Partnerships: Equity Investment Or Strategic Alliance?

Partnerships are a common form of business organisation, particularly for small businesses, as they are easy to create and operate, and offer flexibility in management. They are often used in professional services such as law and consulting. A partnership consists of two or more people who join together to operate a business and share in its profits and losses. Partners may contribute money, other assets, or services to the partnership, and their ownership interest is set through a partnership agreement.

An equity partner is an individual who holds an ownership stake in a business and is entitled to a share of its profits and losses. Equity partners are often involved in the management and decision-making processes and may influence the strategic direction of the company. They typically contribute firm capital in return for a percentage of ownership and a share of the profits.

In law firms, a distinction is made between equity partners and salary partners or non-equity partners. Equity partners have made an investment in the business and are entitled to a direct share of its profits, while salary partners receive a fixed compensation and are not entitled to the profits.

Equity partners vs. non-equity partners

Overview

Partnerships are a common form of business organisation, often chosen for small businesses due to their flexibility, ease of creation and operation, and consistent governing laws. Within partnerships, there are different structures, including equity partnerships and non-equity partnerships.

Equity Partners

Equity partners own a share of a company's equity and are entitled to a direct share of its profits and losses. They invest capital into the firm and earn a share of its income, which is conditional on the business continuing to grow. Equity partners have a personal interest in driving the business forward and are motivated to work harder for its success.

Non-Equity Partners

Non-equity partners, also known as salary partners, are paid a fixed compensation in the form of a salary and are not entitled to a share of the company's profits. They do not own a share of the business and do not have voting rights. Non-equity partners have more flexibility in where and how they work and can more easily move to another firm.

Key Differences

The main difference between equity and non-equity partners lies in their level of ownership and financial stake in the business. Equity partners have a direct financial stake and are entitled to a share of the profits, while non-equity partners are paid a salary and do not have ownership interests.

Another distinction is the level of influence and decision-making power. Equity partners often have voting rights and a stronger voice in firm governance, while non-equity partners have less influence and are treated more like employees.

Additionally, becoming an equity partner typically requires a significant capital contribution, which can be a financial burden, especially for younger partners. Non-equity partnerships, on the other hand, offer the opportunity to avoid this substantial capital contribution, making them appealing to both junior and senior partners.

While equity partnership is generally considered more rewarding and prestigious, non-equity partnerships can be attractive in certain situations, offering flexibility, simplicity, and the opportunity to avoid financial risks associated with equity partnerships. The best approach for partners may be to pursue non-equity opportunities initially, with the potential to transition to equity partnership later, thus delaying the capital contribution while building client relationships.

Partnership equity definition

Partnership equity refers to the ownership stake that a partner holds within a business entity known as a partnership. This concept is particularly important in the context of small and medium-sized enterprises (SMEs), as it dictates how profits, losses, and control of the business are shared among partners.

Ownership Stake

Partnership equity represents the percentage of the partnership's assets, profits, and losses that a partner is entitled to, based on their share. This ownership stake is influenced by the amount of capital contributed by each partner when the partnership is formed. Partners may contribute different amounts, resulting in varying equity distributions.

Profit and Loss Allocation

Partnership agreements define how profits and losses are allocated among partners, typically based on their equity percentages. Partners with higher equity stakes generally receive a larger portion of the profits and bear a greater share of losses.

Voting Rights

Depending on the partnership structure, equity may also confer voting rights. Partners with larger equity stakes may have more influence in decision-making processes within the partnership.

Equity Changes

Partnership equity is not static and can change over time due to factors such as additional capital contributions, the introduction of new partners, or changes in the profit-sharing arrangement. These changes can impact each partner's equity position.

Types of Partners

In a limited partnership, there are typically two categories of partners: general partners and limited partners. General partners have unlimited liability and active roles in managing the business, while limited partners have limited liability but less control. Equity distribution often differs between these partner types.

Buy-Sell Agreements

Partnerships often have buy-sell agreements in place to address the sale or transfer of equity interests. These agreements outline the process for handling equity changes when a partner exits the partnership.

Private equity

The minimum investment in private equity funds is typically $25 million, although it can sometimes be as low as $250,000 or even $25,000. Investors should plan to hold their private equity investments for at least 10 years. Private equity investing is considered speculative and risky, as there is no guarantee that the companies invested in will succeed.

Equity method of accounting

The equity method of accounting is a technique used to record the profits earned by a company through its investment in another company. This method is generally used when the investor company holds significant influence over the company it is investing in, usually defined as owning 20% or more of the company's stock, or having the ability to exert power over the company through representation on the board of directors, involvement in policy development, and the interchanging of managerial personnel.

Under the equity method of accounting, the investor company reports the revenue earned by the other company on its income statement, proportional to the percentage of its equity investment in that company. The investment is initially recorded at historical cost, and adjustments are made to the value based on the investor's percentage ownership in net income, loss, and dividend payouts. Net income from the company invested in increases the investor's asset value on their balance sheet, while losses or dividend payouts decrease it.

For example, if Company A purchases 25% of Company B for $200,000, and at the end of the year, Company B reports a net income of $50,000 and pays $10,000 in dividends to its shareholders, the investor company, Company A, would record a debit of $12,500 (25% of Company B's $50,000 net income) to its "Investment in Company B" account, and a credit of the same amount to Investment Revenue. Company A would also record a debit of $2,500 (25% of Company B's $10,000 dividends) to cash and a credit of the same amount to its "Investment in Company B" account. The new balance in Company A's "Investment in Company B" account is now $210,000.

The equity method acknowledges the substantive economic relationship between the two companies and ensures proper reporting on the business situations for both the investor and the company that the investor has invested in.

Equity partnership tiers

Partnerships are a common form of business organisation, and within partnerships, there are different tiers that partners can occupy. The most common partnership structure is the two-tier system, which includes both equity partners and non-equity partners. However, some firms have a single tier of partnership, while others have as many as four tiers, each with its own set of benefits and obligations.

Equity Partners

Equity partners are individuals who hold an ownership stake in a business and have a financial interest in the company's success. They are often expected to contribute a lump sum of capital to the business and, in return, receive a percentage ownership and share in the profits and losses of the company. Equity partners are also usually involved in the management and decision-making processes and may have a say in the strategic direction of the company.

Non-Equity Partners

Non-equity partners, also referred to as "salary partners", "income partners", or "non-share partners", do not have an ownership stake in the firm. Instead, they receive a fixed salary, which can vary depending on bonuses. They do not have full voting rights and are not expected to contribute capital. In some firms, the non-equity partnership tier is seen as a stepping stone to becoming an equity partner.

Junior Partners

Some firms also have a junior partner structure, which allows non-equity partners to work towards becoming equity partners over time. Junior partners are typically given performance targets they must meet to become equity partners.

Variable Equity and Non-Equity Tiers

The distinction between equity and non-equity partnerships is not always clear-cut, and some firms have multiple partnership tiers that may not neatly correspond to either the equity or non-equity models. For example, some firms require non-equity partners to contribute capital, and some equity partners may not have voting rights or a say in the strategic direction of the company.

Frequently asked questions