Should You Partner with a Private Investment Firm?

Welcome to the Profitable Painter Podcast. The mission of this podcast is simple: to help you navigate the financial and tax aspects of starting, running, and scaling a professional painting business. From the brushes and ladders to the spreadsheets and balance sheets, we've got you covered. But before we dive in, a quick word of caution. While we strive to provide accurate and up-to-date financial and tax information, nothing you hear on this podcast should be considered as financial advice specifically for you or your business. We're here to share general knowledge and experiences, not to replace the tailored advice you get from a professional financial advisor or tax consultant. We strongly recommend you seeking individualized advice before making any significant financial decision.

Hey, this is Daniel, the founder of Bookkeeping for Painters, and this is Richard, tax director with Bookkeeping for Painters. How's it going?

Uh, I think it's going better for you than it is for me, at least weather-wise right now, because we are in the middle of like winter storm thing. It's been going on for the last 12 hours, gonna go on for another 12 hours. Um, you know, typical stuff living in the Upper Midwest, but, uh, I've definitely got to shovel my driveway a few times to keep up with it.

Yeah, my weather's definitely better than that. Uh, I'm, I'm, I'm in Orlando, Florida. Uh, it's still not great, but it's, it's definitely nowhere near that level of of, uh, you know, suck.

So, um, how many inches of snow do you have, man?

So many. No, definitely, definitely none.

So, okay, good for you, that's awesome.

But today I'm, I'm excited to discuss today's topic: should you partner with a private investment firm? And so this has been out there in the business, uh, ether. I think we've seen it a lot, like Alex Hormozi. He has Acquisition.com, which does private investment to build businesses to the next level. Uh, there's also Aleph Holdings, which does that for painting industry. That started a few years ago. Um, then we've seen it on TV with Shark Tank. Pretty often. So, you know, we've seen it happen and we've had a lot of questions in recent— last, really the last couple of years, but even more so maybe in the last few months. So we figured it would be a good time to do a podcast about what are some of the good things of partnering with a private investment firm? What are some of the bad things? What are some of the things to consider?

Yeah, so, you know, the way these things usually work is, uh, you know, maybe you're approached or, or, or you're looking for help and they offer— it could be an individual or it could be a group of individuals. And number one, they offer cash. That's usually, you know, always on the table, but they're also going to want to offer things like, uh, services, helping you fill positions that you can't fill on your own, mentoring and, you know, proven systems that can help get your company into the next level. And in order to get, you know, in order to get these things, they're going to require a part of your company, a part of the equity in your company. You know, all of this is negotiable, you know, price for equity. And if anyone's ever watched Shark Tank, you're real familiar with this concept. They're always trying to value companies and, you know, sell 10% for $100,000 or something like that. But obviously the price that you're able to charge is going to be directly proportionate to how valuable your company is and also how much equity you're giving away, but also how much value the investor is going to bring in non-financial assets. So not just cash, but the, um, experience and the services that they're going to be able to bring in.

Yeah. Yeah. So I think first we could dive into the good things, like why would somebody want to do this? You know, why would somebody want to give away a portion of their company that they've probably spent a good amount of time building. So, you know, one of the main reasons is you can, by partnering with somebody, there's the idea that you could grow your business a lot quicker, get, get to your goals a lot quicker by pairing up with, partnering up with somebody that's either done it before, has the experience, has the, the knowledge, and can fill in the gaps where you're weak. And get you to that level a lot quicker and grow the pie, uh, get there, you know, grow the pie faster.

Yeah, what do they say on Shark Tank? That, um, you know, 20% of a watermelon is better than 100% of a grape. Uh, that idea that, um, if the company grows, uh, you know, overall, then even if you own less of it, it's better to own less of something big than all of something small. And you might be hitting a plateau where you've, you know, you're stuck at a certain revenue and you've tried different things through marketing, advertising, whatnot, and you just cannot figure out how to get to the next level, how to get that growth going again. And it's possible that, that an investor who can, who can provide either cash, if there's a purpose for the cash, or experience or networking or skills, uh, can, can move you up into that next level.

Yeah.

Yeah.

Or you might just want to get there faster. Maybe you're, you've got steady growth, but it's kind of slow going, or maybe you're not reaching the goals that you've set for yourself as quickly as you want. Um, you know, when done properly, throwing cash at something can be like adding gasoline to a fire. Not always. Um, and it does obviously need to be done correctly, but you know, that could be a possibility. Uh, you know, you get to that level a lot quicker than you would on your own.

