Partnership Agreements: 5 Critical Considerations
By: Wesley Henderson
You and a friend or business partner start talking about your great idea. You create an LLC, get funding, and open your doors. Business is going well and you are even starting to make some money. Things are great . . . until they aren’t. Your business partner’s spouse gets sick. He has to move, and can no longer contribute to the business like before. So, what happens?
It depends. If you and your business partner took the time to draft a partnership agreement then the situation will have already been addressed and determined. If not, your business partner will own 50% of your business without continuing to contribute.
This scenario, and thousands of other similar scenarios, plays out all the time. It is not that one of the business partners gets greedy (although that does happen, too) or lazy, but rather life simply happens. It is unlikely that you and your business partners will have the exact same expectations over the life cycle of a business.
You need to draft an agreement at the outset that defines important aspects of your relationship with the business, like what happens if a partner leaves, what happens if someone is not able to contribute to the business as expected, what happens with the profits, how decisions are made, how partners are added, what happens if someone dies, and so on.
When I refer to partnership agreement, I include operating agreements (LLC), bylaws (corporations), and other founding documents. Below are some considerations that need to be addressed when individuals come together to start a business.
The partnership agreement needs to establish decision-making in advance so your business operations can move along smoothly. Day to day management, authority, and limitations all need to be laid out in the agreement. Business owners need to consider from the outset how decisions will be made when there is not a consensus.
A fairly common scenario exists when two owners both own 50% with equal voting rights. When a conflict arises, this can lead to a stalemate and ultimately business failure. I encourage clients to give one party 51% and the authority to make final decisions. When this is not an option, I encourage other decision-making protocols so that a business is not deadlocked.
You will also need to detail quorum and voting rights. You will need to determine things like whether you need unanimous consensus to add members as well as a host of other important business decisions. I also encourage clients to provide a dispute resolution clause that mandates mediation in hopes of avoiding costly litigation when partnership disputes arise.
2. Ownership and Roles of Owners.
The partnership or operating agreement needs to detail each owner’s percentage of ownership. Ownership is often tied to capital contributions, but not always. Sometimes one owner may be contributing more hours of work (i.e., sweat equity) or other skills while the other owners are contributing more of the capital. However you have it structured, your agreement needs to explain the ownership and the role of each owner in the organization. If one partner is the “money” partner and another is the workhorse, it is good to put this on paper so everyone is clear about his or her role.
A common problem arises when one owner, for whatever reason (e.g., health, distractions, relocation, apathy, etc.), stops contributing to the business. You do not want a situation where a large percentage owner is not participating in the organization. This limits the ability to attract additional investors and results in an unfair ownership interest. For example, two owners go into business together, agreeing to split the work and capital evenly, before one owner has to move across the country and is no longer able to work 40-50 hours per week for the business. If the other partner grows the business to a million dollar sale after 10 years, the silent owner would still be entitled to 50%. It is very difficult to have business owners give up their ownership in the business, especially when the business is profitable.
A great tool to prevent this scenario is to have vesting membership tied to certain requirements. Vesting membership allows for you to distribute 100% ownership at the outset while having the ownership actually vest over the course of four years (or whatever duration you determine). If the member fails to meet the agreed requirements, the business will be able to purchase the membership interest for a nominal amount. This way, if a partner has to move and cannot contribute as anticipated, that partner would still have some ownership but ultimately would give up most of the 50% ownership given at the time of creating the business. Vesting can be very complicated but also extremely useful. I recommend you consult an attorney to learn more about structuring your business using vesting schemes.
3. Capital Contributions.
The operating agreement should detail how much capital each owner is contributing to start the business. Partners also need to consider how they will raise additional capital if needed. For example, if three partners contribute $15,000 to start the business, then where will additional capital come from if it is needed in a year?
If additional capital is needed, will the business borrow from a bank, borrow from family members, look for new investors, look to the existing partners for the capital, or dissolve? This is an important consideration as each member may have different willingness when it comes to additional contributions. If only two members could respond to the capital call of $10,000 then the third member may be left with diluted membership interests. These are important business decisions that need to be addressed before the situation arises to avoid conflicts and surprises.
Of course, money is a major cause of problems among members. The money talk needs to happen early in the business relationship so that all members are in agreement. We normally find that problems arise when the business is either generating a lot of money or very little.
Salaries and distributions are really two different issues. Start with basic questions, like When will partners be able to take money out of the business? Will allocations be made in proportion to a partner’s ownership interest? Can partners take draws (i.e., an allocation of profits from the business prior to the actual distribution among all partners)?
If one partner wants to build a national brand, this may require reinvesting in the business early on and having fewer distributions. But, if another partner views the business as a mom and pop, then they will likely be ready to take distributions early on. You also need to consider whether partners will be repaid for the investments they put in. If so, when?
The bottom line is that you need to have a money discussion with all members and reach a consensus regarding the allocation of money.
The partnership or operating agreement needs to explain how the business will handle the death or departure of a business owner. If expectations are spelled out at the outset, it makes parting ways much easier and may limit the chances of costly partnership disputes.
For example, do you want an owner’s interest in your business passing to their spouse or would you rather allow the business to buy the ownership interest? I often recommend that the operating agreement spell out an avenue for the business owners to obtain the passing member’s interest. As a business owner, you agreed to go into business with that individual, not their spouse or relative.
Buy-Sell arrangements are a great way to plan for these situations. The agreement needs to establish a method for valuing the partner’s interests and who will able to purchase the interest. This is necessary for both the death of an owner and the departure of an owner.
It is extremely important to discuss departure and dissolution at the beginning of the business relationship. It is much easier to set these rules out early on when everyone is getting along.
Be Prepared to Face Challenges in Your Business
There’s no way to predict what challenges you and your business partners will face during the life of your business. The only accurate prediction is that you will face challenges, and your ability to respond to those challenges will impact the longevity of your business. The better prepared your business is for these challenges, the more likely it will endure and thrive in the marketplace.
Drafting a partnership agreement is a simple step to help avoid costly conflicts down the road. Even if you do not hire an attorney, I urge you to put your agreement down on paper and have all members sign it. On that note, you are better off typing the agreement yourself than downloading something off the internet that may have serious and severe unintended consequences. I would argue that a one-page handwritten agreement outlining the terms of your arrangement is preferable to a 40-page generic document.
The process of sitting down with your business partners to discuss the topics above and others (whether with an attorney or not) is an extremely valuable business practice that I encourage every business to engage in.
About the Author
Wesley Henderson is an attorney at Henderson & Henderson. His practice focuses entirely on helping businesses and startups navigate the legal and business environment to help them succeed in the marketplace. Wesley can be reached by phone at 843-212-3188 or by email at firstname.lastname@example.org.