# Profit and loss sharing among three co-founders

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I'm participating in some business funding and recently we've faced a severe problem. The question is quite simple: how do we share profit, so that no one would be left behind?

So, there's three co-founders:

• investor (further IN) - contributes most substantial amount of money (60%), however, does not participate in the work being done or participates to a very small extent
• manager (further MGR) - contributes some amount of money (40%) and participates in the work being done
• executor (further EXEC) - does not contribute money, but does most substantial amount of work

It is a test project, so there's quite high chances we'll end up with a loss. Thus we decided to secure certain amount of budget, so that MGR and IN won't loose all their money.

For example, assume our total input is 15k\$ and after the complete business cycle we end up with 10k\$ (assuming that our only possession is remaining money). In such case, EXEC will get 10% of the remaining money, and everything else is split among IN and MGR in proportion, corresponding to their initial contribution (IN get's most of it since he contributed more than others). However this will basically mean that EXEC is being payed by other two guys. We also decided to have profit shared according to the work done. So IN gets 25% of profit, MGR 30% and EXEC 45%.

However, such model doesn't work if we get some profit or if our profit is higher then it was expected. Say input was 15k\$ and the outcome was 20k\$. Then EXEC gets 10% of 15k + 45% of 5k\$ = 3.75k, MGR gets 35% of 15k + 30% of 5k = 6750 and IN gets 55% of 15k + 25% = 9500. In that way IN got +500 to his money, MGR +750 and EXEC +3.75k. Which seems to be unfair towards IN and MGR. Those are rough numbers but obviously in higher cash flow sense doesn't change too much.

Is there an approach to such problem or an already know model of profit and loss sharing?

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Before discussing your specific numbers, it is important to note that in the US anyway, there is no requirement that losses be split the same way as profits. In fact it is often desirable that they be split according to some other formula due to the various participants being in quite different tax situations. In fact the at risk provisions of the income tax code should be a key factor in designing the structure of the venture in such a case.

Lets take an example, Investor (I) who is in a high tax bracket and programmer (P) with no other income start a venture. I contributes \$10,000 while P puts in no cash but does all the work. Lets also assume it is a LLC and that it has losses in the first year. Clearly P can't benefit from a loss in that year (he has no income) while I, being in a high tax bracket, can use it all. This is a case where you would want to pass all the losses back to I and none to P (who can't use them). Provided the losses passed to I do not exceed the at risk amount (the \$10,000 he put in) he is fine.

With this same example lets assume that at the end of the first year there P also finished the program and that in the second year the venture makes \$1,000,000. Now clearly P should not get it all with P getting nothing (since P did all the work). So what I & P would want is an agreement that states that all profits are split in some agreed upon fashion (50% each perhaps).

This is why agreements can seem overly complex to newcomers. They can become lengthy simply because there may be goals and objectives beyond the basic goal of making money. AS in this case, addressing the specific tax treatment for differing kinds of investors, based upon their activities outside the business, may be desirable.

A third type of split is to consider how the remaining assets are distributed in the event of liquidation (that is shutting down the business, selling it or otherwise ceasing to operate).

Lets apply it to this example. Suppose that at the end of year one a company had offered to buy the whole venture (basically the software is the only asset) for \$500,000 with both I and P going on to do something else. Well I & P, before they started and while writing the original agreement might have thought of this possibility and decided that in such a case I would receive the first \$20,000 from the sale and then the remaining 30% would go to I and 70% to P. Remember that when drafting the original business agreement you can come up with about whatever terms and provisions that you want. The logic here is that I doubles his investment + some more (what he would presumably be happy with) while P gets the majority if the venture is a big success (remember he did the work). If however it is only marginally successful, they sellout for \$30,000 for example, then P does not get nearly as much. This too may also be "fair" in that if P worked for an entire year on software and it is only worth \$30,000 then his performance is less than stellar.

To review, we have gone through the splitting of three (3) different things:
1) Losses, 2) Profits from operations and 3) Value in liquidation and each was handled differently.

Your specifics: If that is what your business agreement laid out in writing when you started, then I guess you have to live with it. Quite frankly it seems sub-optimal in that both IN and MGR have contributed \$15,000 between them but that in the event you loose it all EXEC gets a \$1,500 loss (and in fact he may have a \$1,500 paper profit as well since he is apportioned equity for which he did not contribute cash). IN and MGR contributed \$15,000 between them but will only be able to write off \$13,500 since they "gave" the remaining equity to EXEC.

Perhaps you should have had a better tax adviser before you started.

• +1, nice answer. It's interesting to observe that IN and MGR actually come out worse off by "passing" the loss, even though it might be counter-intuitive at first. – Paul Stovell 12 years ago
• @Paul - Actually it may be far worse than that in that they also passed equity to EXEC on day one that EXEC may need to pay taxes on although he received no cash. – Jonny Boats 12 years ago
• However, the shareholders can agree at any time to change the business agreement. – Dave Feyereisen 12 years ago
• @Dave - That is true, but if the IRS finds that the agreement was changed after the fact in an attempt to evade taxes.... – Jonny Boats 12 years ago
• @JonnyBoats - Great point. How would the IRS treat changes to a business agreement in order to reallocate profit or loss, if they felt the purpose was to evade tax? I believe I was told by my lawyer that changing the business agreement to reflect differences in ownership participation was legal at anytime by mutual agreement. I believe the accountant told me something fuzzy, like changing it once would be fine - but if you keep changing it you attract IRS scrutiny and then you will be answering a lot of questions and they'll be in a bad mood. Can you expand on this? – Dave Feyereisen 12 years ago
• @Dave - Basically changes involving the future are OK, changes involving the past are suspect. So changing from FIFO to LIFO going forward would be OK. Running a business for 5 years and then deciding OH! we should have been using LIFO, lets change and re-file our taxes to get money back would raise lots of red flags. Add yes, your accountant is right in that you do not want to make such changes too often (as in every year). – Jonny Boats 12 years ago
• @Dave - As to 'if they felt the purpose was to evade tax?": if that was the sole purpose and there was no legitimate business reason then it would tend to raise red flags and invite scrutiny. Some "evasion", such as taking the standard deduction is perfectly fine (everyone is entitled to it). I assume you are referring to "creative accounting" as in transactions with no other purpose than to avoid taxes. – Jonny Boats 12 years ago
• Gosh, its great that the discussion is still ongoing. You are completely right about having separate loss, profit and liquidation formulas. However, my concern is neither of those (thanks to your answer). In your example, the misfortune when there were only 30k income may not fall solely on programmer, since there are way more factors. It might be that the whole business idea was a failure and responsibility for it should be split among both founders. And that's what we're trying to clarify: if it fails, what to do with those, who did most work? – Denys S. 12 years ago
• @den - Well if the business fails basically IN & MGR lost money while EXEC lost time. EXEC (the programmer) will have learned a lot and sharpened his programming skills + have a great resume for the next venture. The next question is who gets to keep the source code? – Jonny Boats 12 years ago
• @JonnyBoats, sadly, in our case the "source code"/assets are not worth to argue about. – Denys S. 12 years ago

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You are looking at using two different formulas for profit and loss sharing. One one money contributed is king. In the other formula hours worked is King. You will have to determine how this transition from the first to the second takes place.

You may need a 3rd formula, that splits the profits more evenly for the long term. The three individuals will have to determine the percentages, and transition level for the long term agreement. You could go with switching to the long term formula when all three have been credited with same amount of profit.