Business partners should always enter a partnership or similar operating agreement when entering a business partnership. This type of agreement allows each partner to understand its role, responsibilities, and protections to ensure a successful partnership.
This article describes what a partnership agreement is, who needs one, and tips for creating a strong agreement to set up a successful venture. If you have any questions, you should always consult with knowledgeable business lawyers to avoid legal issues in the long run. Our legal team of experienced business lawyers has years of experience advising our clients and drafting partnership agreements to achieve both partners' goals.
What is a Partnership Agreement?
Partnership agreements are a contract among people who are going into business together. This agreement outlines the nature of the relationship and what each party's responsibilities to the partnership are. One of the more important aspects of a partnership agreement is that it will determine each partner's share of the company's ownership and how and when everyone will get paid.
Additionally, these agreements will typically include procedures for all kinds of scenarios that can happen with the business, such as:
- The sale of the business
- The business dissolving
- The business expanding
- The transfer of shares
- The death of a partner
A partnership agreement is crucial so that all parties understand the partnership's expectations, goals, ownership, and other important legalities. The document should clearly explain how the business will operate, and no matter what your company faces, you and your partners (hopefully) don't have to quarrel about what to do.
Who Needs a Partnership Agreement?
Anyone going into business with another individual or individuals needs a partnership agreement. Typically, small for-profit companies starting with two or more people in ownership will draw up a partnership agreement. However, partners can execute a partnership agreement at any time, even if they have already been operating for some time.
Partnership agreements are not legally required contracts for business partners. Yet, it might be a good idea to check with a local attorney who will be able to tell you what the laws are in your state so that any agreement you have will comply with contracting and other business requirements.
Not All States Require Partnership Agreements
You will want to have a lawyer help you figure out how your state's laws will govern your business's operation if you decide not to have a partnership agreement. Keep in mind, though, that state laws governing partnerships without partnership agreements tend to be very boiler-plate. Therefore, while they are in place as a fail-safe for partnerships operating without contracts, having a partnership agreement drafted for your partnership will help ensure your specific needs are met.
Although the law does not require partnerships to have these types of agreements, it would probably be a bad idea to skip it altogether. Going into business with other people can be an incredibly rewarding experience. However, it can also lead to conflicts, and a partnership agreement will help you and your business partners stay on track with the goals and organization of the business.
Anyone starting a business with others should have a partnership agreement, no matter your industry. Partnership agreements are most popular with partnerships such as law firms, financial firms, tax practices, medical offices, and joint ventures.
Partnerships are somewhere between sole proprietorships (individual business owners) and corporations. They are the simplest form of business structure for two or more people. The three most common types are “Limited” (LP), “Limited Liability” (LLP), and “General Partnerships” (GP).
The main difference between these is the level of liability for the owners.
- LP: In an LP, one owner, or some owners, has unlimited liability (the general partner), and all the rest have limited liability (the limited partners).
- LLP: In an LLP, all owners have equally limited liability, and there is not one owner who is more liable for the company than the rest.
- GP: In a GP, all owners have unlimited liability.
Pros and Cons of LPs
Limited liability for a few partners and unlimited liability for one partner may sound like a great option for the owners with less liability. However, in an LP, the partners with limited liability also tend to have less ownership and control than the ones with unlimited.
There is a bit of give-and-take with these types of structures. A limited partnership can be beneficial for injecting capital into the company and sharing responsibility among partners. However, the general partners in these arrangements are at the maximum risk if the company goes bankrupt or is sued. So general partners are generally at a greater disadvantage in these entity forms. While limited partners have less risk, they also may have less power or say in the business.
Therefore, if you are considering creating an LP, understand your role in the partnership compared to your goals.
Pros and Cons of LLPs
One thing to note about LLPs is that they are taxed as a pass-through entity. They do not have the option to designate themselves as S-corporations for tax purposes. Further, they cannot avoid having the partners pay a self-employment tax. This means that all the partners of an LLP will pay self-employment taxes since the entity itself does not get taxed by the federal government.
The profits of the business are considered the income of the partners. A tax attorney can help partnerships assess the best designation and structure for their business, depending on annual revenue, business size, and many other factors.
A benefit to LLPs is that all partners are on equal footing regarding ownership shares and level of liability and responsibility to the company. They will each be protected from partnership debts, and an additional benefit is that they aren't responsible for the actions of other partners. This can protect each partner during situations where a lawsuit might arise or if one partner is conducting illegal activity.
