This article has been written by John N. Haramalis, pursuing the Diploma Programme in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho.
Table of Contents
Introduction
Going into business can be one of the most important endeavours that a person undertakes. That route could involve a business partnership. A business partnership is an important union of two or more persons (or entities) that form a legal relationship to conduct business through a written agreement but maintain individual liability for the endeavour.
The business structure, responsibilities and obligations that the agreement between the parties sets forth is critical to ensuring the success of the effort. As each partner in the business is responsible for the actions of the other partners, professional legal expertise is essential from the start. Properly drafted, a business partnership agreement (also known as “partner deed”) protects all parties and provides a fair method to resolve disputes and disagreements; it also outlines the procedures needed to amend the working relationships or dissolve the business completely.
Benefits and disadvantages of partnerships
Benefits of partnerships
Parties to an agreement should be advised of the benefits and disadvantages of partnerships. As business needs expertise and collaborative efforts, the “pros” of a partnership can be many. The advantage of taking on partners includes having experienced people that can share the workload and the numerous tasks that the business will have to face. Each partner can bring their experience and expertise to bear in areas that will positively affect the new business, and combined efforts often reduce the amount of time that critical tasks need to be performed. Other partners may have experience running a business and know how to avoid or negotiate complicated business and regulatory matters, leaving the other partners to focus on the product or service that is being provided.
Another added benefit is that financial matters, including resourcing the business, can be divided among the partners and therefore are not the sole responsibility of any one partner. This means that financial risk and burdens are reduced and shared, and any debt undertaken may not have to be excessive. In addition, administrative related tasks can be allocated accordingly and reduced or spread out among the partners, and business entity taxes may be avoided completely (this is the case in the United States where profits pass through to each partner and a separate filing for business taxes is unnecessary).
Disadvantages of partnerships
There are disadvantages to every effort that requires business decisions being made by more than one person, and if the agreement requires unanimous decision-making, this can be an important “con” to consider. Though unanimous decision-making requirements are designed to protect each partner from the irresponsible decision making of another, it is not uncommon to have disagreements or conflicts among partners, and if these cannot be amicably and expeditiously resolved, the business will likely suffer the consequences.
In a partnership, you are responsible for the actions of the other partners and do not have a business liability shield to fall back on. The misconduct of one partner will be borne by all partners, and business debts can end up as individual responsibilities. All these bear serious consideration for those wanting to establish a business partnership. A lawyer’s responsibility is to advise the parties of the pros and cons of partnerships and proceed if the parties concur that a partnership is still the type of business that they want to form.
Types of partnerships
The next step in the process is to identify the type of partnership that best fits the needs of the parties. The three main types of partnership agreements used are:
- General Partnership (GP),
- Limited Partnership (LP), and
- Limited Liability Partnership (LLP).
There are other partnership agreements available, such as a Limited Liability Corporation partnership, a newer model, but this article focuses on the main three.
Which type of partnership agreement will be chosen will depend upon the type of business and how the parties value characteristics of the business, such as control (management decisions), liability, profit distribution, and tax liabilities. In addition, some jurisdictions may have regulations that also influence these decisions:
General Partnership (GP)
A general partnership is basically two or more individuals in business that share equal management rights and responsibilities, and each partner is fully liable for all debts and obligations incurred. This means that a general partner has virtually unlimited liability for the debts of the business and may have to sell their personal assets if necessary to resolve the debt.
Limited Partnership (LP)
A limited partnership allows a partner to have a financial interest in the business, but not any management responsibilities. Because they do not exercise control over the business, they are not personally liable for the debts incurred by the business, therefore the sum total of any losses that may be incurred by a limited partner is restricted to the investment the partner has made. A limited partner has similarities to a corporate shareholder. However, a limited partnership must have at least one general partner who takes on the management responsibilities and liability risks.
Limited Liability Partnership (LLP)
A limited liability partnership is a derivative of the general partnership, but in an LLP all partners have limited liability in the sense that they are protected from the actions of the other partners. Unlike an LP, there is no requirement for a general partner.
The business structure is what provides some legal protections for the partners, as it is a hybrid between a corporation and a general partnership. The limited liability shield usually extends to “errors, omissions, negligence, incompetence, or malpractice committed by other partners or by employees of the firm, just as in a corporation.” Some jurisdictions (especially in the United States) restrict LPs to certain professions like doctors, lawyers, accountants, and others. An LLP maintains the same pass-through tax advantages as a partnership.
Necessary elements of a Partnership Agreement
Once the parties have decided on the type of partnership, the next part is completing the business agreement. In the United States, the Small Business Administration has created a checklist of questions to be answered and a recommendation for clauses that should be drafted in every Partnership Agreement. Some of these are outlined below:
Company name, status, and duration
This sounds simple but is important enough to mention. The company name, type of corporation and purpose of the partnership should be included. Some sample clause language could read as follows:
“The purpose of this XXXX General Partnership is primarily to engage in and conduct the business of owning and operating XXXX, and to engage in any other activity permitted under XXXX law and the laws of any jurisdiction in which the XXXX General Partnership may do business.”
Other relevant information that identifies the nature, place and purpose of the business, trademarks, regular or periodic business meetings can also be added. The governing laws and jurisdiction in the event of a dispute can be listed in the initial sections. If more detail is needed, specific office location and hours of service can be included, as well as whether any special licenses or permits must be obtained to do business. The duration of the partnership may also be specified in the agreement.
