Some of the most common questions I receive from the SPI audience are about the legal aspect of starting a business. Although I've had my fair share of legal-related experiences (both positive and negative) since starting my business, I also know that I don't know everything and need someone in my corner who does.
That's why I've been working with Richard A. Chapo from SoCalInternetLawyer.com for almost ten years now. He's my attorney, and he's here to help all of us understand the bits and pieces of legal information we might need to know to protect our online businesses.
Richard was featured in Smart Income Podcast Session 231 where he and my trademark attorney, Alena Herranen, tackled the most common legal questions for those just starting out in business. Richard is back today to tackle the important decision of starting a business with a partner, and all that should be considered. It's an important topic a lot of people like to stay away from, because it involves a lot of hard decisions that all those who start a business have to figure out.
Richard will likely be back in the future to tackle other specific topics related to the legal aspect of business, but for now, here he is talking about starting a partnership. Take it away, Richard!
No formula guarantees business success. If one existed, you can bet we would all be following it. Instead, your goal when starting a business is to create as fertile a field as possible for company growth. Gathering a talented collection of partners to run the business is a time-tested strategy for priming the pump. One problem exists. How exactly does one distinguish between individuals who can take a company to the next level and those who will be anchors? Picking partners is very much an art, but following the Dos and Don’ts can improve your chances of success significantly.
Plenty of information exists online regarding the business partner selection process. My intention is to provide something a bit different today. The following tips will be based not on general concepts of “missions” and “ecosystems.” Rather, the focus will be on what I’ve observed and experienced in twenty-five years as a business attorney. I’ll even present examples where clients have consented to show how certain situations might play out. No, the stories do not involve Pat.
For clarification purposes, I’ll refer to individuals taking an ownership position in a business as “partners” and the business as a “partnership” regardless of the type of business entity selected by the founders (e.g. corporation and limited liability company).
Entering into a business partnership is the equivalent of getting married. It is not uncommon to spend more waking hours with a business partner than with a spouse. I’m going to assume that you would find the notion of walking into a bar and marrying the first person you see as laughable. Unfortunately, many partnerships are formed in this manner. Picking partners on a wing and prayer is asking for trouble. Following a process gives you a much better chance of identifying reliable and competent talent.
Here are the Dos of finding business partners.
1. Do Match
Entrepreneurs launch businesses for a variety of reasons: Passion, financial independence, to fulfill a dream. In twenty-five years of practicing law, I’ve yet to meet a single person who launched a business because they hoped to be miserable. Yet, a life of misery is a definite possibility when forming a partnership with an individual who has a personality that grates on you like fingernails on a chalkboard.
Take a moment to reflect on romantic relationships you’ve experienced in life. The reasons those relationships might have failed are likely not akin to the dramatic soap opera betrayal (“You slept with my twin I didn’t know I had while I was in a coma after finding out your uncle is my father’s mother!). No, most relationships unwind because of small personality conflicts. He might be pretentious. She might always be late. He might be unduly sensitive. She might be offensive at parties.
Personality conflicts kill business partnerships at roughly the same rate as romances. The corporate buzzword often used is values, but what does this term really mean when considering potential candidates? As the original founder, you are looking for partners who share your position on taking risk, employee relations, and crisis management, among other areas. The optimal method for evaluating the values of another person is to ask questions that produce indirect evidence of those values. While there are serious legal limits regarding questions you can ask an employee, few limits exist when considering a co-founder who is not your employee. Questions could include:
- What interests you about this business idea?
- Have you ever failed at anything?
- A company programmer publishes pictures on their Instagram account where they are clearly drunk. Fire them, warn them, or none of our business?
- What are your expectations regarding the time commitment for this business?
- Is there anything about your family life that could impact the time commitment?
- How do you foresee the decision-making process working out?
- Should employees be given equity or not?
- We don't have the cash flow to pay the employees one month. Do we dip into personal savings, tell the employees there will be a delay, or . . . ?
- What does this business look like in one year?
- You learn the spouse of a good friend is cheating. Tell the friend or not?
- What does this business look like in five years?
- Legal counsel indicates we are conducting business in a gray area. Proceed or not?
- Should we be aggressive or conservative with the company tax returns?
- What are your expectations of me?
- At the company holiday party, an employee throws a pie in your face in good humor. Fire them, laugh and take pictures, or . . . ?
- What do you expect your role to be in five years?
- Should the company contribute to political causes and, if so, what types?
