Introduction
Profit sharing arrangements like royalties, partnerships, and joint ventures can seem extremely lucrative on the surface. But it’s essential to dive deeper before jumping into a profit-splitting relationship. This comprehensive guide examines key considerations and provisions to include in contracts with profit sharing elements.
Define the Agreement Upfront
Create an Initial Non-Binding Agreement
In the early stages, draft a non-binding Memorandum of Understanding (MOU) or Letter of Intent (LOI) to document agreed-upon terms verbally. Include proposed deal structure, revenue splits, contributions required, management roles, major restrictions, termination provisions, and other fundamental terms discussed initially. Specify the MOU/LOI is non-binding and a formal contract will follow. This prevents misunderstandings later about what was already decided.
Define Profit Calculations and Accounting Precisely
Avoid vague “50/50 split” language. Lay out specifics on how net and gross profits will be determined and accounted for. Provide clear definitions of key terms like gross revenue, net profit, direct costs, operating expenses etc. Specify what can and cannot be deducted in calculating net profit. Watch for “Hollywood accounting” where expenses are inflated to avoid payouts. Require approval for major expenditures if basing payment on net profit.
Establish Partnership Structure
Address Capital Contributions Upfront and Ongoing
Detail initial and future capital contributions and how they will be handled. If additional funding is needed later, will partners be required to contribute more? Can outside investment be sought instead? Define how non-cash contributions like services, IP rights, equipment etc will be valued. Keep in mind tax implications of receiving partnership interest for services.
Outline Management Structure and Partner Restrictions
Specify which partners can make what business decisions and bind the company. Can any single partner take loans/distributions from revenue without approval? What outside activities can partners engage in? How will new partners be admitted? Build consensus rules for major decisions without unanimity. Include removal procedures for non-performing partners.
Limit Liability and Allow for Audits
Limit Liability Proactively
Require indemnification for damages caused by the other party’s negligence or misconduct. Authorize recovery of legal costs. Include liability disclaimers where possible. Consider requiring confidential arbitration which is faster, cheaper, and less adversarial than litigation.
Secure Right to Review Financial Records
Give yourself and partners the right to inspect accounting records, invoices, and documents related to profit calculations. Require the other party maintain thorough books and records. Mandate that underpayments above a set threshold revealed in audits must be reimbursed along with audit costs.
Build in Exit Strategy and Dispute Resolution
Allow for Termination Without Ongoing Liability
Outline steps for dissolving the arrangement if it’s not working out as hoped. Specify that terminating the agreement itself does not end the obligation to pay any outstanding amounts still owed per the profit sharing terms.
Address Dispute Resolution
Require confidential arbitration and define procedure if disputes arise. An arbitrator with expertise in the subject matter is recommended. Include a process for selecting the arbitrator. Specify the arbitration decision will be final and binding.
Other Key Considerations
- Consult a tax professional regarding potential tax implications of the profit sharing arrangement.
- Ensure compliance with any applicable laws and regulations.
Conclusion
Profit sharing agreements require considering much more than just the split of profits. Protect yourself by defining terms intricately, limiting liability proactively, allowing for transparency and audits, and building in an exit strategy. With proper forethought and provisions, profit sharing arrangements can be mutually beneficial.
FAQ
How should intellectual property be handled in a profit sharing agreement?
The contract should have a full section dedicated to outlining IP ownership, rights, and revenue sharing from IP. Specify who will own any intellectual property (patents, trademarks, copyrights, trade secrets, etc.) developed as part of the partnership/joint venture. Will it be jointly owned or will one partner retain full ownership? Include provisions for licensing the IP between the partners or to third parties – this should detail royalty rates and/or revenue sharing. If IP is jointly owned, neither party should be able to license or assign the IP without consent of the other partners. Registering patents and trademarks should require mutual approval. Outline how expenses related to IP will be shared.
Should a profit sharing agreement have a definite term or end date?
It’s generally advisable to include a definite term, like 2 or 3 years, that auto-renews for another term if not terminated by either party. This allows either partner to exit the arrangement if desired after the initial term is up, upon reasonable notice to the other party (e.g. 90 days written notice). An indefinite agreement with no defined term or exit provisions could lock you into an undesirable situation with no easy way out down the road.
What provisions protect against a partner transferring their interest to someone undesirable?
The agreement should include rights of first refusal – requiring a partner to notify the other partners before selling or transferring their interest to a 3rd party, and allowing the other partners to match any 3rd party offer and acquire the interest instead if desired. Outline consent requirements for any transfer of interests, requiring majority or unanimous approval. Impose restrictions on who interests can be transferred or sold to – for example, prohibiting transfer to a competitor. Buy-sell provisions are also advisable, outlining a process for existing partners to buy out a partner who wishes to exit the partnership.
How can silent or anonymous partners be handled?
If a partner wishes to remain anonymous or keep their involvement confidential, the agreement should have strong non-disclosure and confidentiality provisions to prevent disclosure of their identity and interest in the venture. This would include requiring consent from the anonymous partner before their name or likeness can be used in any public communications about the partnership. In the contract itself, specify “John Doe” in place of the silent partner’s actual name. Include a statement that anonymity does not limit legal enforceability and rights under the agreement.
