Some small businesses consider bringing on a silent partner that primarily contributes capital and advice. They do not intend to participate in daily business operations. Silent partners often provide expertise or special contacts that make the partnership more attractive than simply obtaining capital from a commercial loan. There are pros and cons to this arrangement from the silent partner side and active member side. Small business owners considering this arrangement benefit from negotiating a highly detailed operating agreement. Do not skimp here, and the details matter.
Why Might a Business Benefit From a Silent Partner?
There are a number of important considerations when taking on a silent partner in a small business. The silent partner likely provides money. They are unlikely to be involved in daily operations. Silent partners are likely expected to provide advice when asked, but are not expected to jump in and tend bar or start bussing tables when the need arises.
The silent partner will want to negotiate a financial arrangement that allows them to recover their initial investment as quick as possible, and then continue to receive some earnings indefinitely thereafter (even if they have recouped their entire investment). They will likely expect returns greater than other passive investment opportunities because they are risking capital and are not completely passive. Most will want the potential payouts to be indefinite, accepting that as part of the risk of investing in the business. Silent partners may also push the other members to provide personal guarantees for the money supplied to the business. This helps protect them in the event the business is an immediate bust.
Some silent partners do not actually own any part of the business. They may provide a hard-money loan with an interest rate that is likely higher than what a bank would provide. They often negotiate an agreement that they would be paid before the other owners are allowed to receive distributions.
Active Partner Considerations
The active partners will want to make sure the financial arrangement makes sense. They would do well to avoid overpaying for the advice. They will want to clearly articulate the silent partner’s responsibilities.
The active partners will prefer to extend the payback as long as possible and negotiate the silent partner’s ownership interest in the company. The active partners may benefit from being paid more in W2 salary, and not be limited to corporate distributions to realize the benefits from the business. They may benefit from avoiding a silent partner that has the right to take all of the earnings from the business early on. This may hinder growth more than the benefit realized from the silent partner’s financing and advice. The active partners will also want to minimize the royalty-like distributions that the silent partner will likely demand for the duration of the business. They may also want to have the first rights to buyout the silent partner.
If You Do Not Know How You Will Get Out, Do Not Get In
It is also very important for EVERY OWNER to have a clear exit strategy. I cannot stress this point enough. If you do not know how to get out, do not get in. Most small businesses do not last a lifetime. Many fail, or do not earn as much as expected. Folks die, get divorced, go bankrupt, struggle to get along, want to retire, or have other financial needs. The operating agreement should clearly articulate this exit strategy. Taking on a silent partner will likely require a more extensive operating agreement. This is no biggie, but do not skimp here. Your largest exposures as a part-owner of a multi-member LLC come from your co-owners. An operating agreement can help you decrease that exposure.
This is not an exhaustive list of pros-cons and topics to consider. However, these are some of the high points and can help guide your discussions. I highly recommend anyone considering this arrangement to consult counsel. You likely don’t know what you don’t know. An experienced business attorney can help protect you and improve the chances your business is a success.