Liability of the partners
The liability of each of the partners should be addressed within the agreement. As mentioned earlier, the type of partnership and the status of the partner will determine liability. In a general partnership, a clause may be read as: “Except as otherwise provided in this Agreement… each General Partner shall be jointly and severally liable for the debts and obligations of the Partnership.”
In the case of a limited partnership, the clause may be read as: “no Limited Partner shall be liable for the debts, liabilities, contracts or any other obligations of the Partnership. Except as agreed upon by the Partners, and except as otherwise provided…”
Number of owners/control of the business
This is about the percentage of the partnership each specific individual owns and it should be provided along with the initial contributions made by each partner at the time of the founding of the company. Equal contributions usually result in equal shares, but different contributions require a calculation to determine the percentage each owner has in the business. Contributions can be monetary or in-kind, such as tools, equipment, and intellectual property.
Partners bring in an existing customer base, goodwill, and network and professional contacts that can also be a significant contribution. This can be done with straightforward language such as “the Partner’s ownership interest in the Partnership will be as follows:” (then list out the names and percentages).
Capital
Capital accounts identify the amount of equity (ownership) each partner has. The capital account shows initial and subsequent contributions made by each partner. Sample clause language could include the following: “the capital of the Partnership shall be the aggregate amount of the capital contributions made to it by the General Partners, and an individual capital account shall be established and maintained for each Partner and shall be credited with the amount of each Partner’s capital contribution to the Partnership.” This will include “distributions, earning and payments” made to the partners.
Management, decision-making and binding the partnership
The process of decision making and who can bind the partnership must be specified or the usual default provision is that any partner can make a decision that binds the entire partnership to a legal obligation. How decisions are made in a business is important, especially when there are multiple partners.
A lack of clear guidance or authority can lead to disorder and confusion, and this is a recipe for disaster. In some agreements, a managing general partner may be designated. Such a clause may include broad authority as follows: “the management and operation of the Partnership will be exclusively vested in the Managing General Partner…who may undertake those actions, in its sole discretion, as deemed necessary, advisable or convenient to the discharge of its duties under this Agreement and to the management of the operations and affairs of the Partnership.”
Dissolution
The agreement must provide a method to dissolve the partnership. An appropriate clause can be as simple as “the Partnership may be dissolved by majority vote at any time, in which case the Partnership will be liquidated, and the debts paid. All remaining funds will be distributed based on the percentage of ownership interest outlined in this Agreement”. Additional criteria can be added to ensure accountability through an audit or other means if necessary.
Death and disability
The unexpected death of a partner or the unexpected departure due to disability should be provided for in the agreement. This can include a life insurance or disability policy where the owner of the policies and the beneficiary is the business, and the insured is the partner.
The payments from these policies can contribute to a “buy out” of the partner’s business shares or pay a portion of the salary during the period of disability. These can be structured in various ways to support the business. Another matter to address is whether the business will continue and what will be done with the deceased partner’s shares. A sample clause related to the death of a partner could read:
“Upon the death of a Partner…the business of the Partnership shall be continued to the end of the fiscal year in which the death occurs. The estate of the deceased Partner shall share in the net profits or losses of the Partnership for the balance of the fiscal year in the same manner… At the end of the fiscal year, the surviving Partners shall have the option either to liquidate the Partnership or to purchase the interest of the deceased Partner.”
Transfer of partnership interests
If a partner wants to leave (or must leave) the business for whatever reason (such as disability or retirement) the partnership agreement should have a mechanism for the business to purchase back the partner’s shares or allow them to be sold to an approved third party.
Should the company have the first right to buy the shares before considering taking on a third party as a new partner? This is something that must be addressed in the agreement. A sample clause might read “a Partner may transfer or assign their interests at any time subject to the following provisions: the Partner’s own shares of the business will first be offered to the business itself, which shall have 90 days to purchase the shares at the prevailing market rate.” Additional details or timelines can be added for a proper valuation to occur if needed.
Dispute resolution mechanism
A dispute resolution mechanism is essential in many contracts, and a partnership agreement is no different. One method is to help avoid or minimize disputes altogether is to delegate responsibility for decisions among the partners, with each having authority over a certain area or aspect of the operation. Business operations respond well to harmony and expeditious decision-making; amicable settlement of disputes is always best while going to court is usually the worst option for a business. A sample dispute resolution clause could read:
“The parties will attempt to resolve any dispute arising or related to the Partnership or this Agreement through friendly negotiations amongst the parties within 5 days upon written notification by a party to the Partnership. If the matter is not resolved, the parties will submit the dispute to Mediation. If Mediation does not resolve the dispute or is unavailable, the parties shall submit the dispute to arbitration, which shall be binding upon them.”
Conclusion
Preparing and properly drafting a business partnership agreement will take some time, but trying fix problems stemming from a business with no partnership agreement or a poorly written one may take far more time, energy, and resources than the partners could have ever contemplated, and affect business operations in ways that they could not have imagined. Partnership agreements can be relatively straightforward and easy enough to set up if all the foundational questions have been answered and the partners are well informed on the issues.
This is where the preparation done by the lawyer is critical to the drafting of a solid agreement that supports the success of the business and provides a mechanism and alternatives that assist with amicable dispute resolutions. A well-drafted partnership agreement will eliminate uncertainty and keep the business operating as intended by the partners, allowing them to focus their efforts on other important matters.
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