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How to avoid problems with partnerships

September 27, 2011

Many small businesses are partnerships. Yet circumstances and ambitions change, partners fall out or die. Without a good partnership agreement things can get acrimonious. Here’s how to protect yourself from the start.

A partnership is a legal trading entity that is formed automatically when two or more people run a business, possibly sharing the workload and/or investing capital to get the business started.

You can also find yourself unwittingly in a partnership if you run a business with somebody but don’t employ them (often the case with husbands and wives).

You don’t need a written agreement to form a partnership but it is wise to have one drawn up and checked by a solicitor.

Choosing your partner

Naturally it is important to choose your partners carefully. But how well do you know them? Will they work as hard as you? Might they run up large bills? Do you have the same long-term goals for the business and your roles in it?

There are other pitfalls for partnerships. For example, there is no limit to their liability. Moreover, partners are each responsible for business debts incurred by other partners – even if these are not agreed.

However, a new type of trading status – a limited liability partnership – offers protection from personal bankruptcy and from a rogue partner acting with out authority, with all the tax advantages of trading as a partnership.

The types of partnership available

There are fives main types of partnership:

  • Equity partners contribute capital to the business and share in the profits and losses;
  • Salaried partners receive a salary but are unlikely to contribute capital;
  • Sleeping partners take no part in running the business, though they may contribute capital and receive a salary;
  • Limited partners, where the liability of one or more (but not all) partners is limited to the amount of capital they invest. Limited partners must be registered at Companies House;
  • Limited liability partnerships where the business, not the partners, have legal liability to third parties. This type of partnership must also be registered at Companies House.

The legal position

Partnerships are covered first by terms set out in a partnership agreement. If there is no written agreement, or particular points are not covered in it, the relevant partnership Act come into effect.

The Acts are quite arbitrary and their provisions may not always seem fair. For example, the Partnership Act 1890 states that partners are entitled to share equally in the capital and profits of the business. But, if one partner has put more time or capital into the business than the other(s), you probably wouldn’t want to share profits equally.

And under this Act, a partner can withdraw immediately, without giving notice. This could be awkward because they may insist on the return of their capital contribution, which may force the business to close down.

So you may want to over-ride the rules in the Act to reflect your situation now and in the future. This is why a good agreement is so important.

Ten things partnership agreements should contain:

1. The basics

The partnership’s name, address and the nature of its business. When it started and when will it end – if applicable.

2. Money

How much capital each partner invested.

3. Profits and pay

How profits and losses are to be shared. Will partners also receive a wage? How will additional investments affect shares? How can these rules be changed if, say, one wants to work part-time?

4. The bank account

  • The details of the partnership’s bank account, including:
  • Who can sign cheques;
  • When two or more signatures are required on cheques;
  • How much money each partner can withdraw a month. Consider limiting this, as you don’t want to find you have run out of working capital.

5. Division of responsibilities

Who does what? What can and can’t partners do without each other’s consent, including what commitments or expenditure can be made?

6. Time off

Specify precisely the length and frequency of holidays.

7. Incapacity or death

What happens if a partner is temporarily incapacitated through long-term illness, say? They will still be entitled to a share of the profits so it’s sensible to stipulate a time limit. What happens if a partner becomes permanently unable to continue through ill health, insanity or death? A wise precaution is for partners to take out life insurance on each other to provide a fund to buy out their share.

8. Withdrawal

How much notice must partners give if they want to withdraw? How will the other partner(s) finance buying their share? Can the leaving party sell to an outside party?

9. Disputes

Settling disputes in court is expensive. You can probably avoid this by including a clause stating that all disputes will be resolved by arbitration. If you belong to a trade or professional body, they will nominate an arbitrator, or disputes can be referred to the Institute of Arbitrators.

10. After a partner leaves

It is important to specify in the agreement what is to happen if a partner leaves, or if you dissolve the partnership, vis-à-vis assets, goodwill and capital contributions. This is a complicated area and one in which you will need good legal advice.

There are other provisions you may like to include in your agreement (some may relate to the specific type of business). If a partner leaves the partnership, for instance, you may wish to take steps to prevent them setting up in competition – although these may be difficult to enforce.

Never too late

The chances of a business partnership surviving increase greatly if everyone knows exactly where they stand, both in the good times and in the bad. If you are in a partnership and have no partnership agreement, sort one out today, even and especially if you are married to your business partner.

About this article

This article was first published by Better Business magazine.