Mm-hmm. Yeah. Plus you get, you get some support, you know, it's being an entrepreneur oftentimes can be pretty lonely when you're, especially if you're the only, uh, the only owner. Everything's on you. So getting support from a team that, uh, is in there with you to help you and, and give you that mentorship can be, you know, can be very helpful.

So absolutely, you know, we run into problems as entrepreneurs and we have to kind of fix them from scratch. If you've got a team that's already seen these problems, figured out how to overcome them, or, or better yet, figured out how to avoid them in the first place, you're going to go a lot faster. Than trying to reinvent the wheel every time an obstacle comes up.

Yeah. Yep. So those are, those are some of the good things, some, some of the reasons why you might want to consider partnering up with a private investment firm. So let's now go through some of the bad things or the things that, you know, the risks that you'll have to face and decide, you know, Does it still make sense, you know, after going through these? So the first one is pretty obvious, is you're going to have less equity in your business. You know, you're likely gonna right now have 100%, you're gonna have to give a good amount of, a good amount of that equity away, whether that's, you know, 20, 30, 40, 50% of that equity to partner up with somebody.

Yeah, and I try to remind folks, too, that this is not a one-time event. It's not like you go out and you purchase something, you spend that money one time. When you give up equity, you're giving up a portion of this year's profits and next year's profits and next year into perpetuity. So the cost of giving up equity is very, very high. And we want to make sure that we're getting something of greater value in return.

Yeah. And with equity also comes control because usually, you know, voting rights are attached to, to stock. So you're— now that you're— you have a partner, you have to consult with that partner and make decisions together oftentimes depending on the operating agreement. So usually means less control or at least slower decision-making because you have to, you know, consult with your partner. So that is another thing that could be potentially a bad thing, or at least something to consider.

For sure. Really important to make sure that you and your partner are on the same page with the important decisions. I mean, you may have differing views for the direction of the company, what kind of you know, what kind of things are we focusing on? You know, maybe, maybe you really want to focus on residential repaints and they would like to scale up and do more commercial work that, you know, has less profit, but, but greater volume. That's going to be a real problem if you guys don't see eye to eye. So if you're going to give up some of the control in your company, really important to make sure that you're on the same page with the important things.

Yeah, another big one to consider is the growth is not guaranteed. Just because you partnered up with a private investment firm, there's no guarantee that they're going to get you to the next level. I'm sure that's the goal and that's their intention, otherwise they wouldn't do it because their incentive would be to grow your business. But there's no guarantees in life. And so there is a risk there that you won't grow, or at least you won't grow as much, or as much as you were hoping, or as fast as you were hoping. So that is a thing to consider, um, for sure in this situation.

Yeah, you know, when you think about the reasons for bringing on a partner, uh, you know, it's, it's for support. Is it possible that you could get support in another way that does not involve giving up a part of your company in a way that, that turns out to be less expensive? You know, business coaching, workshops, hiring out some of these roles, maybe you need help with managing your finance, your company's finances, hiring out CFO services or accounting services. You know, these things aren't necessarily guaranteed either, but you're not giving up a big portion of your company in order to get this. So there could be other ways to get the things you need to get you to those, those next levels.

Yeah. Yeah. So along the same lines there, it's important to evaluate the track record of whoever's your, of your partner, potential partner, to make sure that they have what they say they have, you know, talk to businesses that they've worked with in the past and really do some due diligence to make sure that they do have the tools, processes, and the ability to get you to the next level so that you're not wasting your time.

Yeah, yeah, I think of like some of the big personalities on Shark Tank and these are obviously very successful people. No doubt about it. But not every company they get involved with hits a home run. In fact, more than half fail. That's pretty common in, you know, the investment space. You know, a lot of the things you swing at, you're just, you're just going to miss and you're looking for those few big home runs. So definitely, definitely check into the track record and maybe they're, they've been very successful at other types of businesses. Are they successful in the space that you're operating in? Are they going to bring something valuable to your personal company? And, you know, money is not enough. Money in itself does not equal success. Otherwise, everyone who got a bank loan would be, you know, a billionaire. So can they, can they bring something to you that you simply cannot buy elsewhere, that you cannot get for yourself? And are they, is there a very high degree of certainty that they're going to be able to bring, you know, value to your company that's worth giving up equity for.

