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What to Include in Profit Sharing Agreements

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This post is about contracts that include profit sharing, e.g., royalty, partnership, joint venture, licensing agreements, etc. My main advice for agreements with profit sharing elements is to see beyond the dollar signs in front of your eyes.  Don’t just think about profits. Think about losses, audits, disputes, liability, restrictions, regulatory compliance and other potential problems.

1.  Always have “something” in writing. Prior to entering a partnership, consider signing a Memorandum of Understanding (Letter of Intent). It doesn’t have to be anything fancy, as long as you have at least “something” in writing. MoU/LoI is not legally binding but it really helps prevent future misunderstandings. When you negotiate profits, lots of ideas get passed around and rejected. To ensure that at the end of the day everybody is on the same page, you need to have something in writing. Write down the bullet points on a napkin, if you have to, and have everybody confirm that this is what you have agreed to so far.

2.Ratios. Again, do not just think about the profits. Memorialize how you’ll divide any losses. Agree on when exactly are the profits to be distributed. Consider tax issues, expenses. Are the profits to be paid before or after any salaries? Gross profits or net profits? In Southern California we often see examples of “Hollywood accounting” even in contracts that have nothing to do with the entertainment industry.  Hollywood accounting refers to the practice of inflating expenditures in order to reduce or eliminate the reported net profit to avoid paying royalties which are based on the net profit. That’s why you hear about actors in $100+ million movies never receiving any residuals because technically those movies never turned any net profit. So, if your royalty agreement is based on net profits, you better make sure you really trust the payor, you have a say in how those net profits are calculated and have audit rights. Otherwise, net profit could mean no profit for you at all.

3. Contributions, expenses. Suppose, your initial contributions are insufficient to get you any profit. What will you do if if the business needs more money? Close doors, seek outside investment or require partners to contribute?  Your contract should spell out whether any future financial contributions to the partnership are required. How will it affect your profit calculations if they are not required but one partner contributes anyway? How will
non-monetary contributions (IP, sweat equity, tangible property) be valued? Keep in mind that it is taxable income to receive a capital interest in exchange for services in an LLC that is taxable as a partnership. So, the higher you valuate your sweat equity the more tax liability you’ll incur.  It is very important to outline who has a say in what expenditures can the partnership incur since it directly affects the profits. Can a any single partner make loans out of the profits without unanimous consent of all the other partners? The agreement needs to outline what each partner can do with company resources.

4. Management. Is any partner required to contribute a certain minimum amount of time/work to the partnership each month?  Will some partners have the authority to act freely within their assigned fields or responsibility, without the need to seek approval of other partners? What happens if one of them is not pulling their weight? Are partners allowed to participate in outside business activities that might be in competition with the company business? How can the new partners be admitted and how will it affect your profits share? Who is the manager and what would it take to remove him/her? How are the decisions made, particularly when it’s a crucial issue and there is no consensus?

5.Liability. Disclaimers of warranty state that there are no guarantees that there will be any profits or that things won’t go wrong. Indemnification clause can ensure that if the other party’s wrongdoing causes you damage, you’ll be reimbursed. Attorney fees can be authorized as well.

6. Audit.  Trust, but verify. For example:

Company shall maintain a reasonable accounting system that enables each Partner to readily identify Company’s assets, expenses, costs of goods, and use of funds related to this Agreement. Each Partner shall have the right to audit, to examine, and to make copies of all financial and related records relating to this Agreement. Costs of any audits will be borne by the auditing party, provided, however, that, if the audit identifies underpayment of royalties in excess of 5% of the total contract billings, the Company shall be responsible for the total costs of the audit.  

7. Dispute resolution. Consider arbitration instead of litigation. Arbitration is normally confidential, quicker, cheaper and less formal. The American Arbitration Association offers an excellent free online ClauseBuilder tool. There is an option to have a “documents only” hearing that does not require any personal appearances.

8. Dissolution. Finally, you need a way out of the deal if things are not working out. Termination of the profit sharing agreement should not terminate the obligation of the other party to pay the money due you.

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