An Introduction to Partnership Agreements
Before we get started, I’d like to make it clear what partnership agreements are and how they differ from other types of agreements.
When I say partnership agreements in the context of these blog posts, it refers to the agreement between two or more people who are going to be operating the business, and it is independent from the structure of the business. Strictly speaking, the agreement is between the members/owners of a business.
Other types of agreements that are at the core of any business are Operating Agreements, and Shareholders Agreements:
- A Partnership Agreement, strictly speaking is for general partnerships, limited liability partnerships, and limited partnerships. These are the three common forms of partnerships, each with its own quirks.
- An Operating Agreement is a type of partnership agreement that is unique to Limited Liability Companies (LLC’s). LLC’s are governed by their Operating Agreement so that there is a mechanism for managing the business between its members.
- A Shareholders Agreement is often used for small corporations that are owned by just a small number of shareholders. They have many of the same features that we are going to be discussing, but it refers to the ownership of the stock shares. Shareholders agreements are common in start-ups.
For the purposes of this post I will be referring to a partnership agreement to refer to all three kinds of agreements. In the future there will be individual posts that are specific to LLC’s or Shareholders, but we will get to those later.
A partnership agreement is best thought of as the constitution of a partnership. It is the document that lays out the large scale operational matters from a strategic or ownership standpoint. It is not designed to govern the day-to-day actions between partners nor the decision-making about the business. It is designed to provide a large scale plan for operating the business. I am a big believer in partnership agreements because it is better to have a mechanism that you think of at the beginning of the relationship. If you don’t have this agreement, you will be trying to deal with events and circumstances on the fly, rather than thoughtfully implementing a management scenario to resolve a dispute or crisis.
For the most part, partnership agreements can take whatever form the partners themselves want to have. It is a set of private laws and a private constitution of how the business is going to operate.
Before entering into any partnership agreement you should consult with an attorney. All partners should have their own attorney advising them on the partnership agreement. The partnership or company may retain an attorney to draft the document, but that attorney is often representing either one of the partners or the company itself. You should take care to see how that affects the balance of your operations and to avoid conflicts of interest.
A partnership agreement has relatively standard sections that should be included. Whether you’re writing a new agreement or reviewing one that’s already been written, you can use this information as a guide.
Quick Note About Partnerships by Accident:
Yes, you read that right. It is possible to end up in a situation where you and a colleague have created a partnership by accident. A partnership is an association of two or more people acting together for business purposes. A partnership does not have to be making money to be a partnership. I have reviewed situations where a partnership was formed without any intent but because the parties were acting together for a business purpose—voila! a partnership was formed. For the most part, the bigger concern for partnerships by accident deals with the liability side of things rather than financial, but it can happen.
The moral of the story—be deliberate about starting a partnership of any kind.
Core Information about the Company
Generally the first section of a partnership agreement is about the business itself. You’ll note the name of the business and the names of the partners. You’ll also include the nature of the business, principal office, resident agent, and where the company is registered (aka all the basics about the business).
Initial Contributions
The next section will outline the initial contributions into the partnership, whether that be cash, assets, intellectual property, sweat equity, and/or expertise. The partners need to describe what they are putting in and if possible what value can be assigned to each contribution. This helps to understand the value of the company as a whole, taxation of the company, and taxation of the partners themselves.
Voting Rights
Next, you’ll want to include clauses regarding voting: how will partners vote on critical issues? There are usually a few different ways this could happen. Each person could get one vote, or you could vote by shares or proportion of ownership shares. If you are dealing with a 50-50 partnership you would keep it pretty simple, but if you are dealing with a partnership that has three or more partners, voting by shares is pretty common, though you could still vote per person. The one thing you must be careful with if you are voting with shares or ownership interest is minority owner rights. You need to make sure folks with smaller shares are not going to get frozen out of decisions.
Pick your Partner Provision
In most situations I recommend that the partnership agreement have a “pick your partner” provision. This ensures that if there is any transfer of ownership from one partner to a third party, the remaining partners have some control and mechanisms to avoid being in business with someone they did not choose. In the case of illness or death of a partner or divorce of a partner where the non-partner spouse gets a share of the business in the divorce decree, often times only an economic interest is transferred (management rights are not included). Ownership involves both economic (the profits and losses) and management (voting) rights. Most states allow a separation of economic and management rights, but you will definitely want to bring up this topic with your attorney.
Large-Scale Management Matters
What is a company going to do if it wants to sell all or a substantial amount of assets? What if they want to bring new partners in, or hire new employees over the salary cap? What if the company wants to borrow a large amount of money?
These are large-scale structural decisions that will have to be made by the partners. These kinds of questions should be laid out within the partnership agreement so that partners can easily make decisions without having to go through complicated consultations.
Some topics will require a majority vote from partners, while others will require a unanimous consent of the partners. These would be big decisions that the partners should be making about a business. I want to caution people not to get too far into the weeds in this section. If you get too detailed you constrain the partnership in such a way that decision making becomes very difficult. Sometimes answers are needed immediately. There must be some sort of mechanism that allows the partners a freedom to operate, but also to efficiently manage large-scale decisions.
Buy-Sell Provisions
There may come a time when a partner needs to leave the business, becomes disabled and is unable to contributes to the business, is put in jail, or passes away. In these situations, there needs to be a mechanism by which the other partners can buy the partnership share, or to allow the partners to sell their own interest to a third party, but give the remaining partners the right to manage that and on what terms the sale can take place.
A buy-sell agreement is incredibly important and something that partners should both discuss in advance to ensure that they fully understand what their rights are in the case of a partnership dispute, death, disability, etc. A buy-sell agreement is a delicate balancing act of trying to find enough flexibility while limiting options which can cause dissension among the partners. You want the partners to have as much flexibility as possible, but you want to limit the number of options that they have.
Dispute Resolution
I am not a fan of arbitration and litigation. I am a huge fan of mediation. It happens quicker and it is private. I recommend having a robust mediation provision in any partnership agreement. Mediation is designed to lead to compromise. You may need to have a compromise in order to have the parties be in a place where they can move forward. If you don’t have a mechanism to make that happen and rather one party is picked as a winner over the other, future business relations can get sticky. There can be an informal arbitration between the partners and a third party, such as an attorney or CPA, who can provide a way to reach a compromise.
Arbitration and litigation require a third party to pick winner in any dispute. In my experience, the only people who win in an arbitration or litigation are the lawyers. In a business dispute, a winner-versus-loser mindset often brings hurt feelings and a dissolution of the partnership. You want to include a dispute resolution tool such as mediation is a better bet for partners moving forward.
The Boiler Plate
The Boiler Plate sections deal with very broad policy questions. What happens if we have to file a lawsuit? How are parties going to inform each other of important matters? While I do recommend you include these topics, in a partnership agreement they don’t take on a prominent role as they would in other agreements.
This is a broad overview of a partnership agreement. Stay tuned to future posts where we will go in depth into some of these sections. As always, contact us anytime for support in your partnership agreement legal needs.
Matt Johnston (#mattthelawyer) represents small- and medium-sized business in a variety of industries. Matt and his team assist clients offering services as an outsourced General Counsel with subscription-based pricing where clients pay one flat monthly fee for services including Meterless Communications.Frederick Chamber Insights is a news outlet of the Frederick County Chamber of Commerce. For more information about membership, programs and initiatives, please visit our website.