each member of a CC gets a company car. Member A gets a Jaguar at R10 000 p/m, while member B gets a Tata at R1 000 p/m. If the CC makes R20 000 p/m of which R5000 is profit (after company cars and other expenses), it wouldn't be entirely fair for member A to get a R3500 salary while member B gets R1500.

We are in the process of putting together a formal document, and we're trying to determine exactly what should go into it, hence this thread.

@Justloadit
You make a valid point. I've been meaning to start my own company (in the same industry) for quite some time (I already had the business plan drawn up last year), but my situation with my employer prevented me from getting it off the ground. Since I already had a bunch of plans and products lined up, I'd like to bring them to life through my friend's company - however, I don't want that to mean that I own less than 50% of my own ideas. This is one of the things that I am particularly concerned about. Because I have a lot to contribute, I saw this almost as a merger between my (conceptual) company and his company.

Your post has prompted me to start thinking in another direction - instead of him practically giving a part of his company away, perhaps we should look at registering a new company (not a CC), in which I can have a 50% stake and his CC can have a 50% stake. This should be a win/win situation. Any thoughts on this?

[Mark Atkinson]

As far as I know (just spent an entire semester on the Close Corporations and Companies acts) skills/expertise can only be counted as a contribution on the incorporation of a CC. Any members being introduced after incorporation either need to make a contribution or buy another member's interest (or portion thereof).

Perhaps the solution would be to set a salary for each member and then deduct whatever expenses the CC is paying for from that salary. Just be careful with personal expenses - the tax man might not be too impressed!

Your suggestion of incorporating a new company is a possibility. You will, however, be making extra admin work and expenditure for your business venture by doing this. Also, his CC isn't really going to grow by doing that. As Justloadit mentioned, this guy has spent 3 years working on his business, and you probably can't expect him to give a lot of that up easily.

[BusFact]

Perhaps a way of looking at the ownership angle is to consider the following:

Percentage ownership is determined by what you put into the company in terms of money, knowledge, assets, connections, etc at the formation of the company or in your case when you join / merge.

Separate this from how much work will be done once the company starts trading. This work must be rewarded by salaries, bonuses, fees, dividends, etc.

I think what Mark is trying to get at is that when you buy your share in his cc, there will have to be a value put to this. Yes you are bringing skills, but you need to put a value on that. You can determine that by estimating how much extra money your skills will earn the company compared to what its already earning. That money should then be paid over to your partner even if its from your future earnings, i.e. by loan account.

What is the current value of his CC? That will aslo be crucial in determining what percentage you should get and for how much. Often companies have relatively low values if you exclude future profit potential, unless they have bought property, equipment and other similar quantifiable assets.

I feel that ultimately too much value is put on the percentage shareholding in small companies. Unless the company is reinvesting large portions of its profit back into itself and buying assets or issueing serious dividends then percentage shareholding only holds weight is board meeting resolutions, and lets face it, thats way too formal for most of us small blokes anyway. Most of our business decisions are by mutual consent. The shareholding will only be used to break dead locks, and then whether you have 49,9% or 1%, the result will be the same.

To minimise the shareholder effect, simply agree that all "profits" are distributed as bonuses on the basis you mentioned above (as per work brought in and done). This leaves nothing to reinvest in the company or be declared as dividends which would be biased against the minority shareholder. If the company needs cash or to expand, the sharehodlers can loan it money in a separate agreement.

I expect some will disagree and mention the goodwill in the business name. Perhaps. However that takes years to develop and is only applicable for a minority of established businesses. Most of the time the client is doing business with you and couldn't care less about which company you work for.

If the above is a concern, then put together an agreement where you can increase your shareholding if your contribution to the company income reaches certain targets relative to those of your partner. In other words, you deliver on your promises.

[wynn]

Perhaps you should also consider starting a new cc (pty ltd) because you may be putting your head into a noose you cannot see, he may have history you have no idea about.

[rfnel]

As far as I know (just spent an entire semester on the Close Corporations and Companies acts) skills/expertise can only be counted as a contribution on the incorporation of a CC. Any members being introduced after incorporation either need to make a contribution or buy another member's interest (or portion thereof).

Mark, off the top of your head, can you think of somewhere where I can find a proper explanation of the procedure for joining an existing CC? I scanned over the CC section on the CIPC site, but I couldn't find exactly what I was looking for.

...the tax man might not be too impressed!

What?! I though he was a nice guy!

Your suggestion of incorporating a new company is a possibility. You will, however, be making extra admin work and expenditure for your business venture by doing this. Also, his CC isn't really going to grow by doing that. As Justloadit mentioned, this guy has spent 3 years working on his business, and you probably can't expect him to give a lot of that up easily.

