You want to start a small business because you have an interest in or are an expert at the services you are offering or the products you will manufacture or sell.
While you may have considered running your new enterprise as a sole proprietor, you recognize there are aspects of running and funding your startup better served by the backing and expertise of a partner.
It sounds simple enough. You and your friend, relative, or colleague will join forces to create and run a successful for-profit business. But before you sign a lease on a new office space or open a joint bank account with your new partner, consider reducing your relationship into a written small business partnership agreement.
While a business partnership doesn't carry the same legal and tax consequences of a corporate business structure, it's still a legal association with its own share of legal and income tax implications. This article will discuss how business partnership agreements are formed and why taking the time to reduce your partnership relationship into a written document is a good idea.
What's Included in a Business Partnership Agreement?
Contrary to what many people think, a partnership can be formed — and dissolved — without creating a legal document. In fact, you can form and dissolve a partnership on a simple handshake. But if your partnership breaks up under less than amicable conditions, any disputes regarding the partnership will be out of your hands. Absent a partnership agreement, partner disputes are resolved by the courts applying applicable state law.
Most state laws follow the Uniform Partnership Act (UPA). As a general rule, under the UPA, all partners share equally in both the profits and the losses of the company without regard to who might have contributed what services or expertise.
If you don't want the government dictating who owns which partnership assets or how your partnership is to be structured, you need to create a written partnership agreement setting out the terms and conditions of the partnership, including:
- The business name
- The rights and obligations of each partner
- Who receives what portion of ownership interest
- How assets and liabilities are shared
- How assets and liabilities are divided if the partnership dissolves
- How disputes will be settled
The Importance of Partnership Agreements
A business partnership is like a marriage, except it's legal to have multiple business partners. A well-constructed partnership agreement — whether it's a general partnership agreement or one covering limited partnerships — serves the same purpose as a great prenup. Each partner goes into the relationship understanding what they own, what they can expect during the relationship, and what happens if the relationship ends.
When properly drafted, a partnership agreement should clearly describe each partner's interest in the business, giving each partner a feeling of security because all major issues have been addressed.
How to Create a Small Business Partnership Agreement
Small business partnership agreements don't have to be overly complicated or full of legalese, but they must reflect the relationship of the parties, how the business is to be run, how decisions are to be made, and when and how the relationship will end.
Outline Basic Partnership Details
To begin with, the agreement needs to set forth the basic structure of the business relationship, including whether the partners are general partners, limited partners, or limited liability partners.
- General partnerships: When two or more people become general partners, they bear equal responsibility for the debts and other liabilities of the business. They also share equal power to manage and exert control over business decisions, unless the partnership agreement explicitly sets forth another arrangement. Without an agreement to the contrary, under a general partnership, if one partner obligates the business, all partners are equally bound even if they had no knowledge of the matter or consented to it.
- Limited partnerships: Sometimes called silent partners, limited partners invest in the business but don't expect to manage its day-to-day activities or have much of a say in its operations. Limited partners are not liable for any business debts or liabilities beyond the amount of their investment. There are legal restrictions regarding how involved a limited partner can be in the business operations. Breach of these restrictions will cause a loss of limited partner status and protections.
- Limited liability partnership (LLP): Like a general partnership, the partners in an LLP are full partners and take part in managing the business. Liability is also shared, but only to the extent of each limited partner's ownership interest in the business. LLPs are often used for professional service providers, such as law firms or accounting firms. Agreements covering LLPs are called operations agreements, although they are substantially similar to a partnership agreement.
Other basic details in your agreement should include:
- The purpose and type of business
- The place of business
- What types of outside business activities partners can engage in (and which would be considered competition)
- How long the partnership will operate (including an intention for it to operate with no termination deadline)
Once you have outlined the basic details, you can move on to the more complex terms of your partnership agreement.
Describe Each Partner's Role in the Company
The partnership agreement should spell out the role each partner will play in running the company, as well as the purpose of the partnership. Sometimes, there are obvious lines of demarcation. For instance, in a business manufacturing and selling toasters, one general partner might be in charge of research, development, and manufacturing operations, while the other might be involved in marketing, sales, and distribution.
Often, however, the role of each partner is not so easily delineated. For instance, will every partner have the right to bind the company to a contract? Who among the partners must consent to hiring or firing decisions? Determining which partner has binding power or partner authority for what type of decisions is important to avoid future conflicts or, as a worst-case scenario, the company becoming exposed to risks and incurring costly liabilities.
Determine Ownership Interests
The parties must determine who owns what portion of interest in the company. Remember, absent an agreement to the contrary, it is likely a state court would determine all general partners have an equal ownership interest.
When drafting your partnership agreement, be precise about who owns what portion of the partnership property based on, for example, contributions of cash, services, real property, or intellectual property.
Clarify Profit and Loss Distribution
How much and which partners will receive an allocation of profits — and be compelled to cover losses — should also be spelled out in explicit terms in the agreement. Again, this could be based on how ownership interest is apportioned or in any other manner agreed to by the parties. You should also set forth the timing for when distributions can occur, for instance, at the end of the fiscal year.
Set Voting Procedures
Detailed terms regarding who can make what types of decisions and when should be included in every business partnership agreement. Conflicts surrounding decision-making and voting rights are one of the primary partnership disputes resulting in litigation. To avoid any misunderstandings, detail how the partnership decision-making process is to occur and how adherence to the process will be enforced.
Clarify Accounting Requirements
Accounting in a partnership differs from accounting in a sole proprietorship. Agreeing to partnership accounting procedures is an important part of every partnership arrangement.
Typically, the partnership balance sheet designates a capital account for each partner — so their investments can be tracked — and an account to cover draws or withdrawals of assets from the company. Liability for each partner is also tracked. Whether a partner can take a loan from the partnership should be laid out in the partnership agreement, along with how and when any loans must be paid back.
Clarify Termination Rules and How Disputes Will Be Resolved
The partnership agreement should also specify how any partnership terminations are executed. What will the partner who is severing the relationship — or their estate — receive? How will rights to any remaining or forfeited assets be apportioned to the remaining partners?
This is also where the terms regarding limitations on a partner starting a competing business would outline detailed instructions as to time, geographical limitations, and use of any part of the partnership name or branding.
Dispute resolution is one of the primary reasons you need a partnership agreement. How disputes are handled — whether through alternative dispute resolution mechanisms like mediation or binding arbitration — is important to avoid costly litigation in the event the parties can't agree on their own.
Consult With a Legal Professional as Needed
With most small business partnerships, the terms and conditions of the partnership agreement will be pretty straightforward. While many new business owners choose to go it alone when creating their initial agreement — using one of the partnership agreement templates readily available online — you may want to seek legal advice before drawing up the actual partnership contract.
As your business grows and becomes more complicated, your partnership relationships will also grow and become more complex. Thinking through not only the issues you face at startup but also the issues and potential hurdles you may confront as your small business grows is something an attorney well-versed in business contracts can help you with. This is one of those instances where an ounce of prevention — as a relatively small outlay in legal fees — can save you a pound of pain.
Stay on Top of Your Small Business Finances With Skynova
Once your partnership is established and your business is launched, you will face the day-to-day accounting tasks of any small business. Skynova's small business accounting software can help manage all of your accounting needs, while our business templates — many are tailored to specific industries — can save you time and money.
Create a free Skynova account and see how easy running the accounting side of your business can be.
Notice to the Reader
The content within this article should be used as a general guideline when creating a small business partnership agreement and may not apply to your specific situation. Always consult with a legal expert to ensure you're abiding by rules and regulations.