When starting a partnership, you should craft a partnership agreement. Let's address one common question: Is a written agreement legally required?
The short answer is no. In most states, partners can form a general legal partnership based on verbal or implied agreements through their actions.
However, even though a written agreement is optional, it is highly recommended for all partnerships. Let's explore why.
Making a partnership agreement allows entrepreneurs to clearly define the roles, responsibilities, and financial rights of all partners involved in a new business venture.
Having alignment and expectations in writing from day one can set up your partnership for success as you grow and evolve.
Why Have a Written Partnership Agreement
Having a written partnership agreement comes with numerous protections and advantages for partners:
Avoids ambiguity - Documents terms verbally agreed upon.
Defines responsibilities - Delineates roles, duties, and decision powers.
Outlines financial terms - Covers equity splits, profit/loss allocation, and capital contributions.
Specifies change protocols - Provides procedures if partners change.
Dispute resolution process - Allows partners to agree on mediation or arbitration for disagreements.
Meets legal formalities - Satisfies requirements if the partnership is ever legally challenged.
In summary, a written agreement provides clarity, accountability, and documentation. It is highly recommended that expectations be aligned from the start.
Now that we've discussed the importance of having a partnership agreement let's explore the steps to create one tailored to your partnership.
Learn More>
Step 1. Defining Your Partnership Structure
The first section of your agreement will outline basic partnership details:
Partnership Type - Is it a general partnership where all partners share profits, losses, and liability equally? Or a limited partnership with general partners overseeing operations and limited partners who have less control but are also less liable? Specify which structure you will form.
Partner Names and Information - Provide each partner's full legal name and contact information. Also indicate any title a partner holds, like general partner, managing partner, or limited partner.
Nature of Business - Briefly describe your business's purpose and activities. This helps define the scope to which the partnership applies.
Principal Office Address - Indicate the physical street address where your partnership will be located and headquartered.
Partnership Name - Specify the name under which you will operate. You will need to register it with the state formally.
Step 2. Ownership and Equity Distribution
One of the most important decisions you and your partners will make is how to divide equity interests in the partnership. This will impact voting rights, profit/loss distribution, and compensation allocation. Consider:
Even Split – Each partner receives an equal ownership interest, such as 50/50 or 33/33/33. This works if every partner contributes and is responsible for an equal share.
Based on Capital Contributions – Partners who contribute more cash, property, or other assets to the initial capital receive a more significant proportion of ownership.
According to Sweat Equity – Ownership is divided based on partners' time commitment or responsibilities in operating the partnership. A more significant workload means more equity.
Class Structure - Create different classes of partners with varying rights. For example, Class A partners share in management and profits, while Class B partners are more passive investors.
Vesting Schedule - Partners' equity shares change over time based on tenure or achievement of goals, which incentivizes long-term commitment.
Document the agreed-upon percentages or points (e.g., Partner A gets 35%, Partner B gets 15%). Also, indicate whether dilution of shares is permitted if new partners are added.
Learn More>
Step 3. Clarifying Roles, Responsibilities
Delineate the roles and responsibilities each partner will take on based on their expertise and partnership title.
Operational Partner – Oversees day-to-day business operations, hires and manages staff, and makes ordinary business decisions.
Marketing Partner – Develops marketing campaigns, brand-building strategies, and client relationships.
Financial Partner – Manages accounting, taxes, budgeting, legal compliance, and insurance needs.
Also indicate any actions that will require approval from all partners, a majority vote, or a set percentage of partners, such as:
Raising additional capital or taking on business debt
Entering contracts above a specified dollar amount
Making major company purchases
Adding or removing partners
Filings taxes and major legal documents
Learn More>
Step 4. Determining Partner Compensation
There are two main ways to compensate partners for their services to the partnership.
Guaranteed Payments – Fixed compensation like a salary, typically paid monthly or quarterly. This provides income stability.
Profits Interest - Partners receive a percentage share of partnership profits each year or quarter, which incentivizes business growth.
You may make guaranteed payments, share profits, or do both. Document how compensation will be handled.
Step 5. Allocating Partnership Profits
Specify how you will divide profits and losses annually:
According to Ownership Percentage – Each partner receives a share of profits/losses based on their equity ownership percentage.
It is based on an Agreed Ratio – Such as a 60/40 or 70/30 split between partners, which may differ from equity percentages.
