Current and Capital contributions should be rewarded differently. Allow me to explain this with Pies;
Sometimes you’re making the pies, sometimes you’re making the kitchen. The pies create profit right now. The kitchen creates profit for years to come. If you made the pies, you should get your share of profit now. If you made the kitchen, then you should get a little bit of the profit share for as long as the kitchen is used.
In accounting terms, pies are current assets, meaning they are expected to be used up in the current year. A kitchen on the other hand is a fixed asset, because it remains around from year to year and continues to generate income the whole time.
Some types of fixed assets, such as kitchens or cars, do eventually wear out over time. In accounting terms this is called depreciation. It means the value of the asset that is recorded in the accounts is reduced every year as it wears out. On the other hand, if you make a contribution by repairing or upgrading an asset, then the value of the asset recorded in the accounts will increase, by capitalising the shiny new contribution.
So how much of your contribution should be considered Current, and how much should be considered Capital? Well, just like the actual value that your contribution has, it is something that you will need to negotiate (and regularly re-negotiate) with your colleagues. You need to reach an agreement about what a fair allocation of profit share is, based on all the different contributions that have been and will be made.
Being part of an alliance depends on contributing to the alliance. A contributor should be considered to be part of the alliance - i.e. should continue to receive a share of profit and have an equivalent share of control - for as long as their contributions are still creating profit for the alliance.
This means that if you are only making Current Asset contributions, and you stop contributing, then you should stop receiving any profit share and should not have any vote in the decisions of the joint venture; you are out of the alliance.
On the other hand, if you are making Capital Asset contributions that continue to create profit even after you have finished contributing, then you should still continue to receive a proportionate amount of profit share and control. Note that these Capital Asset contributions can include things like creating customer satisfaction, building an ongoing reputation for quality work and customer service, and other side-effects of work that would generally be thought of as only creating Current Assets.
To avoid any doubt, this sort of classification and proportioning of your contribution into Current and Capital components should be negotiated (and regularly re-negotiated) with your colleagues, written into the joint venture agreement, and recorded in the company accounts.
If you are contributing things to the business on the understanding that they will continue to generate income for you in future years, then you need to be sure that you will retain your entitlement to that income and not have it taken away from you by some act or decision of your colleagues. This is something that should be addressed by the joint venture agreement. The exact way this is done will depend on the way the business is structured and what your Capital contribution was.
For example, if you have formed an incorporated joint venture, then Capital contributions can be recognised by issuing shares that will have voting rights in future years, whereas Current contributions could be recognised either by temporary shares that expire at a certain date or when contribution stops, or you could simply have Current voting rights and profit share enforced by a contract with a fixed end date.
This type of structure could provide you with ongoing influence over the alliance, and if you have protections for minority shareholders in the company constitution and shareholder’s agreement, it should also prevent you from being deprived of the value of your contribution without fair compensation.
Most joint ventures will eventually end up in a situation where some people, often the newer members, are contributing lots of effort towards current assets such as making the pies or taking customer orders. And there will be other people who largely made contributions in the past, having invested their time in building the business up over many years, and who may not actually be making current contributions at all. The current profit they are generating is due to assets they created, that still exist and that the Current contributors depend on to make current profits.
So how do we work out how much of the current profit is due to current contributors, and how much is due to assets (including intangibles like existing customer relationships) that were created in the past by people who are not contributing right now, but should still receive a share of current profit?
Again, this will come down to a negotiation. And if prior Capital contributors demand more than the assets they created are really generating, then Current contributors will have no incentive to join the alliance or to remain in it. On the other hand, if Current contributors demand too much and fail to acknowledge the real value being provide by existing Capital assets, then prior Capital contributors will have no incentive to renew the current agreements when they expire. At that point Current contributors would cease to be part of the alliance and would not have any voting rights in the joint venture, because they are no longer contributing anything. The Capital contributors will then be free to go and find new Current contributors, if they can…
In other words the incentives to negotiate fairly and constructively are quite strong on both sides, and one would hope this would quickly lead to fair and enduring agreements.
When you are negotiating recognition of your Capital contribution, you are asking for an increase in your ongoing share of the profits and control of the alliance. By definition this will have the effect of permanently diluting the share of profit and control that your colleagues have. If everything else stayed the same, then they would end up with less. So for them to agree to recognise your contribution, they will need to expect that whatever you are contributing will increase total future profits by enough to offset their loss from the dilution.
That will depend on the size of your Capital contribution and the amount of profit share you are asking for, but it will also depend on how much profit comes from fixed assets in your particular type of business, and also what stage of development the business in; are new contributions likely to be a significant percentage of total contributions, or will they be a relatively small increase to a large existing base of fixed assets?
Written by John on 3rd October 2020