Should a profit sharing agreement specify what happens if a partner dies?
Yes, the agreement should outline in detail what happens if a partner passes away during the term of the contract. Are heirs and successors bound by the contract terms or can they exit upon death? Is a buyout of the deceased partner’s interest mandatory? If the business is to continue, outline whether existing partners can continue operations with the heirs inheriting the interest or whether the death triggers mandatory dissolution of the partnership. Address this situation explicitly upfront to avoid messy situations down the line.
What provisions help protect minority partners?
Minority partners should negotiate for strong information rights including audit rights, access to books and records, and rights to monitor expenses. Require majority approval or unanimous consent for major decisions like taking on debt, entering new markets, or dissolving the entity. Institute compensation limits for partners active in management roles. Clearly define dispute resolution procedures like mandatory arbitration to prevent getting railroaded. Secure rights of first refusal on transfer of interests. Outline buy-sell procedures.
How can partners protect against liability from the actions of other partners?
Include indemnification clauses requiring partners to reimburse and hold harmless the other partners for any damages or legal claims arising from their own negligence, willful misconduct, or breach of the agreement. Require sufficient insurance coverage be maintained by all parties. Limit authority of any single partner to bind the company as a whole.
How should expenses and overhead be allocated in a profit sharing partnership?
The agreement should define if a separate entity will be established and capitalized to cover overhead and common expenses. If partners will directly incur costs, determine an equitable way to allocate shared expenses like office rent, utilities, admin staff, etc. Approval caps on partner expenses may be prudent. Reimbursement procedures should be outlined.
How can partners prevent disputes over time and effort contributed?
The contract can mandate minimum time commitments and duties for active partner roles. Build in accountability by requiring activity reports detailing accomplishments. Establish right to remove non-performing partners. Alternatively, do not attach partner profits to time/effort and instead allocate based on expertise, capital, or reputation contributed.
Should vesting schedules be used for profit sharing interests?
Vesting partners’ profit share over time prevents them from leaving shortly after gaining interests. Typical schedules vest 20-25% each year over 4-5 years. Accelerated full vesting can be allowed if partnership dissolves. Vesting motivates partners to commit long-term.
How are valuations handled for different types of contributions?
Outline valuation methodology for capital contributions – either a fixed value or based on third party valuation. Sweat equity should be valued lower, often at a discount or nominal rate. Contributions of tangible property can be valued at fair market rates with an independent appraisal.
How should control and decision-making power be divided?
The agreement should outline which partners have voting rights, and on what matters. Certain major decisions like admitting new partners or dissolving the entity may require unanimous consent. Day-to-day operating decisions could be made through simple majority vote. Control and voting rights can be allocated based on proportion of ownership interests.
What common profit sharing ratios and splits are used?
Equal 50/50 profit splits are common for two partners providing equal contributions. 60/40 or 70/30 splits reflect unequal contributions. Royalty percentages usually range from 2-15% of sales for intellectual property licensing deals. Carried interest for investors often falls between 20-30% of gains.
How are partners paid their share of profits?
Specify distribution timing such as quarterly or annually. Allow flexibility for managing partner to make interim distributions as feasible. Partners may want to set distribution minimums to cover tax liability. Direct profit shares into each partner’s capital account.
Should partners be subject to non-competes or non-solicitation?
It may be advisable to restrict partners from competing, or from soliciting customers/employees, for a reasonable period after disassociation to protect the business. Typically 1-2 years is considered reasonable. Overly broad restrictions that limit partners’ earning ability can be unenforceable.
How can partners exploit each other’s contributions?
Partners should specify contributions made, such as intellectual property and trade secrets, are being provided solely for use under the partnership. Protect confidential data that gives your contributions value. Require consent from all owners of jointly developed IP for licensing deals.
How can partners withdraw or exit from a profit sharing arrangement?
The agreement should outline steps partners must take to disassociate and withdraw. Requiring notice periods of 3-6 months allows for transition planning. Buy-sell provisions are recommended to govern how a withdrawing partner’s interest will be valued and bought out. Rights of first refusal also come into play.
How are disputes settled if arbitration fails?
As a backup, require mediation before resorting to litigation. The partners work with a neutral facilitator to communicate openly and attempt resolving the issue. Mediation is also faster, cheaper and less adversarial than going to court. If all else fails, then the courts can be used as a final resort.
How are profits shared for partial year participation?
Prorate profit distributions based on the period of time in which the partner provided contributions. For example, if Partner A worked Jan-June before leaving, they would receive 50% of their normal annual distribution. Accrual accounting is helpful for situations involving partial periods.
What happens if the venture becomes insolvent?
The contract should specify partners cannot be held personally liable for business debts beyond their contributed capital, except in cases of fraud. Ideally incorporate the entity separately from the partners to limit exposure. Address how losses will be allocated among partners.
How should leadership transitions be handled?
Outline a process for transferring management roles. Require sufficient notice periods for departing leaders. Make leadership changes subject to majority approval. Define interim leadership selection if a managing partner departs unexpectedly or becomes incapacitated.
How are bookkeeping and accounting handled?
Depending on scale, either appoint one partner to handle or employ an independent accountant paid from partnership funds. Require regular access to detailed financial reporting for all partners. Institute strong controls and auditing procedures.
