One of the most difficult issues facing business founders is determining how to apportion ownership interests in a new entity. In an effort to keep things cordial, entrepreneurs often elect an equal ownership split. Unfortunately, a decision to make ownership percentages equal can lead to disputes among the business owners, some of which may emerge almost immediately. While 50-50 ownership may be appropriate for some entrepreneurs, the advantages and disadvantages of equal ownership should be carefully considered before ownership shares are allocated in a startup entity.
Initial Capitalization and Problems with the 50-50 Split
Typically, a business is formed through the efforts of more than one individual. These individuals are usually expected to contribute some form of equity during the business formation. Under Minnesota law, a business may accept anything it deems valuable as an equity contribution. See Minn. Stat. §§ 302A.405, subd. 1; 322B.40, subd. 2. Businesses may accept money, property, future promises, and human capital or “sweat equity” as initial means of capitalizing a business. Problems arise when assigning a proper valuation or percentage ownership to individuals contributing future promises and “sweat equity.”
Businesses have wide discretion in how they value the equity contributions of their founders. See Minn. Stat. §§ 302A.405, subd. 2; 322B.40, subd. 4. To new partners it might be reasonable that Partner A’s initial contribution of $50,000.00 is equal to Partner B’s contribution of “managerial experience” and the promise to work 50 hours each week for the first year, and that an equal ownership split is thus appropriate. What happens, however, when Partner B’s “managerial experience” results in substantial operating losses, or when Partner B only works 15 hours each week after the first month? Or, even if the business is running well, what happens when Partner A and Partner B, equal owners, disagree on the future direction of the company, or the day-to-day operations?
These are just a few of the early-stage problems that can occur when different forms of contribution are valued equally. An equal ownership split can result in costly legal battles over the strategic direction and operations of the business. Ultimately, there is an increased risk that nothing gets accomplished, the business fails, or the relationship between the partners deteriorates. With proper foresight, however, some of these issues can be prevented.
Individuals embarking on a new business venture often initially feel the equitable path is to establish an equal ownership split. However, that is not the only option available. Business founders should discuss the present value of each partner’s contribution prior to the business formation. When Partner A contributes her $50,000.00 it is likely worth more at that time than Partner B’s managerial expertise and future promise to work. Partner B’s contribution might be worth just as much over time, but until the business is running smoothly, it is more difficult to conclude the partners’ contributions are equal.
One option is to have Partner B’s interest vest over time. Partner B’s managerial expertise may equate to only 25% relative to Partner A’s capital contribution, but over time, based upon the success of the business, or Partner B performing 50 hours of work each week, Partner B’s interest could vest to a higher percentage. By creating a vesting schedule, there is an incentive for Partner B to perform her end of the bargain. Partner A can then hold Partner B accountable for meeting benchmarks and ensuring that both parties are able to see a benefit in their contributions to the business. (Please keep in mind, however, that developing a vesting schedule raises tax potential tax implications that the business owners should discuss with their accountants. For example, unless Partner B makes an election under Section 83(b) of the Internal Revenue Code, the fair market value of the membership interests/shares will be measured at the time they vest. By this time, the business may be in full swing and worth more than it was upon incorporation.)
Another option is to separate the financial and voting rights of the ownership interests. If Partner B’s “sweat equity” is intended to justify an increased equity position in the business, it may be fairer for Partner A to have a higher voting percentage, as Partner A has more risk involved in the venture.
Finally, the partners should consider the possibility of granting one partner majority interest (e.g., 51%) upon incorporation, to help prevent future deadlock and paralysis in decision-making. Obviously, this creates certain vulnerabilities for the minority shareholder, but might ultimately result in a more successful business. Some of the risks to the minority shareholder can be addressed through careful planning, anti-dilution protection, and other strategies commonly included in a Minnesota Buy-Sell Agreement.
Equity contributions are a threshold issue to be addressed at the start-up of operations when more than a single owner is involved. While businesses may value the contributions they receive in nearly any manner they see fit, defaulting to an equal ownership split for different types of contributions is often a bad idea. Equal ownership splits can often lead to deadlock. When decisions need to be made swiftly it is advisable to have a person in a position to act quickly and efficiently. A start-up business is typically in a better position when one owner can act decisively rather than if the owners are in a standoff over operational decisions.
For advice on equity arrangements, capital contributions, buy-sell agreements, shareholder control agreements, and other issues facing businesses that are incorporating in Minnesota, contact one of the corporate law attorneys of Trepanier MacGillis Battina P.A.
About the Author:
Minnesota corporate attorney James C. MacGillis advises clients on corporate and business law matters such as business entity formation, business transactions, and corporate governance. Jim may be reached at 612.455.0503 or firstname.lastname@example.org. Trepanier MacGillis Battina P.A. is a Minnesota corporate law firm located in Minneapolis, Minnesota.