The more I think about it, the more I like the idea of starting a new company. At the moment, the CC works almost exclusively for a single customer (in fact, it was pretty much started just for this particular customer), it has minimal assets (basically just computers) and it doesn't have any brand identity (no logo, no website, no advertising, etc). It's also starting to sound like a new company will be less of a schlep.

@Busfact
I'm not sure what the current value of the CC is. What exactly determines the value of a company (apart from property and equipment)?

If the above is a concern, then put together an agreement where you can increase your shareholding if your contribution to the company income reaches certain targets relative to those of your partner. In other words, you deliver on your promises.

I've thought about the same thing. My concern lies with the intellectual property; if the CC only provided a service, I don't think the shareholder effect would've mattered that much. If the minority shareholder comes up with a brilliant new product or idea, wouldn't the majority shareholder be fully within his rights to sell the rights to the product or idea, regardless of what the minority shareholder has to say about it? Not that I don't trust my partner - I have a lot of confidence in him, but I like to make sure that all angles are covered, always.

@Wynn
I've known him for many years, and since he's been working exclusively for a single customer, so I'm confident that there are no skeletons in the closet.

[mother]

Riaan, mine is less of an academic approach, and rather an opinion based on life-experience:

"If you did not conceive this child together, don't try and raise it together!" The real dad will always have a deeper connection with the child, than the stepdad. (Btw, I like metaphors. )

So, if I were you, I'd start my own business. You said you've already got great ideas, and that you would hate to share the credit for those ideas with someone else - so then don't.

[rfnel]

Riaan, mine is less of an academic approach, and rather an opinion based on life-experience:

"If you did not conceive this child together, don't try and raise it together!" The real dad will always have a deeper connection with the child, than the stepdad. (Btw, I like metaphors. )

So, if I were you, I'd start my own business. You said you've already got great ideas, and that you would hate to share the credit for those ideas with someone else - so then don't.

I've spent a lot of time in the past pondering about doing my own thing completely. However, during the past month or two of working with my friend on an informal basis, I've realised that we work together well and that our skills complement each other. Perhaps I could make it on my own, but two heads are better than one, and by combining our efforts we can accomplish much more than either of us could do alone. As John Maxwell put it, "one is too small a number to achieve greatness".

I'm keen on the partnership thing, as long we can iron out all the kinks in the cable. I spoke to him briefly this afternoon, and he understands my concerns with regards to intellectual property. What concerns him most about starting a new company altogether is the fact that he'll have to bear the costs (partially) of running two companies.

[sterne.law@gmail.com]

In terms of entering into a cc. Most cc are registered with the shareholding as R100, hence you can alter it t 70/30 with a payment of R30.
Then accounting can make the neccessary alterations in terms of loan accounts and such.

[BusFact]

I've spent a lot of time in the past pondering about doing my own thing completely. However, during the past month or two of working with my friend on an informal basis, I've realised that we work together well and that our skills complement each other. Perhaps I could make it on my own, but two heads are better than one, and by combining our efforts we can accomplish much more than either of us could do alone. As John Maxwell put it, "one is too small a number to achieve greatness".

I'm keen on the partnership thing, as long we can iron out all the kinks in the cable. I spoke to him briefly this afternoon, and he understands my concerns with regards to intellectual property. What concerns him most about starting a new company altogether is the fact that he'll have to bear the costs (partially) of running two companies.

Is there not a way of you starting your own company without him and then you sub contract some work to him and he some to you? This way you get to work together without being tied into complicated arrangements. You can keep the same revenue streams, i.e. you invoice your customers and pay him 45% of the fee and he invoices his customers and pays you 45% of those fees.

[rfnel]

In terms of entering into a cc. Most cc are registered with the shareholding as R100, hence you can alter it t 70/30 with a payment of R30.
Then accounting can make the neccessary alterations in terms of loan accounts and such.

We saw the accountants over the weekend, and you were spot-on on the shareholding being R100.

[rfnel]

Is there not a way of you starting your own company without him and then you sub contract some work to him and he some to you? This way you get to work together without being tied into complicated arrangements. You can keep the same revenue streams, i.e. you invoice your customers and pay him 45% of the fee and he invoices his customers and pays you 45% of those fees.

We've come to an agreement. For the time being, I get 40% of the CC. We've left the possibility open to either convert the CC to a private company or to register a brand new company when we experience significant growth and start acquiring assets. At that stage we can go for a 50/50 split. Until then, we'll pay ourselves from the CC based on who was responsible for getting a contract and the amount of work done by each of us.

Thanks for your inputs everyone!

[Blurock]

....working with my friend on an informal basis

Riaan, do make sure that you also cover the expectations and duties of the shareholders. Do you have a shareholders agreement or buy and sell agreement?

The surest way to ruin a friendship (and the business) is to assume that the other guy will do as much as you, or vice versa. Make sure that you have clear objectives and duties and that all of that is covered in a document.

Good luck with your venture!