Creating Lasting Business Partnerships
As you move through your business experiences, you can often look to areas outside your business scope for examples and support. In the world of partnerships, the names “Barnum and Bailey” or “Mickey and Minnie” often come to mind as examples of great partnerships.
In order to strive toward a great partnership in the business world, there are a few key elements you can implement within your small business partnership. In this course, we will outline several things to consider prior to starting a partnership as well as some guidance on how to maximize your chances for success once you begin operating a partnership.
In the simplest form, a business partnership is:
Two or more people or entities engaged in a business enterprise for profit.
From this definition, we see that a business partnership could be two individuals, two sole proprietorships, two corporations, two limited liability companies, or any combination thereof. The general requirements for partnership formation vary from state to state, so be sure to review the applicable laws within your state. The definition of a partnership for federal taxation purposes is:*
An unincorporated organization with two or more members whose members carry on a trade, business, financial operation or venture and divide its profits.
As you can see, the definition of a partnership for taxation purposes is a bit more restrictive than the general business definition. Now let’s take a look at the different types of partnerships and some topics to discuss before starting a partnership.
*For a more complete discussion, see the instructions for IRS Form 8832.
Before Getting Started
As with any new undertaking, prior to taking off with your new partnership idea, there are several important areas you should review. Asking questions and understanding the impact forming and operating a partnership will have on your business and you personally are essential. Here is a list of some questions which should be addressed before beginning any business partnership:
- Risk and Control
- Fiduciary Duty
There are several different types of partnerships you can form. The most common partnership types are:
Each of these partnership types will react in particular ways to the questions outlined previously. Let’s review each of these partnership types to see which, if any, is right for you and your small business.
In order to form a general partnership there must be an agreement between two or more parties; this agreement can be either oral or written in nature. The parties can be individuals or other business entities, such as corporations or limited liability companies.
This type of partnership is a basic entity form that generally does not call for any of the formalities required to form a limited liability company or a corporation. In addition to a partnership agreement, a partnership must be unincorporated, which seems obvious, but is nevertheless a stated partnership requirement in the Uniform Partnership Act and the Revised Uniform Partnership Act; these two acts guide state partnership law in nearly all 50 states. (NOTE: If you have gone through the formalities to satisfy the corporation requirements, you cannot then operate as a partnership – which of course would then impact tax, liability and financing issues for the business.)
In short, while the sole proprietorship is the default entity for a single person in business, the general partnership is the default entity for two or more persons in business together.
A general partnership is a pass through taxation entity. What that means is while a general partnership is responsible for tax reporting, it is not responsible for income tax payment. There may be other taxation requirements for a general partnership, but income taxation will result to individual partners after their income shares “flow through” onto their individual income tax returns.
Profits or gains made by the general partnership will be distributed to the general partners as outlined in the partnership agreement. We will discuss the partnership agreement in detail later, but for now it is important to note that distributions to general partners are not required to be even or equal. Rather distributions must be made in accordance with the partnership agreement guidelines.
Distributions made to general partners will be characterized as “earned income” and will be added to that partner’s individual tax return. Additionally, any regular payment to a general partner (e.g., salary) will likely require a self-employment tax payment.
While taxation issues regarding a general partnership are typically straightforward, it is recommended you utilize the assistance of a business specialist or accounting professional if you have any questions regarding taxation issues. Your financial institution will likely have a resource available to assist you in this area.
One of the primary considerations any small business owner should have relates to liability:
“What amount of personal liability will I have?”
This is a question you should regularly ask as a small business owner, regardless of the type of business entity you operate.
In a general partnership, each general partner has joint and severable liability for the obligations of the business. Joint and severable liability means that each partner can be held individually responsible for the full obligations of the business.
For example, assume Businessman A and Businessman B are operating a partnership. We will also assume that Businessman B has significant personal assets. If Businessman A commits the business to a $500,000 cash loan and the business defaults on that loan, Businessman B could be sued individually by the lender for recovery of the full loan amount from his personal assets. In this example, if Businessman B was required to repay the entire loan individually, he would have the legal ability to try to obtain 50% of the $500,000 from Businessman A.
Joint and severable liability is a concept you must fully understand before engaging in business with other general partners. Not only does a general partnership share give little to no protection for your personal assets, this type of liability could potentially put your personal assets at risk to offset poor partnership decisions made by other general partners. As a general partner it is important that you fully understand potential liability risks prior to moving forward as a general partner.
Risk and Control
As we discussed previously, there is no liability protection for general partners of a partnership; this creates a high risk factor when it comes to the exposure of personal assets. Additionally, the general rule is a partnership can be bound to performance on contracts, loans or other business obligations by any general partner. While your partnership agreement can put into place procedures and safeguards to limit this type of risk, the nature of partnerships creates a high risk environment.
