Business partnerships are often settled with fingers crossed – and faith that friendship will overcome all hurdles. But business lawyer Joe Kafrouni says formal Partnership Agreements are essential.
A typical scenario: Plumbers Phil and Mick meet over lunch and confirm the ‘what, how and when’ of their new partnership.
The two men, dividing their work according to their specialisation and geographical location, agree that a partnership will allow them to cut costs, have a greater market presence in a small city, and generally improve their business.
Each partner brings a different set of skills and experience to the table. Phil is the elder by far, and, as one of the most respected plumbers around, offers much in the way of experience and business knowledge.
Mick, with several large industrial maintenance contracts, has just invested heavily in equipment. Although young, he is establishing his own name as a dependable plumber.
The two decide they will split their area geographically, advertise together and cover for each other during holidays.
Arrangements like this between Phil and Mick are typical of the basis of most partnerships. However, choosing to work in partnership with other people will either make or break you. My experience is that partnerships often fail for the same reason that any other relationship fails: lack of communication; and misunderstanding as to expectations.
If you can’t meet someone’s expectation, there is going to be a problem. It requires communication to understand expectations. Not only does the process of entering into a Partnership Agreement provide the partners with a legally binding document, but it also allows the partners to define their respective expectations. Also, notwithstanding the initial good intentions of both parties, it is important to recognise that the needs and behaviour of individuals within the partnership – and the character of the partnership itself – will change over time. These ‘growing pains’ of the partners and the business may or may not be predictable when the partnership is formed. For example:
- Phil may retire in the next few years. Thought should be given at the time of entering into the partnership as to how he will exit.
- Phil may expect Mick to deal with the bookkeeping, whereas he does not intend to do so, or to do so would be unfair on top of his normal workload.
- Mick, having just invested capital into the business to buy equipment, may be intending to draw more of the profits for his broadening family obligations.
- Mick may also have a side business or investment that requires him to spend time away from the partners’ venture. This may be seen as unfair as time is given to the other enterprise, which may even conflict with the business of the partnership.
- One of the partners may die or become incapacitated.
Some of the issues that Phil and Mick should consider in forming the partnership, and which should be recorded in the Partnership Agreement, are as follows:
Structure and Relationship
Where the partnership adopts a business structure outside of the strict partnership model, for example in a company structure, there are alternative agreements that fulfil similar functions to the Partnership Agreement. For example, a Shareholders Agreement achieves the same result around the specifics of a company structure. It is important to understand the nature of the relationship as this will affect their legal, tax and contractual obligations to other parties.
Objectives and Goals
The objectives and goals of the partnership are crucial. If there is any misunderstanding about where the business is going, the partnership may be jeopardised. The Agreement should specify the vision of the partners and their fundamental goals. It may be that a partnership will end right there if the partners cannot agree, but I have found that often the shared vision and goals are what have brought the parties together.
Phil and Mick, like some of my clients over the years, may smile at the question “What are the goals of the business?” and respond “To make money, of course.” However, it is rare that profit is the only objective. Phil may be looking to retire in the next 2 to 5 years and looking to sell his share to help fund his retirement. Mick may be seeking to grow the business and employ others over time or focus on a particular part of the industry that he expects to increase over his working life. Without agreement and the possibility of this reference, the likelihood of miscommunication increases. The positive benefit is that formal objectives and goals can be reviewed each year and changed as the partnership matures.
With the objectives and goals in place, the other important points often fit into place quite easily.
Shares and Profits
Not all partnerships will be ‘50/50’. The method of splitting and distributing the proceeds will probably be more complicated, reflecting each partner’s need to draw on the funds throughout the year, or taking into account adjustments for the use of partnership assets such as the company vehicle.
Sometimes the contributions from the partners may be uneven in either experience, the goodwill that they bring to the business or in contributions of capital. It is best to address this disparity in the Partnership Agreement and discuss how the profit will be distributed to reflect it. Including the method for distributing profit in the Partnership Agreement in this context not only removes one of the greatest sources of frustration and discontent between the partners, but it also assists in accurately determining tax liability and the financial position of the partner.
