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Partners and Equity (Part 3): The Basic Principles of a Comprehensive Approach to Dividing Ownership

Posting by Ed Kopf, Ph.D., Principal at BMC Associates

The first two posts in this series (Part 1 and Part 2) explore the many risks and opportunities that arise when business partners discuss their division of equity. They also describe a unique Comprehensive Contributions-based Equity Process (CCEP) that can minimize the risks and maximize the benefits of that critical discussion. (The CCEP is an integral part of BMC Associates’ comprehensive Partnership Charter process.)

To illustrate this process in action, I created hypothetical partners in the previous post, Ellen Birch and Phillip Rivera. This post describes their fictional (but not atypical) experience in putting the contributions-based equity process to good use in establishing “Insight Coaching and Consulting LLC.”  We’ll follow them and the consultant who was aiding them with their Partnership Charter through the five steps of the process.

Step 1: Identifying All Contributions. The first step in the CCEP was actually very comfortable and satisfying to Ellen and Phillip. Each partner had to list as many contributions as possible that he or she was bringing to the partnership. Each also listed as many contributions as possible that the other was bringing. As they shared their lists with one another, they were glad to acknowledge the other’s contributions and quite pleased to hear how much their prospective partner appreciated theirs. In addition to listing hard items such as capital, intellectual property, websites, and office equipment, they identified strong reputations in the community, integrity, strategic vision, and people skills as vital contributions. This mutual reinforcement generated a mood of appreciation and collaboration.

Step 2: Selecting Key Contributions. The listing of all contributions that Ellen and Philip generated provided the starting point for the next step in the process. This involved agreeing on a limited number of these types of contributions as most important to the success of the venture. They didn’t have too much difficulty agreeing on twelve key areas of contribution (including all those mentioned above – as well as long-term contracts, client relationships, managerial, and marketing skills. As they discussed these subjects, Phillip got a better sense of how central Ellen thought her web-based ideas for the business were to the future. Ellen had developed a sophisticated approach to using web-based video and social media to enhance the coaching process (the “In-sight” method) that could really differentiate the new practice from the growing crowd of executive coaches. She had never implemented her well-developed ideas for lack of time, technical sophistication, and money. As she became aware that Phillip was quite sophisticated technically and was prepared to put capital into their new venture, Ellen began to believe that this was her opportunity to realize her dream. Phillip made sure that Ellen understood that the ideas were important but the ability to implement and pay for the innovations was also of critical value. Each listened and learned.

Step 3: Assessing and Analyzing the Contributions. Now the prospective partners went on to the third step in the CCEP process. Each took a form that their consultant had provided and listed the key areas of contribution on it. They then, separately and privately, assigned values to each of the key areas. This involved distributing 100 points to the several areas of contribution in relation to their importance to the success of the new practice. Their respective lists looked like this:

 

Ellen’s form100% of value contributed
Capital10%
Intellectual Property20
Websites2
Office Equipment2
Reputation3
Integrity3
Vision10
People Skills5
Contracts5
Clients30
Management Skills5
Marketing Skills5
Phillip’s form100% of value contributed
Capital25%
Intellectual Property10
Websites2
Office Equipment2
Reputation2
Integrity3
Vision3
People Skills3
Contracts5
Clients35
Management Skills3
Marketing Skills7

 

Next, Ellen and Phillip, again separately, entered onto the forms their respective opinions concerning what portion of these key contributions each of them was making. The lists came out this way:

 

Ellen’s formPortion from EllenPortion from Phillip
Capital0%100%
Intellectual Property9010
Websites5050
Office Equipment2575
Reputation4060
Integrity5050
Vision6040
People Skills4555
Contracts1000
Clients5050
Management Skills2575
Marketing Skills2575
Phillip’s formPortion from PhillipPortion from Ellen
Capital0%100%
Intellectual Property7525
Websites5050
Office Equipment4060
Reputation5050
Integrity5050
Vision5050
People Skills5050
Contracts1000
Clients4060
Management Skills4060
Marketing Skills2080

 

At this point the consultant stepped in to help Ellen and Phillip with a bit of analysis. He asked each of them to calculate a provisional distribution of equity based on the judgments they’d made. The process was fairly straightforward. They would take the total value percentage they’d identified for each type of contribution and then divide it between the two partners. For example, Ellen had assigned 20% of total value contributed to Intellectual Property. Since she believed that she was providing 90% of the Intellectual Property value, her equity credit from that area would be 18% (that is, 90% of 20%). Phillip would get the remaining 2% of credit from Intellectual Property. When Ellen had done this calculation for all areas, her analysis looked like this:

 

Ellen’s Equity AnalysisValue contribution to venturePortion From EllenPortion From PhillipEquity “Credit” To EllenEquity “Credit” To Phillip
Capital10%0%100%0%10%
Intellectual Property20%90%10%18%2%
Websites2%50%50%1%1%
Office Equipment2%25%75%1%2%
Reputation3%40%60%1%2%
Integrity3%50%50%2%2%
Vision10%60%40%6%4%
People Skills5%45%55%2%3%
Contracts5%100%0%5%0%
Clients30%50%50%15%15%
Management Skills5%25%75%1%4%
Marketing Skills5%25%75%1%4%
100%53%47%Total Equity shares

 