Yeah, absolutely. All right, so those are some of the good things, and then we went through the bad things, uh, or the thing, you know, things to think about, uh, when partnering with a private equity or private investment company. So let's go into some things to consider when going into agreement. So let's say that you You, you know, you did your due diligence with, you know, talking to former, um, you've talked to, you talked to the partner and you, you feel confident in their expertise and what they have to bring to the table. You talk to, uh, other businesses that they've invested in, so you have a good feeling there. So you're ready to sit down at the table and you know, sign some paperwork and partner with this, with this private investment firm. So let's go through some things to consider when going through that process. Yeah.

So, so number one is it's, it's your operating agreement. I mean, this is your Bible. This is what you're going to live and die from. This is where you put everything down in writing. And, you know, every, every relationship starts off great with, with good intentions. And, you know, you think of like a handshake agreement. The problem is, is when things, things go wrong and maybe not even so much when things go wrong, but just when there's misunderstandings or we don't know how to handle this, that's when your, your operating agreement is going to be your touchstone. It needs to be very, very clear. It needs to be explicit. This is what's going to prevent misunderstandings. And if for some reason things go really, really south and lawyers or judges have to get involved, they're going to look at your operating agreement and that is going to be the only thing that actually matters. You know, conversations over dinner, handshakes, agreements, those don't stand up in court. Things in writing do. So most important thing in any kind of partnership, whether it's private equity firms, investment firms, you know, stockholders, operating agreements spells out everything.

Yeah. And it's good to get the lawyers involved early so you don't have to get them involved later.

Yes.

So with that operating agreement, because this is the instructions on you know, what is happening, you know, are, are you selling, selling the business? Are you forming a new company? You know, what, who's giving money? Where's that money going into? Is it going to you, the person, or is it going into the company? All these things are, you know, they're not just minor details. These are really important on what's happening. And so you really need to have a very needs to be clarity. So not only a lawyer, really, you also want to have a tax professional, tax planner go through this document as well before you sign anything. Yeah, because, you know, if there's confusion in that operating agreement, it's going to, it's going to create a mess and a lot of headache later on. And also because these documents are hard to understand, you might not have the full clarity on what it's actually saying as well. So, you know, in the way one person might explain what it says and the way another person might explain what it says, like, could be different. So having those professionals explain what's going on to you in those operating— in that operating agreement is really important. So, you know, the implications from a tax perspective or from an ownership perspective.

Yeah. Should we talk maybe about some of the things that are in an operating agreement? I know you kind of touched on the idea of, you know, capital contribution versus a stock purchase. If you're forming a new company, a new partnership, the operating agreement needs to spell out who is contributing what. And that's going to be the basis for your capital accounts. Because, because the amount of the company that, that you own is going to be set in the operating agreement. But the amount of money that you've put into the company, the amount of profit that is allocated to you and the amount that's available to you to take out, that's all going to be spelled out by the operating agreement. You might also have a situation where you are doing a stock purchase. So this is an area where you have an existing business and instead of trying to form a new partnership, a new company, your investor wants to purchase a portion of your preexisting company. What is, you know, how much are they going to pay for the stock? How much stock are they going to get? You know, we have small businesses, so we think like, well, I don't actually have stock. Well, if you're an S corp or corporation, you do have stock on paper at least. So, you know, if you have 100 shares, is the new partner going to get, you know, 20 shares for how much money? That's going to be spelled out. Another big one has to do with profit allocation and taxes. So, you know, if you're 50/50 partners, is each partner going to get 50% of the profit? Is one partner going to get a disproportionate allocation maybe because they contributed more capital upfront? So they're going to be entitled to more of the profits down the line. I mean, when you, when you have a part at like a general partnership, you can get very creative with these types of things. Maybe it's tax advantage for one partner to be able to receive losses because you expect the company to have losses upfront or whatever. But that all needs to be spelled out. You know, who gets what, who's going to pay the taxes on what.

Yeah, it's an important point to emphasize there because if you this might seem like just some, you know, I could see someone listening to this and be like, this is just coming in and out of here. Okay. Yeah, there's, there's things I need to pay attention to. Got it. But it is really important because if you don't pay attention to these details, you're going to get potentially hit with some tax bills later on that you weren't expecting because either you didn't understand or your tax plan, you didn't have a tax planner to look it over for you. And point these things out and say like, hey, maybe we should, you know, ask it to be done a different structure, a different way. Otherwise you're going to be having to pay, you know, a lot of taxes in this situation.