In addition to joint and severable liability with other general partners, any general partner may also be held responsible for any actions of a partnership employee acting within the scope of the business. Once an action has been taken by another general partner, and most probably any partnership employees as well, that action typically cannot be “undone.” Your only recourse would be an action against the offending party within the partnership; therefore, it is important not only to understand the laws of your state regarding partnership risk and control, but also to ensure your fellow general partners are upright in their business judgment and actions.
While there are many pressing issues that should be addressed in your partnership agreement, money matters are often the most significant. Not only what to do with the money you make, but also how to pay for expenses are important areas. Here are several expense-related issues to consider:
- Is the expense actually a business expense?
- How will business expenses be apportioned if the business does not have sufficient revenue?
- How will additional partner expense related contributions be treated?
- When will expenses be paid?
Identification and payment of business expenses is a crucial part of successfully operating a small business partnership. Money is often tight when your business is first starting out, and initial business expenses don’t always have corresponding sales revenue as an offset. This fact of business life requires good planning and a disciplined effort in following the plan in order to overcome potential early expense-related stressors.
Having the foresight to identify within your partnership agreement what an expense is, when and how they will be paid, and what the plan is when you cannot pay an expense will help ensure success for your small business general partnership.
In order to understand the concept of “fiduciary duty” and how it applies to your general partnership, we will first define the individual terms, give a complete explanation, and then provide an example.
The term fiduciary is derived from Roman law, and is defined as “a person holding the character of a trustee.” A trustee is an individual in whom some interest or power has been conferred, with either an express or implied agreement that he/she will administer that interest or power on behalf of someone else.
The term duty means a “legal or moral obligation.” In this context, it also includes an obligation to meet a legal standard of reasonable decision-making in light of apparent risks.
So putting the terms together, a fiduciary duty is a legal obligation, which requires general partners to act primarily for the benefit of the partnership rather than for their own benefit; this duty also requires these actions be “reasonable” as well. While it may seem clear on paper, when the rubber hits the road and you are engaged in the day-to-day operations of your business, lines can get a bit cloudy. Let’s take a look at a few examples.
Fiduciary Duty: Example #1
Let’s assume for purposes of this example that you own a paint contracting business. You paint houses primarily, both interior and exterior. You start a general partnership with another individual who operates as a general contractor. This individual builds home additions as well as undertakes room and full house remodel projects. The two of you decide to enter into a partnership in order to pool your resources in an effort to increase your revenues.
While operating the general partnership, you come across an opportunity with a new home builder that is a significant financial opportunity. Here are the choices you have:
CHOICE #1: Take the opportunity to your partner and decide collectively on whether this would be a good opportunity for the general partnership.
CHOICE #2: Decline the opportunity without discussing it with your partner.
CHOICE #3: Accept the opportunity on behalf of your paint contracting business without disclosing the opportunity to your partner.
What is the best course of action for you here? What is the required course of action? In order to act primarily for the benefit of the partnership rather than your own personal interests, the first option would likely be the correct choice. Then, if you decide as a partnership not to pursue the opportunity, you would be free to accept the opportunity on behalf of your paint contracting business.
Fiduciary Duty: Example #2
We will assume the same initial set of circumstances for this example, namely you operate a paint contracting business and you enter into a general partnership with an individual who operates as a general contractor.
Your partnership agreement outlines that you are primarily responsible for the purchase of operational as well as fixed assets. In a moment of consumer weakness, you determine it would be a nice idea to outfit the entire operation with new vehicles. So after a week or two in operation you purchase, on behalf of the partnership, two new Ford F250 long-bed pick-up trucks, two Ford F150 four-door pick-up trucks and a Ford F250 panel van. The total outlay is roughly $200,000 and requires a monthly payment of between $3,000 and $4,000 per month. We will toss in the additional fact that the partnership already had similar vehicles, so the new vehicles are upgrades.
A determination on whether you have breached your fiduciary duty to the general partnership would likely depend on the financial condition of the partnership. If you are operating three to five teams of employees and generating $40,000 of monthly revenue, the decision would seem to be in line with the operation. However, if you and your general partner are the only two employees and you are generating $10,000 of monthly revenue, it would clearly be an unreasonable purchase, and therefore, a probable breach of fiduciary duty.
While these examples are straightforward and clear, the real world issues that arise within the context of day-to-day business operations are usually much more difficult to decipher. Additionally, the laws governing fiduciary duty can vary from state to state; therefore, if you are not absolutely certain of what your duty is, or where a particular decision will fall with respect to a duty, be sure to seek out guidance from a small business or legal professional.
Operating a general partnership may be an option that helps your small business get off the ground, or become more successful. Some advantages of operating your small business as a general partnership are:
- Multiple Owners: The owners share costs and risks while pooling resources.
