Admitting new owners to non-corporate entities

April 7, 2015

check-listMarch 2015 marks the introduction of separate chapters on the admission of new owners to two important non-corporate entities: partnerships (see §§ 50:1 et seq.) and limited liability companies (see §§ 61:1 et seq.). Admission of a new partner or member, whether at the time the entity is formed or during the operation of the business, is a fundamental change that requires the most careful consideration and time. A variety of factors and characteristics should always be considered including the functional skills of the candidate, the type and amount of contributable assets, level of participation, goals and objectives and the chemistry between the candidate and the current owners.

In a small- or medium-sized business, each principal should be able to contribute significant experience in one or more key functional areas. For example, one or more of the owners should have expertise in product development, procurement and manufacturing, marketing and distribution, finance and accounting, strategic planning and personnel. In some cases, one or more of these activities can be outsourced to outside professionals and vendors, including consultants, attorneys, accountants and payroll services. Strategic alliances can also be used to supplement the core skills and resources of the business.

In assessing a potential new owner, the current ownership group should determine if the candidate’s functional skills are complementary. Clearly, if the current owners are particularly strong in the marketing area, a preference in recruiting might be given to an engineer or scientist with proven experience in product development or manufacturing processes. On the other hand, a candidate with a marketing background may not add that much to the current mix and may even create conflicts among the ownership group unless he or she can bring a unique set of contacts or ideas to the company.

While functional skills are important in evaluating a new owner, consideration should also be given to the contributions the owner is willing to make to the business. While new owners are often admitted on the basis of their experience without further contribution of assets, new owners are also a good source for working capital, equipment, facilities and intellectual property rights. For example, a new owner may contribute cash for operations and the owner’s rights to patents that might be useful in developing new products to be commercialized by the company. A new owner may also be able to contribute needed equipment or arrange for the equipment to be available to the company under a long-term lease on favorable terms.

The current owners should get a clear idea of how much time and effort the new owner candidate is willing and able to devote to the business affairs of the company. While it is anticipated that all of the partners of a general partnership will be actively involved in the day-to-day management of the partnership business, use of a limited partnership or an LLC allows the parties to plan for different levels of participation. At one extreme, there may be owners who do not have the time or functional skills to be actively involved in the business and who are only looking to be silent financial partners. In that situation, the business will be organized as a limited partnership or a manager-managed LLC and these owners will become limited partners or non-managing members, as the case may be. They will generally have the right to receive regular reports on the progress of the business and special voting rights as permitted by statute on fundamental matters relating to the company (e.g., mergers). Assuming that the new owner will be participating at some level in the day-to-day management and operation of the business, the parties must reach agreement regarding the specific duties and obligations of the new owner. This often takes the form of an employment agreement or a detailed description of the agreed services in the partnership or operating agreement.

Each owner has his or her own personal goals and objectives for participating in the management of the business entity. In general, each owner should be dedicated to the overall success of the business, which may be defined by profitability, development of new products and markets, expansion of the workforce and/or increase in the value of the ownership interests. However, specific goals of an owner may conflict with the objectives of the other owners. For example, if one owner is much older than the others and is looking to retire in the near future, he or she may be less inclined to incur business risks that might endanger his or her ability to liquidate his or her interest on retirement. The other owners may want to take on more risky projects that will increase the value of their interests over the long-term. The divergent interests of the owners may lead to conflicts among the group and make it more difficult to manage the business. Similar issues may arise when owners have different levels of separate personal wealth.

Goals and objectives are also important when adding new owners looking for what is nominally a passive investment interest in the business (e.g., limited partners). While a passive investor is generally relying upon the active managers to conduct the business in a proper fashion, passive investors may have specific financial goals and objectives that need to be taken into account. For example, a limited partner may require that a certain amount of cash must be distributed to the limited partner on a regular basis regardless of whether or not the cash might be better used for internal projects in the business. In any event, the goals of the passive investors should be carefully described in the partnership or operating agreement.

The ownership group of a small- to medium-sized business should expect to spend a good amount of time with one another and to share tasks that might be delegated in a larger organization. The intensity of these relationships means that personal chemistry is a very important element in adding new owners. Ideally, new owner candidates will be well known to the other owners, either from past business relationships or from time that the candidate has spent as an employee in the current business organization. In fact, many businesses will not admit new owners without some trial period to make sure that there is a good fit. If that is not possible, and the candidate has no prior working relationship with the other owners, detailed interviews should be conducted and references should be carefully checked.