This post is about contracts that include profit sharing, e.g., royalty, partnership, joint venture, licensing agreements, etc. There is a basic template at the end. My main advice for agreements with profit sharing elements is to see beyond the dollar signs in front of your eyes. Don’t just think about profits. Think about losses, audits, disputes, liability, restrictions, regulatory compliance and other potential problems.
1. Always have “something” in writing.
Prior to entering a partnership, consider signing a Memorandum of Understanding (Letter of Intent). It doesn’t have to be anything fancy, as long as you have at least “something” in writing. MoU/LoI is not legally binding but it really helps prevent future misunderstandings. When you negotiate profits, lots of ideas get passed around and rejected. To ensure that at the end of the day everybody is on the same page, you need to have something in writing. Write down the bullet points on a napkin, if you have to, and have everybody confirm that this is what you have agreed to so far.
Read also:
Checklist for Drafting an LLC Operating Agreement, Partnership Agreement, Bylaws
2. Ratios.
Again, do not just think about the profits. Memorialize how you’ll divide any losses. Agree on when exactly are the profits to be distributed. Consider tax issues, expenses. Are the profits to be paid before or after any salaries? Gross profits or net profits? In Southern California we often see examples of “Hollywood accounting” even in contracts that have nothing to do with the entertainment industry. Hollywood accounting refers to the practice of inflating expenditures in order to reduce or eliminate the reported net profit to avoid paying royalties which are based on the net profit. That’s why you hear about actors in $100+ million movies never receiving any residuals because technically those movies never turned any net profit. So, if your royalty agreement is based on net profits, you better make sure you really trust the payor, you have a say in how those net profits are calculated and have audit rights. Otherwise, net profit could mean no profit for you at all.
3. Contributions, expenses.
Suppose, your initial contributions are insufficient to get you any profit. What will you do if if the business needs more money? Close doors, seek outside investment or require partners to contribute? Your contract should spell out whether any future financial contributions to the partnership are required. How will it affect your profit calculations if they are not required but one partner contributes anyway? How will
non-monetary contributions (IP, sweat equity, tangible property) be valued? Keep in mind that it is taxable income to receive a capital interest in exchange for services in an LLC that is taxable as a partnership. So, the higher you valuate your sweat equity the more tax liability you’ll incur. It is very important to outline who has a say in what expenditures can the partnership incur since it directly affects the profits. Can a any single partner make loans out of the profits without unanimous consent of all the other partners? The agreement needs to outline what each partner can do with company resources.
non-monetary contributions (IP, sweat equity, tangible property) be valued? Keep in mind that it is taxable income to receive a capital interest in exchange for services in an LLC that is taxable as a partnership. So, the higher you valuate your sweat equity the more tax liability you’ll incur. It is very important to outline who has a say in what expenditures can the partnership incur since it directly affects the profits. Can a any single partner make loans out of the profits without unanimous consent of all the other partners? The agreement needs to outline what each partner can do with company resources.
4. Management.
Is any partner required to contribute a certain minimum amount of time/work to the partnership each month? Will some partners have the authority to act freely within their assigned fields or responsibility, without the need to seek approval of other partners? What happens if one of them is not pulling their weight? Are partners allowed to participate in outside business activities that might be in competition with the company business? How can the new partners be admitted and how will it affect your profits share? Who is the manager and what would it take to remove him/her? How are the decisions made, particularly when it’s a crucial issue and there is no consensus?
5. Liability.
Disclaimers of warranty state that there are no guarantees that there will be any profits or that things won’t go wrong. Indemnification clause can ensure that if the other party’s wrongdoing causes you damage, you’ll be reimbursed. Attorney fees can be authorized as well.
6. Audit.
Trust, but verify. For example:
Company shall maintain a reasonable accounting system that enables each Partner to readily identify Company's assets, expenses, costs of goods, and use of funds related to this Agreement. Each Partner shall have the right to audit, to examine, and to make copies of all financial and related records relating to this Agreement. Costs of any audits will be borne by the auditing party, provided, however, that, if the audit identifies underpayment of royalties in excess of 5% of the total contract billings, the Company shall be responsible for the total costs of the audit.
Company shall maintain a reasonable accounting system that enables each Partner to readily identify Company's assets, expenses, costs of goods, and use of funds related to this Agreement. Each Partner shall have the right to audit, to examine, and to make copies of all financial and related records relating to this Agreement. Costs of any audits will be borne by the auditing party, provided, however, that, if the audit identifies underpayment of royalties in excess of 5% of the total contract billings, the Company shall be responsible for the total costs of the audit.
7. Dispute resolution.
Consider arbitration instead of litigation. Arbitration is normally confidential, quicker, cheaper and less formal. The American Arbitration Association offers an excellent free online ClauseBuilder tool. There is an option to have a "documents only" hearing that does not require any personal appearances.
8. Dissolution; Termination.
Finally, you need a way out of the deal if things are not working out. Termination of the profit sharing agreement should not terminate the obligation of the other party to pay the money due you.
9. Free General Partnership Agreement Template
GENERAL PARTNERSHIP AGREEMENT
OF
_____________________________________
This General Partnership Agreement (this "Agreement") of ________________________ (the "Partnership") is made as of the ____ day of _________, 20__, by and between ___________________________, residing at _____________________, __________________, __________________ and ___________________________, residing at __________________, __________________, __________________.