- Easy and Flexible: A partnership is simple to set up and can be modified easily if business needs change.
On the other hand, there are also some disadvantages to operating your small business as a general partnership:
- Joint and Severable Liability: There is personal liability for all business obligations in a partnership.
- Longevity: A partnership is tied to partners being willing and able to participate to meet business goals.
Maybe the general partnership will work for you, or maybe it is close to just right. Let’s take a look at another type of partnership that could work best for your small business.
While maintaining many of the same characteristics found in a general partnership, a limited partnership has some significant differences as well. One significant difference between the two types of partnerships is the added requirements with respect to limited partnership formation. In most states, the creation of a limited partnership is not a default business form.
We will now review the requirements for limited partnership formation, and then discuss the same topics we covered for general partnerships.
Each of the 50 states in the United States has particular laws that guide the formation of business entities. Depending on the state, and the type of business entity, those laws can either be common law (guided by court decisions), or statutory law (guided by laws enacted by the state legislative branch of government). The guidelines for the formation of a limited partnership are generally statutory in nature, and the formal requirements can vary from state to state. The most common formalities required are:
- Certificate of Limited Partnership filed with Secretary of State or other governmental office
- Limited Partnership Agreement filed with Secretary of State or other governmental office
In addition to the legal formalities required, a limited partnership requires that you have at least one general partner and at least one limited partner.
The rules for this type of partnership are generally the same as they were for a general partnership. The entity itself is not taxed, rather the revenue generated is “passed through” directly to the partners. One distinction that can be made between a limited partnership and a general partnership is how those pass through amounts will be viewed by state and federal taxing authorities.
Most distributions of revenue through a partnership to general partners may be characterized as earned income; this characterization will lead to a self- employment tax in addition to regular income tax. The same rules will apply to general partners within a limited partnership; however, the distributions made to limited partners will often fall outside of the earned income category, and therefore, will not be subject to self-employment tax.
In order to ensure your limited partnership is taxed as such, and not as a corporation (which would require taxation at both the entity level and the individual level after distribution), there are some requirements that must be met. Typically, the following criteria will be used in making this determination:
- Limitation on liability of limited partners
- Centralized management structure
- Duration of partnership
- Transferability of ownership
It is key to understand how your small business will be taxed, and then follow the formalities and guidelines set out by state and federal statutes to help solidify your tax situation.
In a limited partnership there are two types of potential partners:
The general partner liability exposure is the same in a limited partnership as it is in a general partnership; however, a limited partner only has liability exposure up to the amount of that limited partner’s investment amount. There is one caveat to be aware of if you are a limited partner and expecting to have limited liability: in order to maintain limited liability status, a limited partner cannot take an active role in the business. What an “active role” is can vary, so let’s take a bit deeper look.
Risk and Control
The general rule with respect to liability risk and business control is more control equates to more risk and less control equates to less risk. In a limited partnership, the general partner (the one who is exposed to liability up to the full business obligation) is the one who has control of the business. General partners have full authority to control all aspects of the business from sales to production, from employment to asset management. Of course, this makes sense intuitively as the general partner is potentially on the hook for significantly more liability; therefore, they are in a position to make more business decisions.
The joint and severable liability of general partners will likely be all the incentive one would need to give the business the best chance at success. Certainly one would not expect a general partner to rest on his/her laurels or squander away company resources because he/she may ultimately be personally responsible for repayment of all business obligations.
While the general rule is a limited partner who takes an “active role” in the business waives the liability protection limited partnership offers, how “active role” is defined can vary greatly from one state to the next. To get a good perspective on the potential difference in its treatment between states, you can think of it on a spectrum – one side being the least active in the business and the other end being the most active in the business.
In the strictest view, a limited partner makes an investment in a business and receives payment(s) from the business in response to that initial investment. On the other end of the spectrum, some states will allow limited partners to vote on certain aspects of the business, such as:
- Basic partnership structure issues
- Removal or addition of general partners
- Termination of the partnership
- Amendments to the partnership agreement
- Asset liquidation
As a limited partner within a limited partnership business structure, you can expect to have little or no control over the operation of that business. For a limited partner, the experience would be more like an investor: the money you contributed is at risk, but no personal assets beyond the investment can be reached.
On the other hand, the general partner in a limited partnership maintains unlimited risk, along with a high level of control over all aspects of the business.
In a limited partnership, the general partner will maintain the same fiduciary duty to the partnership as he/she would in a general partnership; however, this duty does not extend to limited partners. Limited partners in a limited partnership do not have a fiduciary duty to the general partners or to the partnership.
It is important to note that there are few absolutes when it comes to business operations. To that end, there may be circumstances where aggressive or unconscionable actions of a limited partner would be viewed as breaching a duty the limited partner had to the partnership. Above all else, though, a general partner will have more a fiduciary duty than any limited partner.
