When starting channel businesses, making the wrong decisions about the business partner agreement and entity selection can have severe consequences later on down the line.
Starting your own channel business may be a journey best not gone on alone, as business partnerships can greatly increase your chances of financial survival. However, entrepreneurs can make several mistakes at this early stage of the process, such as failing to set down the necessary ground rules in a business partner agreement.
“If you’re an entrepreneur starting your own business, doing it on your own will put you at a disadvantage,” said Michael Corey, president of Ntirety Inc., a database services company based in Dedham, Mass., and a division of cloud company Hosting Inc. “Every study that I’ve seen has shown that a business is more likely to succeed if there are partners involved.”
The advantages of going into business with partners are numerous, but Corey cited one of the most important as having someone there to give you a break. “The first thing anyone who goes into entrepreneurship is going to learn is it’s not a 40-hours-a-week job. It’s an 80-hours-a-week job. So, at least with a partner, you have that benefit of taking a break … and knowing that when you come back, the business is still going to be there, and, more importantly, there’s somebody in the business that cares about it as much as you do,” Corey said.
Another benefit is that partnerships can broaden your business’s reach in terms of business contacts, skillsets and capabilities, he added.
Partnerships can have their disadvantages, of course, if you’re unprepared for scenarios that can crop up later on. For example, your business partner’s attitude about the work can change after the business begins to thrive. “Now all of a sudden the business is doing well and one of the partners says, ‘You know, I don’t have to work so hard anymore,'” Corey said.
“I think a common mistake is [to say,] ‘We’ll just split the profits,'” he added. “Well, that sounds good and you finally have those profits and you split them, but four years later you’re still splitting the profits, but you’re the guy who’s working 80 hours a week and the other guy’s working 40 hours a week. You’re not going to feel too good about that.”
Prepare for the worst in a business partner agreement
David Streit, principal and owner of Stephill Associates LLC, an IT services company based in New Jersey, has had a successful solo career as a managed services provider (MSP), opting to work with only the support of independent contractors and through collaborations with peers. He also relies on the support he receives from industry organizations like the ASCII Group and its resources like ASCII Link, an open forum for MSPs to share industry insight and advice. He said he’s in the process of forming an accountability peer group with another ASCII Group member who is located in Virginia.
I think, too often people don’t have these conversations and then they get burned by it in a big way.
Even if Streit has managed to work successfully on his own for 14 years, he admitted he can’t help but sometimes wish he had a partner to have grown with. At the same time, “the problem with partnerships is that most of them break up,” he said.
Many life situations could potentially break up a partnership, so at the outset partners must consider and discuss various hypothetical events that could occur and what should happen as a result. These events include the death of a partner, a partner becoming disabled, and a partner getting a divorce or deciding to leave the business, Corey said, or what he calls “The Four Ds.” “I think, too often people don’t have these conversations and then they get burned by it in a big way,” he said.
In Corey’s opinion, partners should first address these scenarios and set expectations in an informal “kitchen table” discussion before launching the business.
Dan Liutikas, managing attorney at InfoTech Law Advocates P.C. and chief legal officer and secretary at CompTIA, said in this early stage partners should determine the management structure of the company and equity of each partner. Management authority and company ownership are not the same thing, so these need to be treated separately. “Once you’ve identified those areas in terms of authority, then you get into areas” like deciding how an LLC’s membership units or a corporation’s shares of stock get transferred, Liutikas said. “There are a number of areas related to contingencies on the transfer of ownership that you really want to provide for in … a buy/sell agreement.”
Business partners must also select the entity of their company — a decision that many channel partners fail to give serious thought to, in Liutikas’ opinion. “Unfortunately, many of these [entity] selections become a little bit too commoditized and people don’t select the correct entity for what they’re actually trying to accomplish, which produces poor tax consequences for them,” he said. “It really doesn’t lend itself to templating and that sort of thing.”
The selection of an entity, whether it is corporation, LLC or limited partnership and so forth, will affect how the partnership is documented, he said. For example, corporations are far more statutory compared to an LLC, which tends allow for more flexible definitions of the partnership relationship.
“A lot of folks pick an entity because they know somebody else who has it, or because somebody said, ‘LLCs are a good way to go.’ But oftentimes there isn’t a full analysis done as to why you are choosing a corporation versus an LLC. … It’s entirely fact-specific in terms of what kind of business you’re going to run, as to why you choose one over another. And then of course there are tax consequences that run through those,” he said.
Other important decisions partners need to make include whether their business is going to be a lifestyle business or built to sell later on. “You don’t want one partner seeing all this profit and wanting to pull it out and the other partner wanting to reinvest it. You have to have a common vision of what your end game is,” Corey said.
Partners should also figure out a plan for compensation and at what point they can start taking money out of the business.
The value of a good consultation
With so many contingencies and aspects to consider, how are partners to cover all their bases when making decisions about their business and developing the business partner agreement? For Liutikas, it “starts with a good [legal] consultation on what entity would make the most sense for you and then preparing the appropriate documentation for it.”
In the lean, early days of a partnership and channel business, it may be hard for partners to take the appropriate measures to protect their investments. In Liutikas’ experience working with entrepreneurs, he’s observed a lot of people will bootstrap their way until they can get their business going. But trying to cut costs on initial consultations could have regrettable consequences in the long term.
Liutikas said it’s uncommon for solution providers to have received appropriate consultation under entity selection. “I think a lot of folks view entity as one of those simple legal items, and they both hop up on the state website and register with an entity, or they use one of the online services that are out there — ‘$99 gets you an entity.'”
Choosing the wrong entity can cost companies thousands of dollars in additional taxes later on — “all for saving potentially an extra $500 to $1,000 at the outset,” he said.