RECITALS
The parties have agreed to join together as Partners to ____________________________ and to conduct its business in accordance with the provisions of this Agreement.
TERMS OF AGREEMENT
1. Name and Address. The name of the Partnership shall be ________________________ its principal office shall be _________________________________________________, _________________________________, _____________________________________.
2. Purpose. The Partnership is organized for the following purpose:
________________________________________________________________________
The Partnership may enter into, make and perform all contracts and all other undertakings and engage in any and all transactions the Partners may deem necessary or advisable to carry out its purposes.
3. Term and Fiscal Year. The Partnership shall continue until terminated pursuant to Section 11. The fiscal and taxable year of the Partnership shall end December 31.
4. Partners' Accounts. The Partnership shall maintain separate Capital Accounts for each Partner to record each Partners' capital contributions, withdrawals and share of the Partnership's net profits or net losses including unrealized profits and losses calculated in a manner consonant with that of Summit Investors.
5. Capital Contributions. The initial capital contributions by the Partners to the Partnership were as follows:
%
%
Total %
The capital contributions and capital accounts for each Partner to the Partnership effective __________________, 20____ shall be as follows:
$ %
$ %
Additional capital contributions shall be made by the Partners in the amounts and in the proportions as the Partners shall agree upon.
6. Profits and Losses. The Partnership's profits and losses shall be allocated to the Partners in proportion to their capital accounts.
7. Managing General Partner. The general management, control, and conduct of the Partnership business shall be conducted by ___________________, as Managing General Partner. If ___________________ shall be unwilling or unable to serve, the position of Managing General Partner shall shift to __________________. If both shall be unwilling or unable to serve, the Managing General Partner shall be such other Partner designated by all the Partners.
8. Additional Partners. Upon written consent of all the Partners, additional partners may be admitted to the Partnership under such terms and conditions (including capital contributions) as shall be determined at the time by the Partners.
9. Assignability of Interests. The interest of a partner may be assigned or transferred in whole or in part from one Partner to any other Partner within the Partnership with the written consent of the Managing General Partner. Except as provided in the preceding sentence, the interest of a Partner may not otherwise be assigned, pledged, hypothecated or transferred under any other circumstances except by reason of death or incapacity to that Partner's executor or administrator.
10. Withdrawal by Partners. (a) A Partner may, by notice to each of the other Partners at least seventy-five (75) days prior to the last day of any fiscal year, elect to withdraw from the Partnership. The withdrawing Partner's Capital Account shall be valued as of the last day of the fiscal year in which the notice of withdrawal is given. The withdrawing Partner shall be paid the value of that Partner's closing Capital Account in ten (10) equal annual installments (with interest at the average of the prime rate announced from time to time by Amsouth National Bank, or its successors in interest, during the preceding fiscal year) during the ten succeeding fiscal years of the Partnership, payable on the first business day of the next succeeding fiscal year and on the first business day of each subsequent succeeding fiscal year, or in such larger installments and over such shorter period of time as the Managing General Partner may determine; (b) With approval of the Managing General Partner, a Partner may, by notice to each of the other Partners at least 75 days prior to the last day of any fiscal year, withdraw from that Partner's Capital Account a part of the Capital Account as of the first business day of the succeeding fiscal year.
11. Causes for Termination. The Partnership shall be terminated upon the earlier of:
11.1 The incompetency, insolvency or death of all the Partners; or
11.2 The decree of any court of competent jurisdiction directing the dissolution or termination of the Partnership; or
11.3
(a) Execution of a written declaration of intention to terminate the Partnership by all of the Partners; or
(b) Thirty days following the delivery by __________________ to the other Partners of a written declaration of intention to terminate the Partnership; or
11.4 ____ day of _________, 20__.
The incompetency, insolvency or death of any one or more of the Partners (but not all of the Partners) shall not terminate the Partnership.
12. Liquidation. The Partnership shall be liquidated upon its termination and proceeds thereof applied:
12.1 First to the payment of the debts, liabilities and obligations of the Partnership and to the costs and expenses of the liquidation;
12.2 To the establishment of such reserves, if any, deemed reasonably necessary for any contingent or unforeseen debts, liabilities or obligations of the Partnership;
12.3 To the pro rata retirement of each Partner's capital account. The liquidation shall be administered jointly by the Partners, except that should any Partner decline to participate, the liquidation shall be administered by the other Partners.
13. Amendments. This Agreement may be amended only by the written consent of eighty percent (80%) of the Partners; provided however, that Section 7 of this Agreement may be amended only by the written consent of all of the Partners.
EXECUTION
Intending to be legally bound, the parties executed this Agreement whereupon it entered into full force and effect in accordance with its terms as of _________________, 20____.
_____________________________________ ____________________________________
STATE OF _________________
COUNTY OF _______________
On this ____ day of _________, 20__, before me personally came ___________________, to me known to be the individual described in and who executed the foregoing General Partnership Agreement, and acknowledged that he executed the same.
_______________________________________
NOTARY PUBLIC
My Commission Expires:
___________________________
STATE OF _________________
COUNTY OF _______________
On this ____ day of _________, 20__, before me personally came ___________________, to me known to be the individual described in and who executed the foregoing General Partnership Agreement, and acknowledged that he executed the same.
_______________________________________
NOTARY PUBLIC
My Commission Expires:
___________________________
