Are you considering a business partnership? When structured properly, a partnership can benefit your business in ways supported by the timeless adage that “two heads are better than one.” Practical benefits of partnership might include access to a level of capital, labor, know-how, customers, or expertise not available absent partnership. However, just like personal relationships, business partnerships have their ups and downs.
What might seem to be an enthusiastic partnership arrangement at the beginning often will hit bumps in the road. The odds of failure in partnerships (or worse, failure coupled with lawsuits) increase substantially when structured hastily or without a proper written partnership agreement. The potential for success and the ability of the partners to work through issues increase significantly with a partnership agreement that has been specifically crafted with the objectives and desires of the partners in mind and which provides for a dispute resolution mechanism.
Types of Partnership Agreements
For purposes of this blog, we refer to a “partnership agreement” generally as meaning a written agreement between the owners of a business. The legal type and form of the written agreement is determined by the legal entity of the underlying business. For example, “operating agreements” or “limited liability company agreements” are used to document the agreements of the parties in limited liability companies. “Shareholders’ agreements” or “stockholders’ agreements” are utilized for interests in corporations. True “partnership agreements” are used for entities legally formed as partnerships, such as limited partnerships (LPs), limited liability partnerships (LLPs) or limited liability limited partnerships (LLLPs).
Your legal and tax advisors can advise you on the best entity to use based on the business and the objectives of the partners. While we refer to “partnerships” or “partnership agreements” generically below in this blog, the principles would also largely apply to written agreements among owners in a corporation or limited liability company context.
What to Include
1) Purposes; Roles and Responsibilities. Include a description of the principal business and activities to be conducted by the partnership. In addition, whether in the partnership agreement or another written agreement, the partners should consider and memorialize their respective roles and responsibilities involved in any day-to-day or even periodic activities, as well as the rights of more passive owners (when applicable).
2) Capital (and other) Contributions. Disputes over money often occur in partnerships when the financial commitments of the parties are not appropriately spelled out. A clear statement providing for the amount(s) of required initial capital contributions of each partner is critical. The partnership agreement should also provide whether additional capital contributions are required, permitted or prohibited. Consider ownership vesting over a period of time for partners receiving “sweat equity” in exchange for expected provision of services or expertise. With vesting, if partners receiving equity in exchange for services or expertise do not perform as expected, they will typically lose the portion of their ownership interest that has not become earned (i.e., the unvested portion). This can happen for any number of unanticipated changes in life circumstances, discontinuation of service before becoming fully vested, and/or a failure to provide the services required in the manner or at the level required in the written agreement of the parties. Without a vesting provision, non-performing partners are typically able to retain their entire equity stake (and the voting power that goes with it), and in turn often leading to messy disputes with the other partners.
3) Management and Decision-Making Authority. It is paramount to determine the management of the partnership and provide detailed terms regarding the decision-making authority of the partners. While it is inadvisable to require unanimity or consensus of the partners for literally every routine activity or decision (this is simply counter-productive), it may be advisable for some partnerships to require super-majority or unanimous consent of the partners on key “major decisions”. Major decisions tend to be those that could intuitively be expected to have a material impact on the equity or ownership value of a partner or class of partners. In practice, the provisions of a partnership agreement covering these major decision categories are often referred to as “protective provisions”. Examples of protective provisions in the partnership agreement might include provisions (among others) concerning:
- Incurring debt above an established threshold amount;
- Increasing or decreasing the size of a board of directors or board of managers;
- Hiring or firing executive personnel;
- Admitting new partners or issuing equity to third parties;
- Acquiring or starting a new line of business;
- Approving a change in control over the business (and/or permitting or prohibiting the sale or transfer of the equity interests of any partner or class of partners); and
- Dissolving the partnership.
4) Distributions and Allocations. Limited liability companies, legal partnerships and s-corporations are often referred to as “pass-through entities” because the profits and losses get allocated for accounting and tax-paying purposes to the owners, rather than staying at the entity level. This avoids “double taxation,” where the entity pays taxes on its profits and then the owners pay taxes on funds distributed to them. Allocations are accounting entries, and are different from actual cash distributed, which is frequently what matters most to the partners. A good partnership agreement will have clear and detailed provisions regarding distributions of cash, as well as the allocation of profits and losses. It is common in instances where a particular partner (or class of partners) makes disproportionate cash investments (such as venture capital investors) relative to other partners (such as founders or sweat equity partners) for the cash investors to receive their money and a return (referred to as a “preferred return”) before the non-cash partners begin to participate in distributions. Partnership agreements will also often permit cash investors to take a higher percentage of losses given they have taken a greater financial risk (from a pure investment standpoint anyway).
5) Dissolution. The partnership agreement should provide for the circumstances under which the partnership can be terminated through a wind-down or dissolution mechanism. The agreement should also document the understanding of the partners on the disposition of partnership property and the distributions to the partners upon liquidation (such as on a sale of the business).
6) Other Key Considerations. While the specifics of each partnership differ, other terms that should at least be considered in any partnership agreement include:
- A buy-sell provision;
- General restrictions on transfers by partners of their partnership interests;
- Right of first refusal on possible transfer of partnership interests (in instances where a transfer is even permitted);
- Co-sale and drag-along rights;
- Deadlock and dispute resolution procedures;
- Meetings of partners and the persons managing the partnership;
- Financial, reporting and other information rights of the partners;
- Buy-out or disposition of partnership interest in the event of a partner death, disability or other exit from the business;
- Non-competition and non-solicitation obligations (or not) of the partners; and
- Key-man insurance policies benefiting the partnership or other partner(s).
Linden Law Partner’s Experience with Partnership Agreements
The preparation and execution of a partnership agreement is critically important whenever there is more than one owner in a business. Linden Law Partners has extensive specialized experience developing, drafting and negotiating partnership agreements for a broad variety of participants across many industries. Please contact us here if we can be of assistance to your business partnership.