The limited liability partnership is a special type of limited partnership; this business structure allows all partners to avoid joint and severable liability under certain conditions. It is most often used by business professionals such as doctors or lawyers and would mostly likely not be a typical business structure for the average small business owner. Nevertheless, if this business structure was used for your small business, you could expect (aside from the liability issues) all other characteristics of the limited partnership to be applicable.
Operating a limited partnership may be an option that helps your small business get off the ground and/or become more successful. Some advantages of operating your small business as a limited partnership are:
- Limited Liability: Limited partners can be brought in while only risking their investment amount.
- Easy and Flexible: This type of partnership is simple to set up and can be modified easily if business needs change.
On the other hand, there are some disadvantages to operating your small business as a general partnership:
- Lack of Control: Limited partners have limited impact on business operations.
- Longevity: The partnership is tied to partners being willing and able to participate to meet business goals.
Maybe the limited partnership will work for you, or maybe it is close to just right. Let’s take a look at another type of partnership that could work best for your small business.
A joint venture is a type of partnership that is formed when two or more parties form a partnership. While this type of partnership typically consists of two or more businesses, it can consist of individuals, groups of individuals or any type of business entities. The purpose of a joint venture is typically to come together to establish a particular business purpose, or to be established for a specified period of time. The details of the creation, and termination, of a joint venture are generally outlined in a joint venture agreement. After the stated purpose of a joint venture has been satisfied, the joint venture will dissolve.
Let’s review this type of partnership and compare it to general and limited partnerships.
A joint venture is generally treated as a partnership for federal income tax purposes; however, profit shares distributed to joint venture members will fit within the tax structure of each of the underlying businesses engaged in the joint venture.
Let’s take a look at an example to help clarify this tax treatment. We will assume two corporations and a sole proprietor come together to form a joint venture. As profit from the joint venture rolls in, it will be divided between the three entities. The Sole Proprietor’s share will pass through directly to his/her personal tax statement as earned income. The distributions to the corporations will flow through the respective corporations. These distributions will receive tax treatment and then will be taxed again as the corporation profits are distributed from the corporation out to shareholders.
So, while there is no real distinction between joint venture and partnership taxation, there is an added level of tax treatment to manage.
Risk and Control
Upon formation of a joint venture, the joint venture agreement should outline the specifics of how the business risk will be apportioned as well as how control of the joint venture will operate. Typically, joint venture parties will share equally in joint venture risks. The joint and severable liability standard associated with partnerships is generally applicable to joint ventures; however, under certain conditions this joint and severable liability may be altered or completely eliminated.
In the most typical circumstance, the parties in a joint venture are situated much like general partners in a general partnership. They share in control, risks and potential rewards of the joint venture.
As with other types of partnerships, expenses can develop into a major issue for your joint venture. The typical scenario will be for each joint venture participant to share in the expenses of the joint venture; however, circumstances of your joint venture may dictate a different plan. It is important that all expense-related issues are dealt with thoroughly in your joint venture agreement.
In a joint venture, as with other types of partnerships, the members of the joint venture have a fiduciary duty to maintain. Each member of the joint venture owes a duty to exercise reasonable care for activities associated with the joint venture. Here are some examples of what that fiduciary duty entails for members of a joint venture:
- Use appropriate skill and care when functioning on behalf of the joint venture
- Avoid frustrating or hindering the goals of the joint venture
- Exercise due diligence when investing or spending joint venture funds
- Cooperate with other joint venture members
- Inform other joint venture members of decisions and opportunities that can affect the joint venture
- Avoid decisions and actions motivated by personal gain
The fiduciary duty of joint venture members can be stifling to the purpose of a joint venture. Additionally, the typical fiduciary duties imposed on joint venture members may leave unintended or unwanted gaps in the duty of joint venture members.
In the typical joint venture scenario, parties engaging in a joint venture will have the ability to either expand or contract the fiduciary duties implied by the joint venture formation. This analysis will vary state by state, as each state has its own laws regarding joint venture fiduciary duties.
Operating a joint venture may be an option that helps your small business get off the ground, or become more successful. Some advantages of operating your small business as a joint venture are:
Increased Business Exposure: Pooling advertising funds or piggybacking off of a larger business may help open new doors for a small business.
Provide Additional Resources: This type of partnership is especially useful in the research and development arena.
Added Credibility: Associating with an established business can help you gain credibility with customers quickly.
Apportionment of Risk and Costs: Spreading costs over a wider range will give each dollar your business spends more weight.
On the other hand, there are also some disadvantages to operating your small business as a joint venture:
Unity Issues: Merging two or more unique operations informally can create logistical and decision-making difficulties.
Management Styles: Being able to define what you intend to do, how you will track progress and define success may not coincide with other joint venture participants.