Yes. Oh, I'm not interrupting. I was going to say something that sometimes catches people off guard is that your taxable— taxability, that's not a word. The amount that you're taxed on each year is usually not tied to how much you actually take out of the company. So you think, oh, I'm not going to take any money out, I won't have to pay any taxes. That's not true. Profit is allocated, taxed whether or not you take it. So really understand, you know, if you're receiving a disproportionate allocation or a preferred distribution or whatever it's being called, make sure you understand that you're going to have to pay the taxes on that whether you take it out or not.

Yeah. Yeah. So I think the bottom line here is make sure a lawyer— your lawyer, I should say, not a lawyer, but your, your lawyer that has your interests in mind— look over the operating agreement and explain it to you in layman's terms and then have a tax planner, tax professional look over the operating agreement and explain to you what are the tax implications for whatever's going on there. Yeah. And then, so that's gonna give you clarity and then, and then you can go back to the potential partner and, you know, adjust things or, you know, explain it back to them to make sure they're on the same page in layman's terms so that you have a common understanding of what's on that piece of paper.

Just one other thing I want to mention is exit strategy. So at some point you're going to want to stop doing what you're doing, and that might come sooner than you plan. You know, we talk about the 4 Ds that destroy a business: disagreement, disability, death, and divorce. These things unfortunately happen, and we don't know when it's going to happen. They can, they can really take us by surprise. So is there a clear exit written out in the operating agreement so that I need to get out maybe before I want to get out. Is there a path for that? What is it going to cost? What am I entitled to? What will happen to my partners? That sort of thing.

Yeah, good point.

So you mentioned tax planning and, and we kind of touched on the idea of a stock sale versus you know, forming a new company. This is, this is where your tax planner really comes in because there's different ways of doing this. You know, when you have a stock sale, when this is kind of the most straightforward way of buying into another company, you know, your investor is buying a portion of your preexisting company and you're giving them shares of stock, even if it is just on paper. I guess all stock's on paper, even if it is just kind of, you know, I can't think of the right word. I'm sorry. Anyway, you're giving them— you're giving them a portion of your company in exchange for money. So how is that going to be taxed? This can catch people off guard because you have created this business and you've put some money into it. A lot of that money that you've put into it, you've already taken tax deductions on. So you're, you know, you're buying things for the business. Assets, you're paying for advertising, employee wages, and you're getting tax deductions on that. So to figure out how much you're actually going to pay in taxes, you have to figure out how much basis or how much equity you've invested that you haven't already written off as a tax deduction. And that's probably going to be fairly low, you know, and you've grown this business and now it's worth a lot more than what you have as equity, which is great, right? That's the goal. But when you sell it, that's when the IRS says that they want their piece. So imagine having a few thousand dollars invested that you haven't already written off and now you're selling it for $100,000. The difference, that $96,000, $97,000 that's going to be taxed as capital gains. Now, it is a little bit lower of a tax rate than ordinary income, but it's still taxable. So some people say, well, I don't, I don't really want to— I don't really want to cash out. I don't really want to hit, you know, get hit with those capital gains. So they might try something different, such as forming a new company where both partners contribute something of value in exchange for their shares in this new company. You might contribute your business operations or the ongoing concern or what's sometimes called goodwill towards this new company. Your other investor might invest cash or other assets, vehicles, machinery, equipment, whatever. So this is not a sale. You haven't cashed out on this thing that you've created yet. You have put it into a new company. So you've delayed having to pay the taxes on this growth. One day you are going to cash out, and when that day comes, you know, the tax man will come too. But this might be a nice way to kind of push that day off into the future.

Yeah. So this is a point of confusion here. When this happens, you know, you're— let's say I have ABC Painting Company, and then a partner says, hey, I want to go into partnership with you. I'll, I'll, uh, let's go in, you know, 60/40. So let's start an XYZ company, and let's, you know, I'll contribute X amount of dollars, you contribute the business assets. And processes and people, and then we'll start XYZ Company. So ABC Company still exists. You've just, um, you just started a new thing. So that's not, that's not a sale. Uh, so when, you know, you're talking to your, your partner about this, if they say anything about, you know, uh, you're going to get paid for, you know, as a purchase. That's not really what's happening. It's really both of you are contributing money or assets into a new thing, XYZ Company. So this is important because when you start a new company, you have a new— you have basis in the company, which is like a tax thing, which is basis is something that if you have enough of it, you can take money out tax-free. If you take out more than your basis, then you have to start paying capital gains tax on. So that's something that you'll have to keep in mind. Again, having a tax planner review the structure of this so that you're not getting hammered with taxes.