Engaging with the person in as relaxed an environment as possible is likely to produce more insightful answers. Being questioned in an office screams “job interview,” and puts the candidate on the defensive. Being asked the same questions at happy hour or a casual dinner as part of a general conversation tends to mitigate any defensive mental posture.
I once worked with an angel investor who wouldn’t put a penny into a business unless the founders had enjoyed dinner with him at Morton’s Steakhouse where a belly full of wine and steak tended to loosen the lips. You could do worse than take such an approach.
2. Do Look for Complementary Skills
A person should only be added to a partnership if they bring one of two things: a complementary skill or capital.
Capital no doubt peaked your curiosity, so let’s get it out of the way first. If Elon Musk emerges from the VIP room of the local club on a Friday night, chats you up, and offers to invest fifty million in your scrapbook-for-blind-elephants startup, write out the deal on a bar napkin and have him sign it then and there.
As you can imagine, the “randomly meeting super successful business leader at clubs” partner generation business model is not often successful. Finding a partner with complementary skills is a more realistic scenario. Consider an online partnership you are likely already familiar with: affiliate programs. One partner provides a product or service. The other provides traffic. If both partners just provide products, sales are going to be a bit slow.
There are exceptions to this rule, with Google being an example. Larry Page and Sergey Brin were both computer scientists at Stanford when they created BackRub, which later became Google. The gentlemen seem to be doing okay.
Still, failure is the more likely result. For example, I once was approached by a corporate client that comprised three founders, all of whom were programmers. The gentlemen had launched a company providing marketing and programming services. The programming side of the business was doing rather well, which made up-selling the marketing services a breeze. Any goodwill established with the programming services was quickly squandered when it became apparent the marketing department was borderline incompetent. The company ultimately failed. The outcome likely would have been different if one of the partners was a qualified marketing professional.
While there are exceptions to every rule, try to find partners who complement the skill sets of the founders already in the business.
3. Do Have an Exit Strategy
When considering partners, make sure the person understands your exit strategy and agrees to it. No exceptions. An exit strategy is a plan the partners settle on for cashing out of the business. The three options are to sell the business to a third party (e.g. Amazon purchases Zappos), take the company public (e.g. Facebook), or pass ownership to younger family members in exchange for a significant buyout.
Settling on an exit strategy is critical because that decision shapes all other important decisions for the business. Let’s assume we create a company selling lampshade hats online as party accessories. If the exit strategy is to sell the site to a third party within three to five years, then all management decisions will focus on producing short-term results while long-term investment is ignored. For example, we might pump every spare dollar into advertising one-off sales while ignoring developing a mailing list that could give the company a significant advantage over competitors in five to ten years.
If your plan for the business is to leave it to your kids, but potential partners are focused on a lucrative IPO, take down my name because you are going to need a lawyer sooner or later.
4. Do Conduct Due Diligence
Due diligence is critical when evaluating a potential partner. Don’t think so? These postings on co-founder nightmares will change your mind. Due diligence is the process of evaluating a partnership candidate based on independent resources. The focus should be on:
- Does the candidate have a history of business ownership, and what is it?
- Is there anything alarming in the candidate’s history (criminal conviction, etc.)?
- What is the candidate’s reputation?
- Does the candidate have a history of filing lawsuits or being a defendant in litigation?
- Is the candidate a job hopper, and does it indicate a problem with commitment?
- Has the candidate filed bankruptcy or had other financial issues?
Keep in mind that nobody is perfect. I, your humble attorney, earned a speeding ticket the very day I received my driver’s license. I also may have been involved in a “misunderstanding” in an Eastern European country in the 1990s that fortunately no longer exists. (RIP Yugoslavia!) As Oscar Wilde once said, “Never judge anyone shortly because every saint has a past and every sinner has a future.” An event that occurred in 1998 is likely less of a concern than a negative mark arising in 2014.
Before we continue, let’s be clear about something. There are few limits on due diligence when the target is a potential business partner. The same is not true when evaluating an employee. Speak with a labor attorney before using any of these techniques to evaluate a potential employee. With that caution out of the way . . .
Due diligence begins with online research, and social media accounts are your first destination. PeekYou.com is an excellent tool for identifying a person’s social media accounts. Just perform a search for the candidate’s name on the home page, and the site will generate a list.
Read through all the social accounts, but pay particular attention to Twitter. While browsing through original tweets can be illuminating, pay particular attention to their disagreements on Twitter. If the candidate loses their composure or explodes at another person, it may be a preview to how the individual will react during partner disagreements.
