Tuesday, July 28, 2009

Inequity Among Business Partners with Debt Guarantees

 Here is a real situation that has a partnership of four up-in-arms:

Each partner owns 25% of the business.  Three of the four partners have stellar credit and decent net worth.  The fourth partner had a bankruptcy 4 years ago and does not have much net worth, other than the value of the business, to speak of.
The company has a customer present an opportunity to them to double their business in 12 months.  The catch - they will need to buy over $1,000,000 of equipment to capitalize on the lucrative opportunity.  Even though the credit markets are tough, this company is able to secure the financing it needs under one condition - the three partners with good credit have to guarantee the loans, but the fourth partner cannot.
The three partners have exposed themselves to more risk than the fourth.  So, is the partnership still actually equal?  Not in terms of risk.
In this scenario, the three partners are fine to expose themselves to this additional risk to give the company a chance to grow.  They do wonder, however, if they should in some way receive compensation for taking on more risk than the fourth partner.  If for some reason the company defaults on the loans, then the  three who signed personal guarantees will have to resolve the issue eventually with the creditors.  The fourth partner gets to walk away without these issues.
I have seen some interesting ways to handle this issue, and I would welcome additional feedback on how to best handle this.  Any and all ideas are welcome.
One last thought - if anyone is considering taking on one or more partners in their business, this is an issue that should be considered and can even get in the way of financing your business.  If your partner owns at least 20% of the company, some lending institutions will require that they run a credit check on them - and if their credit is bad, the lender will probably decline the loan!
I received some great feedback on a social networks that I wanted to add:
Mark McLeod says:
Interesting situation Ken. You could approach this a few ways: 
1.) Risk adjusted return on the leverage the 3 partners are taking on: some additional premium either as a % of the loan or non equal distribution of profits from the incremental business
2.) Separating the legacy and new business on paper and again having non-equal profit split on the new piece.
3.) Re-evaluating whether this 4th partner is necessary for the future of the business. Will he drag them down or can he be an equal and full contributor?
Peter Towle says:
Another option to explore IF the other partners want to keep the 'bad-credit' partner in as an equal profit participant (or try to keep it equitable) is to create a side agreement between the partners that encumbers the 'bad-credit' partners assets, future assets, or share of the business should there be a problem.
Richard Wong says:
Some good answers from Mark and Peter, I would also add the possibility of another:
Since this new business will result in a major change in the net assets of the company and I am under the assumption the partners like working with each other and that's the reasons they're still partners that they revise the partnership agreement to show the new partnership percentage based on this, otherwise it may be time to incorporate.
They have a holding company, where 3 of the 4 are given a larger %ge of the shares, a subsidiary (the main operating co.) and then based on some measure ie. net profits of the added customer business dividends could be given to the 3 shareholders who took the credit risk, until the loan is repaid, then based on some sort of gentleman's agreement that the 4th partner earn his way to an equal shareholder percentage. 
Now the above could all be thrown out the window if say the 4th partner is the one who brought in the customer and negotiated the extra business because let's say he's a better salesperson than the other 3? 
Hope you can facilitate a paper solution to this Ken.
Great feedback so far...I'm open to more ideas, thoughts, and suggestions!