Management Experience: Each member will bring a different level of experience to the table; too great a variance in this area may lead to difficulties.
Lack of Diversity: What happens if you have only one golden goose? Just because you are in a joint venture does not mean that you automatically have the diversity you need for your business to thrive.
Whether you prefer a joint venture, a general or limited partnership, or some other form of partnering with other businesses, you must be sure to plan well in order to give your new entity the best chance for success. Let’s take a closer look at the first step in developing a great partnership: the Partnership Agreement.
“A friendship founded on business is better than a business founded on friendship”
—John D. Rockefeller, Jr.
Regardless of the type of partnership you form, the partnership agreement will be an outline for your business to follow. While a written partnership agreement is a mandatory partnership requirement in some cases, in other circumstances, the partnership agreement may be an oral agreement.
When engaging in business of any kind risk is involved. Investment of both money and time are required to start a business, and when starting a new business the chances of failure are high. While an oral partnership agreement may suffice, it is better to begin with a written partnership agreement. Being able to fall back on a written document to guide decision-making and resolve potential disputes will give you peace of mind even when times are difficult.
Beginning a Partnership Agreement
A written partnership agreement can be a good guide to help your small business partnership get off the ground. As you and your small business partner(s) get started, the partnership agreement should address formation and operational issues. Here are a few main areas that should be addressed in a partnership agreement:
- Type of partnership entity being created
- Source of business investment money
- Distribution of business revenues
- Dispute resolution
Let’s take a few minutes to review each of these in further detail.
As we have previously discussed, some types of partnerships will require a written partnership agreement as a formation formality. Additionally, we discussed how a general partnership is the default (or automatic) partnership formation when two or more individuals or businesses come together for business operation. In order to ensure your partnership is formed how you intend for it to be formed, be sure to write it down. While it may seem obvious or simple at the outset what you are doing and why, having the obvious and simple in a written form can go a long way to eliminating or resolving issues down the road.
Imagine for a moment you intend to partner with another individual to operate a new business venture. Your intention is to jump in as a limited partner, seeking a good return on the money you invested to help get the business started. After that business goes belly up and the creditors start circling the waters, you can be sure they will want to try to identify you as a general partner rather than a limited partner so that your personal assets can be consumed to satisfy outstanding business obligations. Having a written partnership agreement that predates your business activities to support your limited partner (and limited liability!) stance will help to solidify your position.
This is another area where it may seem simple, but once the machines are operating and the real business bullets are flying, once clearly defined lines can get blurry. Your partnership agreement should at a minimum address the following financing issues:
- Amount of each partner’s initial contribution
- Characterization of initial contribution (investment or loan to business)
- Characterization of additional partner contributions
- Potential sources of additional funds
- Required contribution for any new partners
Where the money comes from, how it is acquired and where you can look to get more in the future are all issues that will come up at some point for your small business partnership. Addressing those eventualities within a written partnership agreement is a solid planning decision.
While knowing where the money will, or can, come from is an important question, where the money will go typically gets more attention. How to spend money your small business partnership generates can be a major source of contention. Here are a few important areas you should consider:
Revenue Distribution: Salary
First, you will want to outline within your partnership agreement what the salary of each partner will be. Oftentimes when a new business starts, there is not enough revenue for salaries to be paid. Regardless of whether there is enough revenue for salaries to be paid at the outset of the business, your partnership agreement should address this area.
In addition to salaries, this portion of the partnership agreement should also outline the responsibilities of each partner required to earn that salary. Ensuring the responsibilities each partner has to the operation of the business are clearly identified, along with the reward for undertaking those responsibilities, within the partnership agreement are key to avoiding dispute.
Revenue Distribution: Distributions
Depending on the structure of your business operation, there may be the opportunity, or requirement, to distribute profit your business generates out to partners. If your partnership consists of two or more limited liability companies, for example, those limited liability companies cannot carry business equity from one tax year to the next; therefore, any “profit” would have to be distributed out to the partners by year end at least. If your partnership consists of two or more corporations, the profit may be either distributed to the corporation shareholders or maintained within the corporation as equity.
At the end of the year, the partnership cannot carry “profit” into the following tax year, so those revenues will need to be distributed in some fashion. Whether it is out to the partners as additional distributions over and above salary, loan repayment to partners or other creditors, reinvestment into the partnership or some other possibility, having the plan in place makes the decision simple when the time comes to write the check.
Revenue Distribution: Equity
In the simplest form equity is an ownership share. When two individuals contribute $500,000 each to start a partnership each will have a 50% equity share in the business. Assuming there are no additional factors or changes to the default position, each individual will share in the gains, or losses, of the partnership.