Yes. And just because this has come up before, basis is not fair market value. Totally different concepts. So if you contribute a company that may have a fair market value of $2 million, your basis is not $2 million. Your basis is something different. So this all comes down to, you know, the IRS lets you delay taxes on growth for a while, but when you start to get the money out, that's when they want their cut. So just be prepared to, to know how that works and be prepared to pay the taxes. You know, when it comes time to take some money out.

Yeah. All right. So we talked about operating agreement, tax considerations, selling versus forming a new company. Once you actually are working with your new partner, there are just some things you should consider from a financial perspective, like accounting and tax perspective. One is internal control. So in a smaller company, it's, it's— let me define what internal control is. So internal control is basically setting up processes to ensure that you're, you're not going to have fraud in your business. So it's a prevention of fraud. You don't want your office person to have the duty to you know, collect checks from customers, drop them off, also have check writing abilities, and also reconciling your bank account. If that admin has all that access and all that power to do all those things, you're basically— your risk of fraud goes up because if that admin person decides, oh, let me just write a check to myself and then miscode it in the record keeping, so that it's hidden. You know, that, that's the thing that, that happens all the time. And the reason why is because that company had weak internal controls. So you'll, if you just Google search, you know, office person steals from company, it, you know, a bunch of results will come up, recent news. So it's, it's definitely a risk for smaller companies because usually you only have a couple people to choose from. It's hard to delegate and have a segregation of duties where one person receives a check and then, you know, hands it off to somebody else to record it, and then someone else is reconciling it. And having all these segregation of duties is, is difficult because you're a small company. Um, so with that being said, a way you can mitigate that is to outsource portions of your, of your processes like reconciliation to a third party that can kind of protect you against internal fraud. So that's something to consider.

Yeah. And, and, you know, obviously you're not going to go into business with someone who's not trustworthy or someone who you think is dishonest. That would just be silly. But it's, it's crazy how how money can do things to people, especially when things get tight. You hear so many sad stories of, of good businesses going south because one partner, you know, got into financial straits. Maybe they're going through a divorce, maybe their kids need braces. And, you know, it's just so tempting to take something that's not theirs. And we don't even want the you know, the appearance of fraud or the appearance of temptation to cause any kind of mistrust in this new partnership that we're making. So we definitely recommend, you know, when it comes to things like finances, accounting, bookkeeping, taxes, if you can get a neutral third party in there to handle these things, that's going to go a long way to you know, keeping that trust strong between you and your partner because you won't even have the appearance or the temptation of something that's, you know, untoward or dishonest.

All right. Well, so we covered a lot, you know, answering the question of, you know, should you partner with a private investment firm? You know, we went through some of the good things of doing that, some of the things not so good things, things to look out for, things to consider from a financial or tax perspective. So hopefully that this episode was helpful. Is there any other thoughts that you had on this, Richard?

Yeah, I mean, the only other thought I might throw in there, and we did touch on it earlier, is, you know, as your businesses get more complex, you're bringing in more partners, maybe you're partnering yourself into other businesses. You're going to want to make sure that you are structuring these things in the most tax most efficient way possible. And that's not always obvious. You know, we're really focused on making money and growing the business, and we're, you know, we're not thinking about like, well, you know, how do I structure this so that I'm not getting killed in self-employment tax or whatnot? And that's where, you know, tax planning can come in. And again, I always say tax planning is for individuals because, you know, it's the individuals who pay the taxes. So setting up an appointment with your tax planner to look at your individual personal situation with the businesses that you own, the things that you're invested in, and making sure that the money is flowing in a tax-efficient way that's saving you on taxes, but it's also giving you asset protection and all these other things. You know, highly recommend. And as, as you grow and you bring new things on, it just becomes that more important. to pay attention to this.

All right, awesome. Well, love to hear your thoughts. Uh, definitely join our Facebook group, uh, Grow Your Painting Business. Love to hear your thoughts on the episode or any ideas for future episodes. But with that, we will talk to you next week.

Yeah, thanks for listening, and, uh, we'll see you on the next episode.