How To Split Profits in a Small Business Partnership

pening a small business may seem like a lonely endeavor, and operating a small business alone can be even more daunting. Entrepreneurs often find community in the support they receive from friends and family, loyal customers, and investors. That said, a small business partnership can be one of the most exciting forms of community for small businesses.

In a small business partnership, you split the responsibilities and profits with a business partner as you work together to help each other and your business thrive. This can be a relief for many entrepreneurs frustrated by going it alone. But it can also be difficult to navigate.

In this article, we'll break down the ins and outs of partnership profit sharing so you can determine if it's right for you and how to do so effectively.

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Partnership profit sharing explained

Partnership profit sharing involves two or more people who split the combined profits of their businesses. In some cases, the profits will simply be split 50/50 – or whatever the equivalent of an even split might be with your number of partners. In other cases, partners receive a base salary while the rest of the profits are distributed equally. In some situations, partners get a percentage of the profits proportionate to their responsibility within the business. All partners must agree on the ratio with which profits will be divided.

When profit sharing is uneven, the person who receives the largest share is often the "managing partner." They sign off on final decisions, both with the partnership agreement as well as business moves.

Partnership profit-sharing example

Law firms are a common example of small businesses that exercise partnership profit sharing. The attorneys who started the firm and those who do the bulk of the casework are all partners. They split the profits based on monthly, quarterly, or annual profits.

Sometimes this is an even split. In other cases, junior partners may receive a smaller percentage and/or a managing partner who receives the largest percentage. These attorneys often have associates who assist them in cases and sometimes handle their own cases. The associates are paid by salary.

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Questions to ask before entering a partnership profit-sharing agreement

A partnership agreement is ideally advantageous for all partners involved, but as with everything else in business, there is a risk. There's always a chance that partners could fall out or that the proposed partnership agreement is unfair. To make the partnership agreement work for everyone, there are several elements you will need to keep in mind, including:

• The number of partners in your business
• The roles and responsibilities of every partner
• The decision-making process within the company
• The type of business you have and the profits you make

A 50/50 split in profits is a great solution for businesses with two partners who share responsibilities equally. However, when there are several partners, and one or two partners take on much more responsibility than the others, the equal distribution would not be fair.

In some cases, if your profits fluctuate greatly from month to month, you may prefer to have a base salary so that everyone has security. The point is you need a solution that suits your business, taking into account all the nuances and differing responsibilities.

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What is a fair way to split profits in a small business partnership?

So, let's get to the meat of the issue: how to split profits in a small business partnership fairly. You want to make sure your own rights are protected, but you also don't want to favor yourself unreasonably and create bad will with your partners. Your partnership agreement should foster a good relationship among business partners for years to come. Here are a few tips:

Choose your category of partnership

There are two common types of partnerships that you can form: limited partnerships (LP) or limited liability partnerships (LLP). Although these names sound similar, they are distinct.

• In an LP, one partner has unlimited liability for the business. All other partners have limited liability. Because of this, the partner with unlimited liability has the greatest decision-making power in the business. If something goes wrong, they will be the ones held most responsible.
• In an LLP, every owner of the business has limited liability. They are responsible for their actions but not those of other partners. In these situations, the partners often share responsibilities and decisions equally.

If you choose an LP, you will probably end up with a partnership that gives the largest share of profits to the partner with unlimited liability. This is only fair since, should another partner do something that harms the business, the managing partner will be responsible for that partner's actions as well as their own.

Settle on a fair profit-sharing ratio

It may take some time to settle on a fair profit-sharing ratio, especially if you have more than two partners. Keep in mind that all partners must be in agreement before the partnership profit sharing goes into effect. This is where you want to draw on those things to consider referenced above.

For example: Let's say you start a business with four partners. Three will be involved in the everyday operations of the business on a regular basis. The fourth partner, however, moves out of state and helps with the business on a part-time, remote basis. If everyone receives 25% of the profits, the three partners working full time may begin to feel that the fourth partner is not pulling their weight. You may, instead, decide that the three local partners receive 30% of the profits each, while the remaining 10% goes to the remote partner.

The remote partner might counter that although they are not on location full time, they carry unique responsibilities, such as offering bilingual services or certification to perform certain services that the others do not provide. They may suggest instead that the three partners receive 28.3% each, and they get 15%. This negotiation will go on until there is a fair decision for everyone.

Put the operating agreement in writing

Verbal agreements are legally binding but hard to prove in court. You should always create a written operating agreement once everyone has agreed upon the terms.

You may want an attorney to review the terms or help draft the agreement to ensure it's solid. A legal perspective can help you avoid conflicts in the future and clarify the terms. In addition to profit sharing, your operating agreement should include the following:

• The roles and duties of each partner
• The decision-making process and decision-making partner
• How disputes will be resolved
• Terms for the sale of ownership or what happens if a partner dies
• How often meetings will be held, and who can bind the partners to business obligations

Ensure that everyone has a copy of the operating agreement and a digital copy just to be safe. If one partner defaults on the terms of the operating agreement, you will need textual proof to hold them to it.

Make adjustments as needed

So let's go back to the example with the four partners. One partner receives a smaller percentage of the profits than the others because they are working remotely and on a part-time basis, while the other three handle the everyday operations on location. But what if that move is temporary? What if that partner returns and has the same number of responsibilities or more than the other partners? Suddenly 15% is no longer fair. Partners may need to reassess a more suitable division of profits.

Businesses change as often as the human beings who run them. Your operating agreement will rarely need to stay the same for the entirety of the business. You may take on new partners, a partner may die or leave the business, or the share of responsibilities among partners may change.

A good rule of thumb is to review your operating agreement once per year. Letting it lapse longer could mean that you are trapped in a partnership profit share that no longer makes sense for the business. Whether you stand pat after the annual review or decide to make adjustments, everything will need to be agreed upon by the other partners, though the managing partner will have the final say.

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