But, what if one of the partners contributes an additional $500,000 after year one of business operation? Will that change the equity share each partner has? Or, what if the two individuals decide to bring in a third partner? Will the third partner get a 33% equity share for a $500,000 investment or will that share cost more or less?
In addition to determining how equity shares will be divided, the partnership agreement should address the transfer or sale of equity shares. In short, will a partner be allowed to sell partnership equity, and if so, what rules or limitations will apply?
Money matters in more ways than one for your small business partnership, and it is vital that all things related to the money coming into and going out of your business are addressed in the partnership agreement.
Beginning: Dispute Resolution
Why is it that conflicts, dispute and misfortune seem to always be around when money is involved? Or, maybe there is another explanation.
“Dealing with people is probably the biggest problem you face, especially if you are in business. Yes, and that is also true if you are a housewife, architect or engineer.”
When people are involved in an undertaking, some form of conflict, dispute or disagreement is a near certainty. In order to put you and your small business partnership in the best position for success, use your partnership agreement to anticipate and resolve these issues before they impact your small business partnership.
When drafting the dispute resolution portion of your partnership agreement, you will want to do your best to cover all potential issues. While it is not possible to address every possible situation, you can address as many as you can that are common to business. Here are a few areas which should be addressed in a partnership agreement:
Financing Disputes: Procedures to take when financing cannot be obtained, falls through or when partners are the financiers.
Money Disputes: Cover all aspects of both the inflow and outflow of money.
Decision-Making: A written determination of who has final authority over decisions within each business context.
Catch All: Create a system for circumstances which may arise but are not specifically addressed within the partnership agreement.
Legal: Consider including an arbitration clause, which requires arbitration before any lawsuit can be filed.
While discussing how to resolve what may go wrong may seem to be a bad way to start a business partnership, having those discussions early in the partnership formation process will not only reduce the likelihood of those eventualities, but will also give peace of mind that any difficulty will be addressed in a predetermined way.
Partnership Agreement – Middle
When planning to start a business partnership, the plan typically contemplates a successful partnership and a successful business. You can use your partnership agreement to help define not only how the business will operate, but also how it will respond to growth. Some areas to consider in this regard:
Scope of Authority: Operational, strategic and employment decisions will ultimately have to be made. Be sure to plan for them even if they are not necessary on the first day of business.
Address Limitations: Place limitations or guidelines on what actions “general” or “limited” partners can take, along with limitations for specific partners; outline who is authorized to comment to the media, submit press releases, comment on blogs and so forth. Be as specific as possible so there are no questions when issues arise.
Changes: Outline how changes in partnership status will affect the business and how changes in business status may affect partnership status.
In the ideal scenario, a partnership agreement will be drafted at or before your small business partnership begins operation and will cover everything under the sun; however, unanticipated issues will likely arise at some point, which could affect your small business partnership. Be sure to plan for when and how the partnership agreement can or should be modified to ensure the document will function properly throughout the life of your small business partnership.
Partnership Agreement – End
Beginning a business with the end in mind is the only way to ensure a smooth wrap up of that business. Whether the business partnership wraps up when the parties intend or prior to the intended end date, having a smooth wrap-up phase will cost less, and cause a great deal less stress, than a contentious, chaotic or haphazard wrap-up.
Here are three important areas that should be addressed in the partnership agreement to help make the wrap-up a smooth operation:
- Duration of Partnership
- Succession Plan
- Partnership Share Valuation Plan
Now we will review each of this in a bit more detail to help give you ideas for this portion of your partnership agreement.
By nature, partnerships are limited in the time they are intended to operate. Whether the purpose of a partnership suggests a time period, or the partnership is created for a specific time period, there should be some concrete method of when the partnership will end, which should be included in your partnership agreement.
Along with the discussion of wrapping up the partnership, comes the inevitable question of how to distribute partnership assets. Keep in mind that assets may be cash, inventory, capital assets (e.g., cars, machines, etc.), intellectual property, business good will (e.g., name, slogans, etc.), and personnel. You should also include an asset distribution or liquidation plan in your partnership agreement, which will ensure a smooth transition at the conclusion of the partnership. Additionally, outlining any potential post-partnership employment clauses is a good idea. For example, you may include a non-compete clause prohibiting anyone involved in the partnership from competing with one of the businesses or individuals that started the partnership.
One of the disadvantages of any partnership is the dependence it has on the partners for survival. That fact is more evident when dealing with small business partnerships, where much, if not all, work is done by a few key hands. When one of these partners is no longer available to work within the partnership, the end could be near for that partnership.
Unexpected eventualities, such as the death or disability of a partner, can stop a successful partnership in its tracks; however, the creation of a succession plan can cover most unexpected events. Having an outline to follow when your small business partnership is confronted with an unexpected situation will help to ensure your small business partnership will fulfill its stated purpose.