According to Contribution – Allocate profits commensurate with each partner's proportional contribution, whether capital, sweat equity, or other resources.
Step 6. Capital Contributions
The agreement should detail the partners' initial and ongoing capital contributions. This includes the amount, type (cash, property, equipment), and timing (monthly, annually) of contributions partners will make.
Also indicate procedures if additional capital calls are required, such as:
Optional Additional Contributions – Partners may volunteer additional funds but are not obligated to do so.
Mandatory Capital Calls – Partners must contribute funds when a capital call is made in proportion to their ownership.
Loans – Whether partners will provide loans to the business, interest to be paid, and repayment terms.
Step 7. Partnership Accounting Procedures
Set guidelines for the partnership's financial accounting and bookkeeping:
Fiscal year – Calendar or tax year you will operate on.
Accounting method – Will you use cash or accrual accounting?
Inventory method – FIFO, LIFO, weighted average, or other costing method.
Depreciation approach – How fixed assets will be depreciated, whether straight line or accelerated.
Recordkeeping – What financial records will be maintained, and for how long? Who will manage bookkeeping?
Step 8. Changes in Partnership Status
Make provisions for scenarios if the make-up of the partnership changes, such as if a partner:
Wants to withdraw from the partnership voluntarily.
He needs to be expelled from the partnership by a majority vote.
Dies or becomes disabled.
Wants to sell all or part of their partnership interest.
Address details like:
Buy-sell agreements – Allow partners first rights to purchase the departing partner's interest according to a valuation formula.
Non-compete clause – Prevent former partners from engaging in a competing business after leaving.
Vesting schedule – Departing partner only receives their vested portion of equity if they leave early.
Step 9. Dealing with Dispute Resolution
Rather than ending up in court, establish alternative dispute resolution processes:
Good faith negotiation period – Partners must make a reasonable effort to resolve amicably before escalating.
Mediation – Require partners to enter formal mediation with a neutral third-party mediator to work towards agreement.
Arbitration – If mediation fails, disputes will be handled through binding arbitration to avoid litigation expenses.
Court as a final resort – Partners may take disputes to court if mediation and arbitration fail.
Step 10. Selecting a Governing State Law
Partnership laws can vary somewhat from state to state. Specify which state's laws govern your partnership agreement and where any legal disputes will be decided.
Call to Action
A comprehensive partnership agreement is essential for setting your new business venture up for success. Outlining terms and expectations in writing will ensure the partnership starts on the right foot ensure your par.
While creating an agreement requires some upfront effort, it is time well spent. From clarifying each partner's roles and responsibilities to specifying equity splits, a detailed contract can prevent issues from arising down the road.
Not sure where to begin? Consider researching partnership agreement requirements in your state. Seek guidance from business lawyers or advisors in your area when crafting sections related to legal governance, ownership, and dissolution details.
Define the partnership structure, capital contributions, profit allocation, and dispute resolution procedures as a priority. Taking the time to work through these key areas with your partners early on is an investment that pays dividends in the long run.
FAQs
Q: Is a written partnership agreement legally required?
A: No, partners can form a legally binding partnership simply through verbal agreement or actions. However, a written agreement is strongly recommended to document terms, prevent ambiguity, and align expectations between partners upfront.
Q: What happens if our partnership dissolves?
A: The partnership agreement should outline withdrawal, expulsion, death/disability, and dispute resolution processes so all partners clearly understand what will occur if the partnership dissolves. Legal buy-sell agreements can facilitate the fair buying/selling of a departed partner's interest.
Q: What is the difference between a general and limited partnership?
A: In a general partnership, all partners share equally in management, liability, and partnership profits/losses. In a limited partnership, general partners operate the business, while limited partners serve as passive investors with less liability and less control.
Q: Should we have an attorney review our draft partnership agreement?
A: Yes, it's wise to have a business lawyer review your agreement, especially if you create a limited partnership or want to customize complex terms. They can ensure it satisfies all your state's partnership laws and legal formalities.
Conclusion
Although covering all these areas requires substantial upfront work, a comprehensive partnership agreement steers your new endeavor in the right direction.
It aligns partners' expectations, clarifies procedures, and protects your business as it grows.
With clear rules, you can avoid unneeded assumptions and focus energy on making your partnership thrive.
Additional Resources
Thank you for reading this article on a Comprehensive Partnership Agreement. We recommend these additional articles related to choosing a legal structure.
Learn More>
Comments