Phil and Mick should also agree how and when the profits are to be distributed and the amount that is to be retained in the business to fund future growth. For example, Mick may wish to retain most of the profit in the business to grow it to a saleable asset, while Phil is seeking to draw as much out as possible to build up his retirement fund. Misunderstanding on this point will mean that either no-one will leave cash in the business or one partner’s share will grow fat on the back of the other’s investment. As this affects profit and growth of the business, I believe that this is one of the most crucial – but often overlooked – points.
Roles & Responsibilities
Partners often come together with the expectation that each partner to bring certain skills, attributes or other benefits to the partnership. These may range from technical ability or marketing skills to financial contributions and must be specified clearly in the Agreement.
Mick has recently invested in the equipment. Together with the promise of secure income that the maintenance contracts promise, he might not be intending to contribute much in the way of start-up money to the partnership. Phil may be expecting to do the paperwork and financials in return for a reduced workload. These and other expectations are fine – so long as they are agreed on and recorded for future reference.
The methods of making decisions can vary greatly. It needs to be determined how decisions are made within the partnership. These decisions include those concerning fundamental issues such as acquiring a new business or changing business direction, disposing of a business, or entering into large financial commitments. How are decisions concerning such fundamental issues to be made?
Mick and Phil may decide to hold yearly partnership meetings to determine the goals for the coming year, followed up by monthly reviews. The formal aspect of the meeting is not as important as the fact that they meet. They may also decide that certain decisions such as changing business direction, selling the business, admitting new partners or amending their Partnership Agreement require the consent of both partners. They should also decide on a solution in the event they do not agree on a fundamental matter – perhaps decided according to who has contributed the most capital, seniority in the partnership or third party arbitration.
Exit strategies need to be considered at the very beginning. If, for example, one of the partners only intends to be involved in the business for 5 years, and at that time would like to sell his share in the business, then that schedule needs to be established from the beginning.
Mick may want first option to purchase Phil’s shareholding when he retires. Alternatively, depending on the circumstances, a partner may sell to another person only on the approval of the other partner. A method of valuing the exiting partner’s shareholding, such as Market Value or Agreed Value, may be appropriate, again depending on the intentions of the parties.
Including these provisions in a Partnership Agreement will save incredible amounts of angst and ill feeling later when the time comes.
Consideration also needs to be given to what other activities each partner may be involved in during and after the termination of the partnership.
In our example, Phil may have a side business. This should not be a problem if it is not related to the work that he does in the partnership and as long as it does not interfere with his obligation to the business. It would be appropriate to insert a condition into the Partnership Agreement that neither partner can perform private plumbing work on a paid basis for the duration of the partnership.
It may also be reasonable to insert a provision ensuring that the exiting partner does not poach customers or staff from the business for a short period of time after exiting.
Death or Disability of a Partner
These issues are normally addressed in a separate Agreement called a Buy/Sell Agreement. If there is no Agreement to deal with such an issue, the remaining partners risk being embroiled in disputes with the family or estate of the deceased or disabled partner. In order to finance the purchase of the shares, the partners may obtain life and disability insurance on each others’ lives, paid by the partnership, with the value of insurance being sufficient to cover the cost of buying the share of the outgoing partner.
When the amount of work and financial exposure that each partner invests into the partnership is considered, not to mention the possible costs and consequences of a dispute, the benefits of a personalised and thorough Partnership Agreement are obvious. Such an Agreement provides greater communication and mutual understanding for each partner at the outset, and allows greater opportunity to identify and agree on all the pertinent issues. An Agreement also provides certainty and security in applying the agreed intentions of the partners in their business. This will maximise the partnership’s likelihood of success.
Joe Kafrouni, Legal Practitioner Director, Kafrouni Lawyers
The information provided by Kafrouni Lawyers is intended to provide general information and is not legal advice or a substitute for it. Business people should always consult their own legal advisors to discuss their particular circumstances. Kafrouni Lawyers makes no warranties or representations regarding the information and exclude any liability which may arise as a result of the use of this information. This information is the copyright of Kafrouni Lawyers.
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