Starting a Small Business/Corprorate Structure

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Question
David,
Last year a partner and I established a small direct marketing company. There was very little up front investment, less than $10K. We were both working other jobs and just feeling the waters to see if we should do this full time in 2014. At the time the assumption was that we were starting this together so a 50 - 50 partnership made sense. In two months we are set to make a strong run at this and have it our only commitment. Based on our budget we felt we needed $300 - 450K to launch the business for success. This is where things get tricky. I was able to raise the capital but the partner was not able to raise anything. We both agreed we wanted to offer ownership to a third party we felt brings a lot of value to the business also. He could not raise any capital either. What are fair share proportions based on the fact that I am carrying all of the financial risk. BY the way, I am taking a more than 1/2 cut in pay to make the budget work and both of these individuals need to make what they currently make at their other companies.
Thank you
Kevin

Answer
Kevin, what "fair share proportions" are in any particular situation depends entirely upon what the principals of the business agree is fair.  

Based on your summary of the facts, it would appear that your co-owners are contributing no capital and very little in the way of "sweat equity" if the salary they are going to receive is reasonably compensation for their services.

If your capital goes in as common equity, you should certainly get the lion's share of the equity, since you should be entitled to recover your capital and a decent return, over and above anything the other 2 owners ultimately receive.  It probably makes sense, instead of common equity, to put the capital in either as a loan or as preferred stock (or some combination) so that your capital is repaid before the other owners receive distributions in excess of their salaries.  If the terms of the note or preferred stock provide for a rate of return commensurate with the level of risk you are taking by investing the capital in the business, once you have recovered the original investment plus the return, you are more or less on an equal footing at that point.

One fact is not clear to me.  You say that you are taking a more than 1/2 cut in pay to make the budget work and both of the other individuals need to make what they currently make at their other companies.  If you all are providing similar services, the real question should be what are each of you taking out, not how that number compares to previous salaries.  For example, if you are making $160,000 a year at your current job and each of the others are currently making $80,000, and you all agree to take $80,000 for performing substantially equivalent services for the new business, the fact that you are taking a pay cut is not really relevant.  If you are all three making $80,000 a year at your current jobs and you agree that they can take an $80,000 salary and you will take only $40,000 for providing similar services, then you are essentially contributing another $40,000 a year over and above your capital contribution. You would deserve to receive something for that extra contribution.

I hope this helps.

Starting a Small Business

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David K. Staub

Expertise

I am a business and tax attorney and have spent more than 35 years assisting people in starting a wide variety of businesses. I can answer questions about the basic differences between the various entities available to new businesses, including limited liability companies, corporations, S corporations and partnerships. I can provide guidance in other areas facing start ups, such as hiring employees, signing contracts and obtaining necessary licenses. I can also direct people to sources for answers to specific legal questions which cannot be answered in a forum of this nature.

Experience

I have an extensive practice in the mergers and acquisitions area and have been involved in the tax and legal issues on hundreds of business transactions.

Website
Staub Anderson LLC
Illinois business attorneys

Practice Areas
Business Organizations
-Corporations

-LLCs
-Partnerships

-Joint ventures
Mergers & Acquisitions
-Buying/selling business
Securities Law
Tax Law
Technology Law
-Software licenses
-Development agreements

Trademarks

Organizations
Illinois State Bar Association; Chicago Bar Association (former Chairman of the Corporation & Business Law Committee and former Chairman of the Mergers and Acquisitions Subcommittee; former Executive Committee member, Federal Tax Committee and Chairman of subcommittee on general tax issues); Keystone Foundation (Trustee); Association for Corporate Growth; Midwest Entrepreneur Forum; Midwest Association of Alpha Delta Phi

Publications
Commerce Magazine; YLS Journal; ISBA Section of Taxation Newsletter

Education/Credentials
Harvard Law School, J.D., 1977; University of Illinois, B.S. in Accounting, with highest honors, 1974

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