When partners initially go into business, they are motivated and happy to embark on this exciting new adventure together. At the beginning, they agree on almost everything. These new entrepreneurs believe they will be in business together forever, or until they sell the company for untold millions of dollars.
They assume nothing can or will go wrong. They trust each other so much that they never bother to get a written partnership agreement. What could possibly go wrong in this scenario? The short answer: A LOT!
The reality is, dreams of longevity and unwavering trust notwithstanding, the desires and expectations of business owners change over time. A written partnership agreement can manage these expectations and give each partner confidence about the future of the business venture. A written agreement can act as a safeguard that protects both the business venture and each partner’s investment.
This article will discuss seven reasons your business should have a written partnership agreement.
What is a Partnership Agreement?
A partnership agreement is a written agreement between the owners of a company. If the company is a limited liability company, the agreement is an Operating Agreement. For a corporation, the agreement is a Shareholder Agreement. If the parties form a general partnership, it is a Partnership Agreement. For the purposes of this article, we will refer to all three generically as a partnership agreement.
When Should Partners Get a Written Agreement?
The ideal time for partners to enter into a partnership agreement is when the company is formed. This is the best time to ensure that the owners share a common understanding of their expectations of each other and the business. The longer the partners wait to draft the agreement, the more opinions will diverge on how the company should be run and who is responsible for what. Putting an agreement in place at the onset can reduce fractious disagreements later by helping resolve disputes when they do arise.
- The bitter lawsuit between former business partners, Tobias Frere-Jones and Jonathan Hoefler who did not have a written agreement, over their multi-million dollar typeface business.
Why Should Partners Have a Written Partnership Agreement?
The purpose of a partnership agreement is to protect the owner’s investment in the company, govern how the company will be managed, clearly define the rights and obligations of the partners, and determine the rules of engagement should a disagreement arise among the parties. A well-written partnership agreement will reduce the risk of misunderstandings and disputes between the owners.
Seven Reasons Your Business Should have a Written Partnership Agreement
Here are some of the most important reasons a business should have a partnership agreement:
1. To Avoid a State’s Default Rules. Without a written agreement, owners in a company will be stuck with the state’s default rules. In California, for an LLC it is the Revised Uniform Limited Liability Company Act, the General Corporation Law for a corporation, and the Uniform Partnership Act for a general partnership. While the state statutes will do in a pinch, most owners need and want more control. A written agreement allows owners to vary the rules when situations dictate that it would be in their best interests.
2. To Have Control Over Who Owns the Company. A partnership agreement should include reasonable restrictions on sales and transfers of interests in a company to control who owns the business. Without a written agreement specifying how interests will be sold, an owner can sell her interests to anyone else, including a competitor. Also, if the parties do not address what happens upon the death or disability of an owner, the remaining owners could end up in business with the spouse or other family members of a disabled or deceased partner.
Provisions setting forth when, how and to whom interests in the company may be sold or transferred can avoid these scenarios and the uncertainly they bring. If properly drafted, these provisions can enable existing owners to retain their percentage stake in the company and protect them from unwelcome new partners.
3. To Agree on Important Issues in Advance. A written agreement will allow partners to agree in advance on important decisions, like dispute resolution, how profits and losses will be distributed, and each partner’s duties and responsibilities. One of the most important provisions in any partnership agreement is how to handle disputes. Partners may include a dispute resolution provision in their agreement that requires mediation followed by binding arbitration. Without that in writing, there is no way to compel mediation or arbitration of disputes, and avoid costly and time-consuming litigation.
4. To Remove a Disruptive or Non-Performing Partner. While partners may form a company with the best of intentions, reality often does not align with those intentions. Over time, owners who were the best of friends or closest of family members can grow apart and commit acts that endanger the business. This can occur when a partner promises to contribute sweat equity in the form of specialized skills in exchange for a piece of the company. An owner with little or no skin in the game is often not as incentivized as those who contribute cash as well as effort.
If the business does not grow as quickly as anticipated and those lofty returns do not materialize, this partner may be tempted to cease working for the company, or worse, start working for a competitor. In that case, the other owners will want to remove this partner who is no longer contributing but still owns a share of the company. A partnership agreement should include a process for removing such a non-performing or disruptive partner and reclaiming his interests before his actions (or inaction) jeopardize the company.
• The Adam Carolla Podcast Case is an example of what happens when friends go into business without a written agreement.
5. To Protect the Business and the Partners’ Investment. An agreement should include provisions that address what happens in the event of an owner’s death, disability or personal bankruptcy. Each of these events could have a negative impact on the company. Without a written agreement that addresses these situations, owners could be forced to dissolve the company, putting at risk the investments of all of the partners. Provisions addressing these scenarios can add predictability and stability when they are most needed.
Other situations that should be addressed by a partnership agreement include non-competition and confidentiality. Provisions that prevent a partner from sharing the company’s confidential information with others or seeking employment with a competitor are key for a business to maintain a competitive edge and to protect the investments of all partners.
6. To Protect Minority Owners. A written partnership agreement should include provisions that protect minority partners. One such clause, the “tag along” provision, protects minority owners in the event of a third party buyout. If a majority owner sells her interests to a third party, the minority partner has the right to become part of the transaction and sell her interests on similar terms. The benefit to the minority owner is that he can avoid being in business with an unwanted new co-owner. This provision also ensures that all partners will receive similar buyout offers and protects minority owners from being forced to accept much less attractive offers.
7. To Protect Majority Owners. Partnership agreements should also include provisions that protect majority owners. A “drag-along” clause forces minority partners to sell their shares in the event of a third party buyout. If a majority owner sells his interests to a third party, the minority partner must either (a) become part of the transaction and sell her interests to the same third party purchaser on similar terms or (b) purchase the majority partner’s interests on similar terms. The benefit to the majority owner is that he cannot be forced to remain in business simply because a minority owner does not want to sell. If a fair offer is made to buy the company, the majority owner is able to take advantage of that offer, even if this runs counter to the wishes of a minority partner.
Owners of a business enter the company full of optimism and good intentions. However, disputes among business partners are all too common and can risk destroying the entire operation. A well-drafted partnership agreement can protect the owners’ investments, greatly reduce disruption to the business and efficiently resolve disputes when they arise, saving the owners tens of thousands of dollars in legal fees later.