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socrateaser
socrateaser, Attorney
Category: Business Law
Satisfied Customers: 33482
Experience:  Retired (mostly)
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Bad business partnership - questions

Resolved Question:

First, I want to start off by saying that I'm not looking to take this to court, and also by saying that I'm not looking for an answer that is ENTIRELY "by the law". I'm looking for an answer on what is right in terms of BUSINESS, AND SEPARATELY, what is right in terms of LAW. 


The situation is that 4 years ago, I was approached by three other people to go into business with them on a new venture. The proposition was that the 4 of us would become partners. They wanted to be silent partners (no direct involvement in the company), while I would manage, run and operate the company on a day-to-day basis. The initial agreement was that they would be able to provide the capital for the company as investors (non-salaried), and I would be salaried, albeit at much lower than my market-rate. My (agreed-upon) market rate being about $120,000/year at the time, I agreed to take $70,000/year. In exchange for this, and for me running the company, I would be made a 20% partner, with the other 3 taking 80%. As these were 3 people I knew and trusted, we initially did not have a formal legal partnership agreement. 


Firstly, six months into the new business, as their "investment" grew to close to $100k, they decided to inform me that the terms suddenly changed so that their money was not actually a capital investment, but instead a LOAN. This was a shock to me as I didn't know why I would do all the work in a company, give them 80% of it, and in the end have to repay all the money they are "loaning". Why would I ever give 80% of my company for a loan? To top it off, since I was the minority partner, I also had to do their bidding, even though suddenly they were only "loaning" money. While upset and confused, I kept my mouth shut. 


Fast forward two years. As I continued running the company, and the 3 other partners continued with shady business practices, I decided I needed a formal written contract in order to protect myself. I began to ask the controlling partner (Zack) for a formal contract. He said "no problem", but kept stringing me along and never producing anything. I asked every month for two years. After two years, the company folded. In the end, I never received a contract despite 20-30 attempts at asking for one. However, when the company closed, we had inventory that was sold to a liquidator for $400k. When that money came in, the 3 other partners promptly proceeded to pay themselves out (which just so happened to cover 100% of their "loans"), and didn't give me anything. 


My questions are:


1. What actually is the recourse when the 3 other partners changed the terms of the agreement 6 months into the business, without my input or consent?


2. What is the recourse for the fact that I asked the controlling partner for a formal contract for two years, and was jerked around without ever getting one?


3. I believe that the "loan" is nonsense. If anything, the 3 others can say that they put money into the company for those 4 years, and that's why they took the money when the $400k came in. However, if we follow that logic, as my market-value was $120k, and I only took $70k because the original agreement was an INVESTMENT, doesn't that mean that technically I also put in $50k/year into the company? Meaning, at the end of the 4 years, I invested more than them ($200k of my money, vs $200k of their TOTAL money for the 3 of them)? Shouldn't I then be owed AT LEAST 20% of the $400k?


 


Thank you.

Submitted: 10 months ago.
Category: Business Law
Expert:  socrateaser replied 10 months ago.
Hello,

You asked:


My questions are:


1. What actually is the recourse when the 3 other partners changed the terms of the agreement 6 months into the business, without my input or consent?

 

A: If there was a written articles of partnership or operating agreement, and you could prove that the other partners breached their agreement with you, then that would be both a breach of the contract and a breach of loyalty, which, if intentional, would entitle you to compensation for the amount that you were owed, and punitive damages (typically three times compensatory damages) for the intentional injury caused by your partners' wrongful acts.


2. What is the recourse for the fact that I asked the controlling partner for a formal contract for two years, and was jerked around without ever getting one?

 

A: Same as #1. It's a breach of loyalty.

 

3. I believe that the "loan" is nonsense. If anything, the 3 others can say that they put money into the company for those 4 years, and that's why they took the money when the $400k came in. However, if we follow that logic, as my market-value was $120k, and I only took $70k because the original agreement was an INVESTMENT, doesn't that mean that technically I also put in $50k/year into the company? Meaning, at the end of the 4 years, I invested more than them ($200k of my money, vs $200k of their TOTAL money for the 3 of them)? Shouldn't I then be owed AT LEAST 20% of the $400k?

A: A person's market value is not an investment in a business entity. Investment must be tangible -- which means that had you taken $120K per year and then actually contributed $50K of your earnings, then that would be a valid investment. But, by reducing your salary and investing nothing, there was no actual contribution, and no change in the asset value of the business.

As a practical matter, your circumstance boils down to apparently your doing this deal on a handshake. You may be "as good as your word." Most people are not. That's why we have written contracts to memorialize agreements between persons -- because we frail humans are simply not capable of keeping our word over time, generally speaking. Even the most noble among us will seize an advantage if the opportunity arises. That's just the way of the world, since the beginning of civilization. And, before that, well, we just killed each other if we decided to change a deal.

Concerning the loans, if the contributions were not originally backed up by a promissory note or other agreement with the partnership, then the loans are a sham, that would never survive litigation. Instead, the partners would be found in breach of fiduciary and loyalty to you as a minority partner. The court would order you credited with 20% of the original investments and you would have to report that as taxable income. On dissolution, you would receive your 20% of the $400K, or $80K.

The problem with all of this is that your partners will deny that they agreed to give you 20% of the business, in exchange for your taking the job. So, unless you have something in writing to prove the deal, you will lose, because there won't be sufficient evidence to meet your burden of proof.

So, if you can prove the deal in some manner, then you would be entitled to that $80K (20% of $400K). Otherwise, you'll just have to chalk it up to experience and move on to greener pastures.

Please let me know if I can be of further assistance.

Hope this helps.
Customer: replied 10 months ago.
Hi,

Regarding this statement, I'd like a clarification:

"Concerning the loans, if the contributions were not originally backed up by a promissory note or other agreement with the partnership, then the loans are a sham, that would never survive litigation."

You state that the contributions need to be backed up by a promissory note or other agreement. There was never a formal agreement that these were loans. However, the "loans" were paid out through the 3 partners' other company, into my company. In their books, these were recorded as loans. When these sums were placed into my company's accounting software (not by me), they were also placed as "loans" that were payable to their company. Does this constitute a promissory note or other agreement?

Thanks!
Expert:  socrateaser replied 10 months ago.
A business loan requires a contract or note. Separate businesses are distinct legal entities, and to protect one's interests and the interests of other investors, a loan needs to be memorialized in writing.

It's easy to call the transaction loans, but without any express repayment terms, nothing about the transaction shows a loan except the entries in the accounting records.

If the IRS were to audit the transactions, it would not find a loan. But, it's not particularly relevant, because loan or not, the real issue is whether or not you can prove your partners' agreement to make you a 20% partner from their investment. If you can, then you would still get your 20%, because the loans would be converted into a capital contribution in your interest. If you can't, then there's no contribution, whether the contributions were loans or capital.

Hope this helps.
Customer: replied 10 months ago.
Hi,

Thank you for the clarification! One final question (I promise) - I have several legal documents (including tax documents like a K1 form, as well as bank documents) that show me as a 20% partner, and which the other 3 partners signed. Is this enough to prove my ownership of the company and that I am owed 20% of the $400k?

Thanks again!
Expert:  socrateaser replied 10 months ago.
If one of the other partners signed the Form 1065 partnership tax return, then that would prove your ownership interest, because the tax return is signed under penalty of perjury.

Hope this helps.
socrateaser, Attorney
Category: Business Law
Satisfied Customers: 33482
Experience: Retired (mostly)
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