A partnership is a business structure where two or more people or organisations work together to own and run a business. The partners will share the costs and responsibilities of the business and will also be required to split any profits that the business generates. An essential element of establishing a partnership is determining exactly how you will divide these costs and profits between the partners. This article provides an overview of how to divide profits and losses among business partners and key points to consider in your own partnership.
Key Considerations When Entering a Partnership
Establishing a fair ratio for profit and loss division amongst partners is an important but sometimes complicated task. There is no obvious answer when it comes to splitting profits, as the division will depend on a range of factors, including:
- how many partners are involved in the partnership;
- the share each partner holds in the business;
- roles and responsibilities of each partner in the day-to-day running of the business;
- the risks and liabilities of each partner, as partners who assume higher risks may negotiate for a larger portion of the profits as compensation for the exposure; and
- how much money each partner has invested into the partnership.
Your Partnership Agreement
While not a legal requirement, it is best practice to have a written partnership agreement to ensure clarity and avoid potential disputes. This agreement will detail crucial elements of your partnership, such as:
- the aim of the partnership;
- each partner's role;
- how the partnership will make decisions;
- how the partnership will overcome disputes; and
- the profit and loss distribution method.
Below, we explore common profit distribution options to consider for your partnership.
Profit Distribution Options
In some partnerships, partners divide profits evenly amongst themselves, regardless of their capital contributions or individual efforts. This approach promotes equality and is suitable when partners have similar roles and responsibilities within the business.
While an equal (50/50) partnership may work for a business with two partners who invested in the partnership equally, other partnerships may be slightly more complicated and require that certain partners receive more profit.
Profit distribution based on capital contributions is a common approach in partnerships. Capital contributions can include:
- cash, property;
- equipment; or
- intellectual property.
You might recognise some partners for their larger capital investment by rewarding them with a proportionately larger share of the profits. This method recognises the financial commitment made by each partner.
For example, if one partner has contributed $40,000 worth of capital into the partnership, and the other partner has invested $60,000, then any profits will be distributed accordingly (40/60).
Ownership Based Allocation
Partners usually have an equal share of ownership unless their partnership agreement states otherwise. Where each partner in your partnership owns a specific portion of the partnership, it may make sense to distribute profits and losses between partners according to their ownership percentages. For example, if one partner owns 70% of the business and the other partner owns 30%, then any profits will be distributed accordingly (70/30).
Once all partners have agreed on the profit-sharing ratio, including this in writing in your partnership agreement is important.
Loss Distribution Options
In the event of business losses, partners generally bear the losses in proportion to their agreed-upon profit-sharing ratio unless otherwise set out in the partnership agreement.
How you divide profits and losses amongst business partners will depend on various factors, including the terms within your partnership agreement, the capital contributions of each partner, and the agreed-upon profit-sharing ratio. Partners should establish a clear and comprehensive partnership agreement that considers factors such as capital, effort, and individual contributions.