3 Reasons to have a Partnership Agreement
If you have your own business or are thinking about starting your own business, this article was written for you, particularly if you currently have or are considering having a business partner(s). Some business owners are hesitant to mention to their business partner(s) the importance of having a written partnership agreement, but this an important step to a healthy business relationship. Even if you’ve been in business with the same business partner(s) for years, if you don’t have a written partnership agreement, it’s never too late to get one. Aside from the common reasons you might think someone should have a partnership agreement, such as to set forth what is expected of each partner, what each partner gets in return, and procedures for decision-making, this article is going to discuss three more crucial reasons to have a partnership agreement.
But first, for the sake of clarity, the term partnership agreement as used in this article is simply intended to mean an agreement between business partners. I’m not suggesting your business should be a partnership; in fact, your business may be an LLC or some other entity type. Regardless of what entity type you select for your business, if you have one or more business partners, you should have a partnership agreement in some form or another. Also, if your business operates as an LLC, it is possible or even likely that you have an operating agreement, but an LLC operating agreement is not necessarily synonymous with a partnership agreement. Typically the purpose of the LLC operating agreement is to help establish the legitimacy of the LLC as a separate legal entity from the owner(s)/member(s) of the LLC and to set forth some minimum standards in terms of management decisions, member meetings, etc. In any case, you should have your operating agreement reviewed because, depending on your situation, you may want to amend your operating agreement, or you may decide to have a separate partnership agreement in order to make sure you’re properly protected. You also may decide to have a separate agreement on just one of the items addressed below, i.e., a buy-sell agreement. Each business partnership is unique and accordingly, the set of documents of the business should be unique and should fit the business arrangement of the partners.
With those caveats out of the way, here are three crucial reasons to have a partnership agreement:
- Restrictive Covenants. You have worked hard and put in many hours over the years to build your business. How would you feel if your business partner left the business to setup shop down the street from you to become a competitor? How would you feel if they took confidential and proprietary information of the business and used it in the new business? What if they took clients away from the business for their new business? Restrictive covenants can protect the legitimate interests of the business and prevent a business partner from taking such actions.
- There are three main restrictive covenants: a non-compete, a non-disclosure, and a non-solicit. A strong partnership agreement will contain all three restrictive covenants. A non-compete can restrict a departing partner from competing with the business for a certain period of time, and within a certain geographical region, as appropriate. A non-disclosure can restrict a departing partner from taking confidential and proprietary information and disclosing it to third parties or using it in an adverse manner to the business. A non-solicit can prevent a departing partner from taking clients of the business.
- Each state’s laws will vary as to what is a sufficient amount of restriction to protect the legitimate interests of the business. Also, keep in mind that these provisions are like a double edged sword, i.e., you can use them to restrict your business partners but they can do the same to you, so it’s important to not get carried away and make certain the restrictions are reasonable. Admittedly, it can be difficult to discuss these matters with your business partner(s), but it’s better to talk with them now and put it in writing rather than fight with them later in court over clients, etc.
- Buy-Sell Agreement. This can be a stand-alone agreement or drafted within the partnership agreement. The purpose of the buy-sell provisions is to have a mechanism or procedure to address a situation such as when a business partner dies, or becomes disabled, etc. Mark Kohler often times refers to the “four D’s”, death, disability, dissolution, and divorce. You can even include in the buy-sell other situations sometimes known as “triggering events” such as bankruptcy.
- Have you considered what would happen to your business upon your death or disability? What if your business partner died, would you want to be “stuck” in the business with your partner’s spouse? What if something happened to you, how can you be sure your spouse/family is fairly compensated given your ownership interest in the company? The result of a well drafted buy-sell is that upon the happening of a triggering event, e.g., death of a business partner, the ownership interest of the business partner is bought back by the business or the surviving business partners from the deceased partner’s estate/heirs at a pre-determined price and upon the terms decided upon and set forth in the buy-sell.
- The benefit of the buy-sell is that it eliminates having to make those decisions in the stress of the moment, when death, disability, divorce, etc., has occurred; it is easier to make those decisions before the crisis/event occurs. You and your business partner(s) can put forth a mechanism or procedure for establishing the value of the business which will determine the purchase price. You can also decide how the purchase price will be paid, e.g., lump sum, installment payments, etc. In the context of death and disability, an insurance policy can be utilized to provide liquidity to pay for some or all of the purchase price. It is never fun to talk about death or disability, but it is better to address it now rather than later when the event has already occurred, which can be difficult when emotions and stress levels are high.
Here is a great video on this topic by a partner in our firm KKOS Lawyers, Mark J. Kohler:
- Partnership Allocations. You and your business partner might have different financial situations, such that it is preferable to allocate partnership items of loss, income, etc., to you and your business partners in a manner other than based on the ownership/interest percentage in the business.
- For example, your business partner might be in a high income tax bracket in a certain year and desire to claim disproportionately large items of loss, if any, to help reduce his or her income tax liability. However, the IRS will not recognize such allocations unless they have a “substantial economic effect”. Particularly, with a real estate based business in which there is the item of depreciation, the partners may want to be strategic about how to allocate depreciation among the partners. Again, the IRS will not recognize those allocations unless they have substantial economic effect.
- A well drafted partnership agreement can address these allocations to help the business partnership keep a proper accounting of the financial arrangement of the business so that such partnership allocations will be recognized by the IRS. Even if the business doesn’t intend to make such allocations, a well drafted partnership agreement will address related matters such as contributions, distributions, etc.
These are just three reasons to have a partnership agreement. There are many more. Each business is unique and likewise each partnership agreement should be unique and should fit the business like a well-tailored suit. If you and your business partner(s) don’t have a partnership agreement that sufficiently addresses these issues, I invite you to call our office.