The importance of partnership agreements

Partnership agreements are there to govern how profits, losses, responsibilities, cash surpluses, and debt are handled within a business. Setting up a company, whether incorporated or not, without a partnership agreement is a very risky thing to do.

In this article, Modina looks at partnerships, what can go wrong with them, and how a partnership agreement can protect your investments of both time and money.

Partnership agreements – one of your partners may not be as good as you believed them to be…

…it’s not unknown for people to overestimate their own abilities either when selling themselves as a potential business partner to someone.

If you’ve ever employed anyone before, think of it like this. A CV can only tell you so much and they might be putting in the performances of their lives at the interviews they have with you. Then, when they join you, they’re a huge let-down. An example that springs to mind is Ali Día – check out Wikipedia’s biography of him.

You need to be able to throw someone over the side if they’re going to be a hindrance to you. After all, you were meant to be joint bosses – you never signed up to being that person’s boss.

A partnership agreement sets out a formal way how:

  • the partnership can be dissolved and the assets, cash, and debt of the business be divided or
  • you can buy out that person’s share in the partnership

Partnership agreements – what if your former partner goes into competition against you?

Post-split, a partnership agreement can be written to set out what former partners can do and what they can’t do. In legal terms, these are called “restrictive covenants”.

Restrictive covenants are complicated and often difficult to enforce. Legal advice should be sought on this but, at the very least, ex-partners should be barred from poaching staff or customers or setting up in competition with you for a defined period of time.

Partnership agreements – one of the partners walks away

This is always a threat. If there is no partnership agreement, then the Partnership Act of 1890 applies.

Under this Act, a partner can just give notice to dissolve the partnership and the partnership then ceases to exist. If the partnership owes money when the walkaway happens (including money to the partners themselves), creditors must be paid what they are owed from the partnership’s cash reserves. If there isn’t enough, each partner must dig into their own pockets and settle outstanding credit agreements from their personal reserves.

A partnership agreement can protect you by setting out in advance what you need to pay the departing partner to buy his or her share of the business. The agreement means that there is a process everyone can follow and this will reduce the likelihood of any disputes, financial or otherwise, between the members.

Partnership agreements – unequal investments

Many partnerships start off with all participants contributing equal amounts of capital to get the business off the ground. Others don’t – there’ll be a lead investing partner and the other partners will put in less cash.

A partnership agreement can specify how quickly each investing partner is paid back and, at the point of selling the business, the lead investing partner’s greater initial contribution can be reflected in the percentage of the proceeds they receive from a sale.

Partnership agreements – responsibilities and performance

Some people are harder workers than others. Some people are more driven to make money than others. It is the way of the world when it comes to business. Those who work harder and those who are more driven are more likely to be company owners. Those that prefer the quiet life prefer to take a wage, more often than not.

What if one partner is not doing as much work as they promised and you’re having to step in all the time? What if your partner promised that his or her contribution would bring “x” into the company but it’s come to nowhere near that?

A solid partnership agreement can codify the responsibilities and the decision-making chain with a business, putting in penalties for one party’s underperformance or lack of work.

Partnership agreements – handling of money and pay

In a partnership, the money in the partnership account should, in practical terms, be treated as separate from personal cash. There should be defined and understood procedures in place for deciding who gets paid what and what needs to happen for a cheque to be signed (for example, to pay a suppler).

Money, more than anything else, is likely to be the reason that you and your partner(s) fall out. If you plan to bring in more business or you have a contribution that, in some measurable way, is more significant than your partner(s) and you wish your pay to reflect that, this needs to be drawn up in a partnership agreement.

Partnership agreements – should I incorporate?

Incorporating, in other words forming a limited company, involves more paperwork than a non-incorporated partnership. In the opinion of most accountants and bookkeepers, a limited company offers a more adaptable and flexible structure for dealing with disputes than a standard partnership. There are also advantages when it comes to separating personal cash from company cash.

If you need expert and impartial advice regarding your partnership and taking it forward, please speak to one of our team on 020 7183 8241, or email us on info@modina.co.uk today.

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