While there will be many different situations you encounter in your small business partnership, one thing you can be certain of is there will be an end to the partnership. Whether that end comes as expected or unexpectedly, you will not know until it happens. Whether the small business partnership is dissolving, being sold or one partner is being forced out of the partnership, having a method to accurately value the equity share of each partner is an important tool to have.
In addition to including a method for the valuation of partnership equity shares in your partnership agreement, you should also address how the partnership will respond to a sale, purchase, buy-out or force out. While some of these may be mutually agreed upon (such as the sale of a partnership to a competitor for a large profit), others are sure to be contentious (such as one partner trying to force another partner out of a business that has turned into a multimillion dollar enterprise).
Be sure to discuss all possibilities in this regard with all partners involved, and make sure the terms of any type of sale or purchase of partnership equity shares is completely covered. Having a complete and concise valuation plan will save you some major headaches down the road.
As much as possible you should be sure to cover all things relating to money in your small business partnership agreement. While most of this information has already been outlined, this is a brief review to help stress the importance of this subject to your partnership agreement.
The most important concept in any written document is to be complete, specific and precise. If your partnership devolves into conflict over money-related issues, the written guidelines in the partnership agreement will be the first place an arbitrator or court will look for answers. You will want to use “terms of art,” which in the legal world means a word that has a precise meaning in a particular subject area. So if you are starting a cake-making partnership, be sure the portion of your partnership agreement detailing money matters uses any and all money terms specific to that industry.
At the outset of your partnership, you want to be certain that all partnership roles are clear. The characterization of money contributed to a partnership is critical to determining the characterization of the person who made the contribution. If an individual contributes $500,000 to the business as an investment in the business, that individual will likely fall within either the general or limited partner scope simply based on the size of the investment. On the other hand, if an individual contributes $500,000 to a partnership as a loan, that individual would be a creditor to the partnership due only repayment plus interest.
While these distinctions will not seem to make much difference when the partnership is shiny and new, if and when contention and conflict arise, these distinctions can make a world of difference for the partnership as well as the individuals involved.
In addition to having a detailed outline of money invested in or loaned to the partnership, it is also wise to establish guidelines for each partner when it comes to spending money. As we discussed earlier in the module, partners have a fiduciary duty to the partnership. Acting outside of the scope of partnership authority would likely be a breach of fiduciary duty.
Let’s look at an example to outline this point in more detail.
Money Matters: Example
For our example, the partnership consists of two general partners, Partner A and Partner B. Both partners made equal contributions to the partnership and both share equally in the partnership profits. In the partnership agreement, Partner A has sales and marketing responsibilities, while Partner B is responsible for business operations and financing. In addition to these duties, the partnership agreement also outlines several restrictions on each partner’s authority.
One of the restrictions listed is Partner A cannot sign for any loans, borrow money on behalf of the partnership or add any investors or partners to the partnership. The authority for such actions, according to the written partnership agreement, rest solely with Partner B. The basis for this restriction is also set out in the agreement, which in this example is that Partner B has an advanced finance degree, as well as a law enforcement background, which gives him the ability to not only analyze potential finance issues but also investigate any potential partners or investors.
Partner A meets an individual who expresses great interest in the partnership, and he accepts a $1,000,000 loan from this individual. Little did Partner A know that his new investor is a money launderer looking for a place to “clean” his illegal money. We will assume a state or federal investigation into the new partner causes harm to the partnership’s business operation, and the partnership ultimately fails. So, even though the partnership will maintain joint and severable liability, Partner B will likely have recourse against Partner A primarily because Partner A acted outside the scope of his authority in the partnership agreement and that action directly impacted the partnership in a negative way.
Be specific, be accurate, cover everything and use those terms of art specific to your business or industry; a complete, well drafted partnership agreement is a must.
Joint Venture Agreement
A joint venture agreement is essentially a partnership agreement for a joint venture. Here are some specific items you want to be sure are included in any joint venture agreement you create or intend to sign:
Structure of Venture: The venture may create an association of businesses or a completely new entity.
Objectives: The venture will typically terminate upon the completion of the established objectives.
Financing: Explanation of where the money comes from and what the cost of the money is at the time writing the agreement.
Staffing: How the staffing will occur within the joint venture, including the transfer of people and assets or the acquisition of new employees or assets.
Intellectual Property: Determination of who will own what the joint venture creates.
Control: Determination of who will run the joint venture and make decisions.
Financial Plan: Explanation of what happens to profits and losses within the joint venture.
Dispute Resolution: Provide the answers for who will resolve disputes, what type of disputes may occur, where they may happen, when they may happen, why they may happen and how they will be resolved.
Exit Strategy: Determine if an early exit is a possibility within the context of the joint venture.
Disclosure: Include all disclosures necessary for the parties to sign within the joint venture. Determine whether or not parties will sign a non-disclosure agreement.
