Business partnerships are a great way to pool significant capital together. An ideal partnership can range from two to a maximum of 20 people. However, you may get statutory exceptions, especially in professional fields like accountants and solicitors. Moreover, you’ll need a partnership deed to help dictate your business’s operations and the partners’ relationships.
A partnership agreement will show the duties and responsibilities of each partner. An essential clause of a partnership deed is its profit share agreement. This clause indicates how the partners will share the business’s profits and losses. Furthermore, it ensures that you won’t have disputes in the future for a vague partnership deed. Hence, all partners must sign off against a profit share agreement.
You can use various bases to ascertain your profit-sharing, but keep in mind that when a profit share agreement is lacking, the law provides that the partners have an equal share of profits and losses. That said, here are some of the approaches:
- Initial Capital Investment Contribution
Each partner contributes a different capital to start up your business. Therefore, your profit share distribution may depend on each partner’s initial capital contribution. Hence, the partner with the highest contribution can get the highest profit share. You can express this profit share agreement as a ratio or percentage representation.
For instance, say you’re a three-partner business. The ratio can be 3:2:1. Alternatively, you can have this as a percentage. Thus, the highest partner can get a 50% share of the profits, while the second partner will get 33% and a share of 17% of the third partner.
This profit-sharing approach ensures that the partner with the highest risk receives the highest reward. But remember that increasing your ownership percentage can also affect the profit-sharing ratio. Your profit share agreement will determine if this other approach will supersede the capital contribution sharing as the business grows.
- The Ownership Percentage Approach
Some partnership deeds can have a clause that allows a gradual increase in ownership percentage in the business. This can be through plowed-back profits or capital funding. Alternatively, percentage ownership can also come in the form of time investment. If a partner actively handles business operations, this can also form part of the ownership.
Therefore, it would be best if your profit share agreement shows how percentage ownership affects profit sharing. Though, the general rule still dictates that the partner with a higher ownership percentage should get a higher profit share. The percentage ownership typically appears as the share capital of the partners.
Like the capital contribution, the percentage ownership can change. Thus, you can use a partner’s share percentage ownership to distribute your profits. This means that a partner with a 40% share percentage gets a 40% profit share, and so on.
- The Responsibility Approach
A business partnership’s success depends on the success of its operations. Thus, you might need one or more partners to take up various roles. Such partners will be responsible for daily operations and other operational decisions. This can mean that these partners take on more weight on the business’s success than those without any roles.
You may decide to share your profits according to each partner’s role in the business. Such a clause in a profit share agreement should state the percentage profit each partner gets. For instance, you can indicate that an active partner gets 60% of the profit share. The remaining 40% can go to the other partners according to their ownership percentage or capital contribution.
The responsibility profit-sharing approach ensures that the active partners get rewarded for their role in the business’s daily operations. This is especially true for a general partnership that doesn’t indicate salaries for partners.
- Type Of Partners
The type of business partnership you have can also dictate your profit-sharing ratio. Your partnership agreement should determine your business’s partnership type—whether it’s a general partnership, limited, or equity partnership. Additionally, you might have salaried partners. Therefore, it would be best to consider what types of partners you have when designing a profit share agreement.
General partners assume the business’s roles and responsibilities and oversee its daily operations. These partners also carry personal liability for the business’s debts. In the absence of a profit share agreement, general partnerships have an equal profit share among the partners.
On the other hand, you can also have a limited partnership. This partnership can have both general partners and limited partners. The limited partners don’t participate in the partnership’s daily operations. Additionally, they don’t have liability beyond their capital contributions. Therefore, you can allocate a higher profit share to the general partners due to their responsibility and liability to the business’s debts.
If you have a limited liability partnership (LLP), you can share your profits depending on each partner’s contribution. But, it’s important to note that partners’ roles in an LLP aren’t equivalent to an increase in their profit share. Equity partnerships mean you can only base your profit share on individual contributions or ownership percentages. The reason is that equity partners don’t participate in the business’s daily operations. Hence, you can’t base their profit share on responsibilities.
Conclusion
Sharing of profits in a business partnership can be contentious. Without a concrete clause in the partnership deed, profit sharing can cause future disputes. Therefore, a profit share agreement is vital before launching and operating.
Veeramachineni Lalitha
I am Finance Content Writer. I write Personal Finance, banking, investment, and insurance related content for top clients including Kotak Mahindra Bank, Edelweiss, ICICI BANK and IDFC FIRST Bank. My experience details : Linkedin