Again, getting a lawyer to help in structuring your partnership business and drafting a partnership agreement can be vital to ensuring your liabilities and expectations are set up correctly.
Pros and Cons of General Partnerships
All partners are responsible for the company's operations and debts (or liabilities) in a general partnership. The biggest advantage of a GP is, like LPs and LLPs, that the business does not pay income tax. Instead, the profits and losses are passed through to the partners individually. While the partnership files a tax return, it does not pay taxes on the income. This allows for less paperwork than when forming a corporation.
Nonetheless, you should still have a partnership agreement that states the ownership, responsibilities, purpose, and other important legal terms.
On the other hand, partners in a general partnership are personally liable for the liabilities and debts. Therefore, the partners may be subject to litigation and bankruptcy court if the company goes belly up.
Partnership Agreement Drafting: What to include?
Here we have compiled some do's and don't's, along with what to include in your partnership agreement. However, it is always best to consult an attorney before finalizing an agreement as important as this.
For starters, make sure to stick to the basics and include information such as:
- The business name,
- A description of the business, and
- Contact information for the company and owners
Make sure to update this information periodically if it changes. Taking some time each year during an annual meeting to review a previously drafted partnership agreement is always good business practice.
The core parts of the partnership agreement should include these points:
- Decision-making and ownership allocation. This will usually be expressed as a percentage of ownership for each partner. The agreement should include rules for how decisions will be made, such as voting and whether or not decisions need to be unanimous or by the majority (or supermajority). This provision can also detail what to do in case of emergencies or if one or more partners cannot be reached when decisions need to be made. This way, no one is surprised later, and everyone has a clear direction.
- Capital contribution. This will discuss how much money each partner or investor has put into the business. This will also describe what might happen if the initial start-up capital runs out before the company can make a profit. Capital contributions can be assets, cash, property, or services. Additionally, a partnership agreement can include how the company intends to fundraise in the future if needed.
Salaries and distributions. As mentioned earlier, this can be one of the more critical components of a partnership agreement. This also tends to be one of the most-often disputed areas of a partnership. It is important to clearly outline how the company intends to handle profits and losses, and it might even be helpful to split these into two sections for added clarity. Some topics to cover might be:
- When and how the partners will get paid;
- If and when the partners will get their initial start-up investments back; and
- When distributions will be permitted.
You might also want to decide on voting requirements for anything involving distributions.
Death or disability of a partner. This section would benefit from the help of an estate attorney because wills, trusts, and inheritance of the interests in the business will all come into play should there be the death of a partner or if a partner is no longer able to help run the business. Questions that should be answered in this section can include:
- If one partner dies, who will inherit their share?
- Will partners be allowed to buy out the other partners' interests?
- Does each partner have a will drawn up and is up to date?
Again, one of the main purposes of partnership agreements is to remove the element of surprise in a business partnership as much as feasible.
- Transfer of Interests. This section should describe how a member may transfer its interests in the business to another party. This may also include whether the other members have a right of first refusal to purchase the interests before the member offers them to a third party.
- Dispute Resolution. Properly drafting your dispute resolution provision can be critical in the event of a dispute arising. You can explicitly state whether the members will enter into negotiations, mediation proceedings, or arbitration before entering litigation. This provision can save all of the members time and money by being able to resolve a dispute rather than suing one another amicably.
Dissolution or “winding up.” This provision will describe what will happen if the partners want to dissolve or wind up the company. Ending a business partnership is a commonly-litigated issue. Therefore, having a comprehensive section in your partnership agreement that instructs on how to wind up the business will alleviate potential headaches down the road. Here, the partners should agree on the following:
- How the business will come to a close;
- How the remaining monies, assets, and property will be distributed; and
- How many remaining debts or liabilities will be handled.
This section should also include what will happen if one partner wants to leave the business without the business shutting its doors completely.
While these are not the only provisions to include in a partnership agreement, all of these points must be discussed. However, avoid getting overly specific about the day-to-day operations and people's individual responsibilities in the partnership agreement. It is always a good idea to consult with an experienced business lawyer to help you draft this agreement.
An attorney who is well-versed in business formation will be able to help guide you to having a partnership agreement that is *just right* for you and your business partners. Contact us today to understand how best to create your partnership agreement.