In many respects, the concepts are the same whether it is a joint venture agreement or a partnership agreement. Each many have their own terms of art, however, which you will want to be sure to address in the agreement.
Keys to Partnership Success
While there may not be one thing to highlight as “the” key to success, there are several different areas you can focus on to help minimize problems and enhance the chances for small business partnership success. The following are five factors for consideration:
- Know Your Partners
- Understand Your Business Goals
- Clearly Define Roles Within the Partnership
- Develop a Solid Partnership Agreement
- Conduct Regular Meetings
Let’s take a look at each of these areas with a little more depth.
Know Your Partners
In order to begin a good business partnership, you must know who you are working with and what to expect from that person. Having confidence and trust in a business partner will lead to a healthy business relationship; however, when mistrust or unexpected actions are taken, uncertainty can enter into the business relationship.
How can you be sure you know who you are working with? While there is no guarantee an individual will always respond the way you anticipate, there are a few ways you can look beyond what a potential partner says to you. You should complete a background check on the person to make sure you have insight into his/her true character. You may also review social media sites and blog sites for comments made by a potential partner as a way to get an unfiltered look at how the potential partner thinks. Finally, looking at past business performance can give insight into not only business acumen, but also the business ethics and character of the potential partner.
Know who are you working with, and what to expect from them and you will be on your way to a successful partnership. Do not enter into a partnership blindly; that will not usually end well for either partner.
Understand Your Business Goals
Before you start your business, you must establish a strong set of business goals to know where you are going and how you will know you have reached your destination. As part of your business planning process, you will likely outline short-, medium- and long-range goals for your business in several different areas.
In order to give your partnership the best chance for success in this area, it would be wise to find business partners who have business goals closely aligned with your goals. As partners join together with synchronized business goals, whether it be as general partners, limited partners or a joint venture, striving to meet the same goals will put your small business partnership on a course for success.
Clearly Defined Roles Within a Partnership
One of the major causes for failure in any type of partnership is a lack of clearly defined roles. Without this clear definition, bitterness can develop as one partner does more of the “heavy lifting” than the other, and both enjoy the fruits of that labor.
Wise business partners will strive to clearly outline not only the rights and responsibilities of each partner involved, but also what expertise or skill is being brought to the partnership table, and how that expertise or skill will be used to benefit the partnership. The more honest and forthright you can be in this step, the more successful your business will be. Remember, there is a reason why you are partnering in the first place.
Assume for a moment that you and your small business partner are operating a pizza shop. If your partner is a morning person, and you are a night owl, maybe the plan is your partner opens the pizza shop each day, and you take over in the evening? Fitting business partnership roles into the strengths, skill, ability and personality of each partner will help to make the partnership successful.
Develop a Strong Partnership Agreement
As we discussed in detail earlier in the module, a well-drafted partnership agreement is a must for your small business partnership. Whether you and your small business partner draft the document on your own, or enlist the services of a professional to assist you, this document will be the constitution of your partnership. Having the ability to guide your business through any type of scenario, and adapt as times, and your business partnership, change is a significant key to the success of any small business partnership.
Where the partnership agreement is especially significant is after your business is off the ground and flourishing. This is a time when greed, poor strategic decision-making, work ethic and other unanticipated factors can halt small business success in an instant. Having an excellent partnership agreement will help keep your business partnership on track for success.
Conduct Regular Meetings
In the business world, entrepreneurs are often grouped into one of two categories: the dreamers or the doers. The dreamers can conjure up ideas, while doers put their shoulder to the wheel to get things done. There is also a third type of entrepreneur that sometimes gets overlooked: the planner. The planner is made up of one part dreamer and one part doer. While each of these types can have flaws, the combination, whether through a group of individuals or within one individual, can help make any small business partnership a success.
In order to keep all three entrepreneur types on the same page, it is important to meet with your partners on a regular basis. There are several items which should be discussed often in your partnership meetings:
- Status of business operations
- Financial status of business
- Review of current goals
- Strategic planning
- Discuss concerns and issues
- Outline next steps
Communication amongst the partners regarding what is going on in the business, what is supposed to be going on, and what you want to go on in the future is vital to the success of your small business partnership. Additionally, planning for such regular meetings can make the meetings more effective and efficient. Develop an agenda for each meeting, outline who will review each portion of the agenda as well as what the protocol is for input from other individuals. Outline how discussion and differences of opinion will be resolved in your meetings in order to keep your meetings efficient and focused on the most important issues at hand.
Small business partnerships can be simple or complex, but in the end, they are all about one thing: meeting a goal. Whether that goal is making money, doing charity work, developing a new product or technology, or some other goal, a partnership can help make those business goals a reality. A well-planned and carefully orchestrated partnership can produce excellent results and may be right for your small business.