Next, conduct a Google search using the following commands:
- “Person’s name”
- “Person’s name” + lawsuit
- “Person’s name” + arrested
- “Person’s name” + accused
- “Person’s name” + judgment
- “Person’s name” + settlement
Reputation management firms specialize in burying negative listings in search results. Take the time to review the top ten pages of results for each search command. Keep an eye out for mugshots and newspaper or television news show listings.
Obtaining background and credit checks is also advisable. However, you should only ask for consent to obtain the information from the potential partner if you are willing to provide the same information to that person. Obtaining a background check on the sly, for example, could come back to haunt you in the future if the partner learns of the report a few years down the line. Spokeo.com is an excellent tool for background checks. Every person is entitled to one free credit report a year, which can be obtained through AnnualCreditReport.com.
And then we have criminal record databases. There is one database you should always check potential partners against: NSOPW. NSOPW is the National Sex Offender Public Website. A bit of free legal advice: avoid sex offenders as partners. To use NSOPW, just visit the home page and conduct a search using the name of the potential partner.
Finally, we have referrals. Ask for referrals from every business the candidate has listed in their employment history. Contact those companies to verify position and dates of employment. You’ll be surprised by how many people lie about where they have worked. You can also ask for impressions of the candidate, but understand the responses often carry little value. Companies are worried about being sued for defamation when responding to referral requests. Many either no longer provide any response or will give a vaguely positive reference regardless of the actual experience with the candidate.
Why conduct due diligence? The time to discover problems with a potential partner is before committing to them, not when a bank or venture capitalist is conducting due diligence on your company.
5. Do Attempt to Conduct a Trial Run
Most people would agree that buying a vehicle without first going on a test drive would be unwise. We can say the same thing about a partnership. Instead of “marrying” your potential partner right away, why not date for a bit by pursuing a single project to determine if you are a match? Matching skill sets and personalities will take you a long way in establishing a successful partnership, but the outcome will always be in doubt until tested in a real world environment.
In the early 2000s, I was approached by a person who was considering launching a business in the natural products industry. This person, who we’ll call Sara, was looking for a partner who had relationships with distributors and retailers in the industry. Sara identified what seemed to be a perfect partner match. The match, we’ll call Bill, had relationships in the natural products industry, a good reputation, and was one of those people who could chat up just about anyone.
A partnership was formed. And it was good . . . for a bit.
Unfortunately, Sara soon realized Bill lacked common sense, which manifested one day when Bill managed to erase the software program the company used for inventory and bookkeeping. The entire program. I swear this is a true story. One tech told us Bill would’ve had to click through something like ten different warning messages before deleting the software. Despite appearing to be a great match, Bill eventually resigned from the company after a number of other incidents.
While it isn’t always practical to take a potential partner on a trial run, the strategy is worth its weight in gold if you can pull it off. All potential partners talk a good game because all entrepreneurs are optimists at heart. Running a trial campaign reveals whether those talking the talk can deliver on a daily basis.
Now let’s get into the Don’ts to finding business partners.
1. Don’t Seek a Partner for the Wrong Reasons
If you are contemplating adding a partner, stop and ask yourself a simple question: why? The answer may have merit, but many partnerships are created because the original partner lacks confidence and is looking for a security blanket. Here is a little secret—every person starting their first business lacks confidence and is fearful. I worked for a well-known law firm for ten years and had relationships with enough clients that I knew I would be fine when starting a firm in 2000. I was still worried. It’s natural.
As a general rule, avoid giving away equity in your company if at all possible. If you can’t program, pay a freelance programmer instead of taking on a programmer as a partner. I’m not suggesting you shouldn't pursue a partner, but just make sure you have an objective reason for seeking one.
Once you’ve decided a partner is a necessity, begin the process with a personal evaluation. I am a big believer in personality tests such as the Myers-Briggs Type Indicator (MBTI) test. The MBTI is based on the psychological theories of Carl Jung, and classifies a person by four factors:
- How we interact with the world—Extroversion vs. Introversion
- How we prefer to take in information—Sensing vs. iNtuition
- How we make decisions— Thinking vs. Feeling
- How we deal with the world—Judging vs. Perceiving
After answering some questions, the system will assign you a personality profile based on the capitalized letters above. So a person with an ISTJ result has Introverted, Sensing, Thinking, and Judging personality traits. From a business perspective, this person would be serious and dependable, but quiet and practical. This individual would likely clash with a partner who is extroverted and makes decisions by the seat of their pants.
