New Partner in Partnership: Everything You Need to Know
A new partner in partnership means the old partnership will have to be dissolved and reformed.3 min read
A new partner in partnership means the old partnership will have to be dissolved and reformed. The new partnership helps redefine the arrangement between the new partner and old partners.
If the partnership does not want to dissolve and reform, there are four ways a new partner can join instead:
- Purchasing another partner's interest in the partnership.
- Investing cash or other assets in the partnership.
- Paying a bonus to the other partners by paying more than their interest percentage.
- Receiving a bonus from the partnership by paying less than their interest percentage.
New Partners and Finances
If the new partner is bringing assets to the partnership, the new partnership will define the value of these assets as determined by the other partners. Then, the new partner will receive compensation in their capital account for the value of the assets.
New partners may also purchase interest from existing partners. The partners should record the transaction by adding credit to the capital account of the new partner and removing value from the capital account of the partner selling the interest. Regardless of the price the new partner paid to the existing partner, the transaction should be recorded in the books of the partnership at the book value of each share transferred.
New partners bringing a profitable client base with them might be eligible for a bonus from the other partners. Usually, this bonus is equal to the assets they're bringing minus the book value of the shares they're getting for joining the partnership. This bonus should be credited to the new partner's capital account.
How to Determine the Value of the Partnership
To appropriately compensate a new partner, a partnership needs to know how much their business is worth. Partnerships often calculate two different types of value — tangible and intangible.
In most cases, tangible equity is based on the accrual-basis net equity of the partnership. Calculating intangible equity is a little harder. There are three main approaches partnerships can use:
- The equity method.
- The multiple-of-compensation method.
- The average annual valuation (AAV).
Problems With the Equity Method
With the equity method, many businesses run into the problem of balancing equity owned by separate partners over time. Usually, businesses that are smaller provide new partners with a smaller ownership stake than existing partners. This helps make the new partner's initial investment manageable.
However, because these businesses change equity allocations only when another partner retires or otherwise leaves the business, it can become hard for new partners to ever rise to the level of their seasoned partners. Take the example of a partner who owns 20 percent of the equity. If they decide to retire, the other partners in the business would accumulate their portion of the equity pro rata based on the amount they owned before the partner retired.
Therefore, a partner who had only a five percent ownership stake in the company wouldn't see a big increase in their shares compared to a partner with a bigger ownership stake.
Advantages of the AAV Method
The AAV method helps existing partners determine how much value the new partner will bring to the partnership. The AAV method is also called the revenue units approach. Regardless of what you call it, AAVs allow a new partner to participate in the firm's growth without needing to sacrifice their personal finances to buy some of the company's equity.
As a new partner starts working, they'll contribute through sweat equity, which will earn them a portion of the newly created revenue units. These new units can be given equally to every partner or awarded based on performance.
Withdrawing From a Partnership
Removing a partner from a partnership is often the reverse of adding a partner. There are three main scenarios which could take place if a partner wishes to leave:
- The remaining partners can use their own money to buy out the leaving partner and take control of their shares.
- The remaining partners can pay out the value of the leaving partner's capital account and include a cash bonus.
- The leaving partner can pay a bonus to the remaining partners by not fully cashing out their capital balance. This capital balance will be split between the remaining partners.
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