This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
Many puzzling problems arise in connection with the custom which has become common in recent years, of giving up the partnership form in establishing enterprises and substituting the corporate form of organization. During the life of the partnership numerous personal agreements have probably been entered into which it is difficult either to continue or replace under the corporate form. Moreover, one essential feature of the partnership form is that every partner, irrespective of his financial interest, shall have an equal voice in the management of the enterprise. If there is wide discrepancy between the financial interests of the partners, it is difficult to continue this arrangement under the corporate form. The following is a concrete example which will make clear these difficulties:
Three partners, A, B, and C, conduct a jobbing business established 60 years ago by A's father. A, having inherited his father's estate, is the principal owner and the head of the concern; B, who began 30 years ago as a clerk, is in charge of the production and a large share of the selling; C, who entered as a bookkeeper 20 years ago, is in charge of the financing, office management, and credits. The capital of the firm is $325,000, of which A owns $275,000, B $35,000, and C $15,000; interest at 6% is paid each partner on the amount of his investment; each partner draws a salary of $7,200 per annum, and the profits are divided as follows: A 50%; B 40%, and C 10%. The annual sales are about $750,000, and the net profits $25,000. An important reason for turning the partnership into a close corporation is in order to allow department heads and some of the salesmen to gain an interest in the business.
It is at once evident, in considering this case, that its difficulty arises out of the fact that profits are divided without any fixed relation either to investment of capital or to the value of services. Six per cent is hardly a sufficient rate of return on the capital employed in a business of this character, so that it is no doubt intended to give some special allowance to A in the division of profits, that will constitute an increased return on his capital. However, this cannot be the controlling interest since B, with a comparatively small investment, receives 40% of the profits. The problem is to preserve these various rights and claims under the corporate form.
It would be possible to issue 6% bonds of the proposed corporation to A, B, and C to represent their respective investments, but, inasmuch as this is a jobbing business, it would be preferable to issue preferred stock rather than bonds. We will start, then, by providing for the issuance of $325,000 of 6% cumulative preferred stock; $275,000 to A, $35,000 to B, and $15,000 to C. The best method of determining the total amount of common stock to issue is to capitalize the remaining $25,000 of profit at some reasonable percentage, say 8%, making the common issue $312,500. If we assume that the distribution of profits to the three partners is meant to represent their permanent contributions to the upbuilding of the business, this $312,500 of common stock should be divided among them, 50% to A, 40% to B, and 10% to C. Possibly this division of profits in the partnership is meant rather to represent discrepancies in the abilities of the three men in directing the affairs of the business; if that is the case, these discrepancies should be adjusted by corresponding changes in the salaries of the three men, which in turn would involve a different distribution of the common stock.
Now comes the difficulty of giving each one of the partners an equal voice in the management of the corporation such as he now has in the management of the partnership. The simplest method of accomplishing that result, and generally the most satisfactory, is to create a voting trust, which should not be for more than five years. There would be a possibility, also, of making a part of the common stock non-voting, so as to make certain that each of the partners will be able to elect a member of the board of directors, but this is a somewhat cumbersome device. If it is adopted, it would be well to provide in the by-laws for cumulative voting so as to make impossible a combination of two partners to freeze out the third.