Sonja and Tarsha are friends who decide to go into business together at S&T Test Prep, LLP. They decide they will be 50/50 owners of the business, so their first order of business is to decide how much they will each put in to “buy” their ownership stake.
Technically, founding Partners can put in as much or as little as they want to establish their business and secure their ownership shares. At KA, our Partner buy-in has been permanently set at $1. Typically, though, the amount of the initial investment is based on some estimate of what it will cost to get the business up and running. For Sonja and Tarsha, startup costs includ:
- Paperwork related to founding and registering the business with the state and county
- Acquiring business insurance
- Initial marketing, including setting up a website and distributing fliers
- $3,000 per month rent for their office/tutoring space
- $5,000 to fit out their office
All in, they calculated it would cost about $26,000 to operate the business for their first 6 months. To give themselves a little cushion, Sonja and Tarsha each kicked in $15,000 to create an initial “capitalization” of $30,000. Drawing off that pool of funds, they set up their office and starting serving clients.
So- now Sonja and Tarsha are each effectively $15,000 in the hole. How did they pay themselves to meet their monthly expenses and get their initial investment back?
In most Partnerships, Partners are not hired as 1099 subcontractors the way we are at Kenning. Instead, your annual pay is based on this equation: business profit x percentage of the business owned.
So, let’s say that in their first 12 months, S&T Test Prep brings in $120,000 in revenue (i.e., fees from tutoring services). To calculate their profit, they have to subtract their expenses/costs from that number. We know it cost them $26,000 to get up and running for 6 months. $120,000 minus $26,000 leaves $94,000. We also know that they had to pay an addition $18,000 in rent for the last 6 months of the year. $94,000 minus $18,000 leaves $76,000. They also incurred an additional $4,000 in costs for materials, marketing, etc, leaving their profit for the first year at $72,000 ($120K revenue – $48,000 expenses = $72,000 profit).
Since they each owned 50 percent of the business, Sonja and Tarsha are each entitled to $36,000 for the year. This will end up being the distribution amount on the K-1 they receive.
But what if like most people Sinja and Tarsha can’t wait until the end of the year to get their money? How do they cover their monthly expenses? They do this by establishing what is called a “draw,” which is essentially a loan against the expected end of year distribution.
Sonja decides that she needs to get $1,500 a month to keep the lights on. Therefor, the business gives her a check for $1,500 every month. This is her draw. After 12 months, Sonja’s draw amounts to $18,000. This is less than the $36,000 distribution she is entitled to as a 50 percent owner of the business, so she is entitled to and additional $18,000 at the end of the year.
Tarsha has larger monthly needs, so she takes a $4,000 per month draw. At the end of 12 months, she has received $48,000. This is more than the $36,000 she is entitled to as a 50 percent Partner, so she owes the business $12,000, and she needs to figure out how to pay that back at the end of the year.
There is one additional factor to consider in year 1 of S&T Test Prep; Sonja and Tarsha each contributed $15,000 to the business to get it started. In essence, the business “owes” them that money, which was used to cover expenses.
Put another way, The business had $48,000 in money out expenses to pay for. It had $120,000 in money in revenue to pay for those expenses and provide profit for the Partners. But it also had $30,000 in seed capital, so the annual books actually show a total of $150,000 of available money. If the Partners don’t mind having no working capital to being year 2, they can actually split $150,000 (year 1 profit plus seed capital) minus $48,000 (year 1 total expenses), or $102,000. If they do distribute all the Partnership’s cash on hand, they would each be entitled to $51,000 for the year. Subtracting the total amount of their draw from this amount, Sonja would get a end-of-year pay out of $51,000 minus $18,000, or $33,000. Tarsha would get an end of year payout of $51,000 minus $48,000, or $3,000. If they paid themselves these amounts, they would have paid themselves pack their initial $15,000 investments plus an additional $36,000 and the books would balance. They would, however, have $0 working capital, which would mean that is an expense had to be covered early in year 2, they might have to put money back into the business (i.e., a “capital call”) to cover it.