On the basis of this calculation, she “deserved” 53% of equity and Phillip 47%. Phillip’s result was quite different.  He projected that he deserved 64% of equity and Ellen 36%. His analysis looked like this:

 

Phillip’s Equity AnalysisValue contribution to venturePortion From EllenPortion From PhillipEquity “Credit” To EllenEquity “Credit” To Phillip
Capital25%0%100%0%25%
Intellectual Property10%75%25%8%3%
Websites2%50%50%1%1%
Office Equipment2%40%60%1%1%
Reputation2%50%50%1%1%
Integrity3%50%50%2%2%
Vision3%50%50%2%2%
People Skills3%50%50%2%2%
Contracts5%100%0%5%0%
Clients35%40%60%14%21%
Management Skills3%40%60%1%2%
Marketing Skills7%20%80%1%6%
100%36%64%Total Equity shares

 

Step 4: Discussion and Decision. In the critical step in the CCEP equity exercise, the two prospective partners came back together to share their analyses with one another.

Each partner thoroughly described his or her analysis and its results with the other. The consultant asked them what they made of what they’d heard. Ellen reacted quickly, saying, “I’m very surprised at the difference between the equity shares we each came to. Phillip, do you actually believe that you deserve 64% of equity? If so, I’m not sure you value me as a partner in the way I thought you did. And I certainly am not interested in a partnership where you have a controlling interest and hold all of the power.” Phillip responded, “Ellen, I was surprised at the outcome of my analysis. But it’s based on my honest assessments on our individual contributions. Let’s look closely at our tables and figure out why our results are so different. But I can assure you, I’m committed to finding an agreement that we both feel good about.”

When the two looked at their judgments about the portion of value they each were contributing to each area, they found that they were generally close – usually not more than 5 or 10% off. This is not surprising. Having known each other professionally and now having worked together on many aspects of their Partnership Charter, they had a good sense of what each could and would bring to the party. (In addition, the contributions in some areas (especially capital) were completely quantifiable and objective.)

They found that the critical differences were in the importance each assigned to particular types of contributions. Phillip and Ellen each considered Clients as the most important area of contribution to the venture (rated at 35% and 30% of total value respectively). This reflected their common recognition that early cash-flow for the venture would come from the clients they each brought into it. But after agreement on this most important contribution, each prospective partner came up with a different second choice. Not surprisingly, they each favored the area in which he or she was bringing a lot to the venture. Ellen focused on Intellectual Property at 20% of total value (which Phillip valued at only 10%), Phillip on Capital at 25% (which Ellen valued at 10%). This mirror image was neither surprising nor necessary disingenuous. Partners often have more insight, from experience, into the value of their own contributions than into those of others. Beyond the top three areas of contribution, their differences were not significant.

The consultant asked the partners to discuss with one another their thinking about the value of Capital and Intellectual Property to their new venture. By the time they were done, each came to see the other’s perspective more clearly. Phillip suggested that maybe the two areas should be treated as equally important and that they see what would happen if they each placed an equal value on Capital and Intellectual Property – at 17.5% each – while keeping the rest of their analyses as they had them. When they tried this, Ellen’s table now allotted 52% of equity to Phillip and Phillip’s allotted him 58%. Ellen said, “Well, we’re getting close. I see where it makes some sense to, maybe, split the equity 45%/55%. I see now that you are taking all of the financial risk bringing in all of the capital; and that deserves recognition. But I still can’t swallow the idea of you having control and me being, in effect, a junior partner.” Having arrived at an agreement on equity split, the partners still had a number of related issues to explore.

Step 5: Beyond the numbers: Control and More. After agreeing to the equity split, Ellen – as we’ve seen – had asked the consultant how they could deal with her concern that she would become a minority partner at the 45% ownership level agreed upon. That was okay with her for the division of economic rights. But wouldn’t it give Philip 55% of the voting power and, with it, total control? Ellen said she couldn’t move forward without addressing this issue.

Phillip responded that, while he did feel he deserved the larger share of profits, he wanted to be equal partners in almost every other sense. He asked if there was some way to divide voting power on a different basis that economic rights.

The consultant explained that Phillip and Ellen could do whatever they wanted about control – within broad limits.  State law provided a default that unless they entered into an agreement that stated otherwise, they would be considered equal partners with equal shares in profits, assets, and decision-making power. But an agreement between them giving Phillip 55% of profits and assets and each of them 50% of decision-making power would override the statutory defaults. Ellen and Phillip were pleased that their “customized” equity arrangement could work and shook hands on the deal. They took satisfaction in reaching an agreement that felt right – but also in reaching a better understanding of how they each viewed their respective contributions.

Fairness and Collaboration

Much of this discussion has been devoted to tools, forms, and procedures that facilitate and enhance partners’ equity discussions. Experience has convinced us that using this Comprehensive Contribution-based Equity Process serves partners well. Our conclusion is based both on observing partners who strengthen their relationships through this process and by working with troubled partnerships that failed to address equity questions thoroughly.

But the final test of the value of any approach to partners’ equity discussions is not procedural. It is whether the partners feel that they have reached a fair agreement through a collaborative process. There is nothing more corrosive to a partnership than a sense of unfairness or highhandedness on as fundamental an issue as equity. The CCAP can contribute to a positive result. But more than anything else, it is the manner and spirit in which partners deal with one another during the process that will determine their sense of satisfaction at the end.

 

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