To take the formal MBTI for $49.95, visit this page. Alternatively, you can take a free version of a simplified MBTI at 16Personalities.com, which also offers an explanation of the test results. Keep the traits of your personality in mind when evaluating potential partners and their personas. If you are highly organized, a partner who isn’t will slowly drive you mad.
2. Don’t Settle for Unequal Commitment
Nothing sinks a business partnership faster than bitterness. Nothing breeds bitterness more quickly than partners with different commitments to the company. If the partners are splitting profits equally, but one is working twenty hours a week and the other seventy—Mount Partnership is going to erupt spectacularly sooner or later.
When evaluating a partner, make sure the candidate is prepared to make an equal time and effort commitment to the business. A good way to ascertain whether this is the case is to ask the candidate very specific questions about what they foresee as their role and daily activities. Do not tip them off and do not make suggestions. Let them talk. If the person describes a list of tasks that could not possibly take more than four hours a day to complete, there may be a problem if you are expecting a forty-hour commitment each week.
Although an equal commitment is not a legal requirement, you should consider it a practical one. With the exception of partners solely making financial contributions, all partners should have similar commitment levels.
3. Don’t Agree To Handshake Deals
Here’s a typical co-founder scenario. You have a smashing business idea. You need a partner who has mastered Facebook advertising, and you identify the perfect person. A 50/50 ownership split is agreed upon, the partners kick in an agreed upon capital, you form an LLC but never get around to an operating agreement, and off the two of you go to launch the business. A year passes, and the perfect partner starts missing days.
- Can you fire them?
- Can you just revoke their ownership interest or do you have to buy them out?
- Do you even have the right to buy them out?
A staggering number of businesses carry one or more “zombie” partners that siphon profits off like leeches because the founders never stopped to put their founders' agreement in writing. With no written contract in place, there is no mechanism for dealing with problem partners. The only option is to pursue a solution in court—a process that is so expensive and aggravating that the functioning partners resign themselves to keeping the zombie partner.
Always retain a lawyer to draft the founders’ partnership agreement for you. The agreement should cover:
- The contribution to the company of each party
- The obligations of each party
- How long a party must be with the company to vest in percentages of their promised ownership
- Whether partners can be fired and under what conditions
- Whether partners can be bought out and under what terms
- What voting percentages are required to validate any of these actions
- Any other issues unique to the business
A quick word about limited liability companies (LLCs). You will often read that one of the advantages of the LLC is no written operating agreement is required. This isn't the case. An operating agreement is critical because it will contain a procedure for addressing partner disputes and removals. If you form an LLC with another party, get one. Otherwise, you are sitting on a ticking time bomb.
Finally, avoid partners who are hesitant to put your agreement in writing. There is no valid reason for refusing. The fact that a candidate is reluctant to do so is a major red flag.
4. Don’t Avoid Friends
“You should never go into business with friends.”
Steve Jobs and Steve Wozniak met while working for the same business in 1970 and became good friends. Jobs eventually discovered “Woz” was playing around building computers and thought he could sell the devices. The rest is history. And did it kill their friendship? According to Woz, the two remained friends until Jobs passed, and despite Jobs’s brutally frank nature, “We've never had an argument.”
Of course, there are horror stories concerning friends launching companies. In my experience, there are three rules one needs to comply with when considering friends as partners:
- Never go into business with a friend solely because they are a friend. There must be some other asset they bring to the partnership.
- You must be willing to lose the person as your friend here and now. If the business fails, it is highly likely the friendship will as well. Blame will be assigned. It is human nature.
- Recognize that both of your “work personalities” are likely different than your “friend personas,” and determine if it still makes sense to move forward.
Still unsure if you should proceed? Conduct a trial run. If you annoy each other to no end, the business can be put to bed before you ruin the friendship.
Great, But Where Do I Find These People?
So, where does one find potential partners in the real world? The good news is you likely already know the person. Co-workers are an ideal place to find partners. The beauty of co-workers is that you’ve had a chance to observe each candidate in action and should have a pretty good idea of who is talented and reliable versus who gossips and avoids responsibility like the plague.
Other possible sources for partners include:
- Employees of competitors who have impressed you
- Individuals who you communicate with online in other niches
- Your mentors
- Individuals suggested by a mentor
- Freelancers who you have hired in the past
Don’t speak with just one candidate. Play the field until you find the optimal choice.
The addition of valuable partners can be a galvanizing event for a business. This guide should assist you in identifying those individuals who can be invaluable as well as those who should be avoided.
To your success!
Richard A. Chapo