Why your business should have a partnership agreement

What is a partnership agreement?

A partnership agreement is a binding contract between the parties of a partnership. Its purpose is to set out the terms and conditions of the relationship between the parties, including the duration, capital, percentages of ownership, how the assets will be divided, and the distribution of profits and losses.

If you do not have a partnership agreement, the Partnership Act 1890 shall apply to the business. The Act is over 130 years old and lacks sufficient scope for modern-day businesses and the complexities of today’s world.

Broadly speaking, the Act treats all parties as equals in terms of entitlement to profits, decision-making, and liability. Having a partnership agreement will immediately override the Act’s provisions and allow the parties to control the way their business is run.

Why do you need a partnership agreement?

If you are in business with one or more other people, with a view to making profit, then you are in ‘partnership’.

Partnerships frequently encounter difficulties. It is, therefore, key to have a partnership agreement in place to record each of the parties’ intentions at the outset of the formation of the business.

Some of the more important reasons why a company should have a formal partnership agreement are:

1. To provide certainty and formalised unwritten rules to reduce potential misunderstandings

Having a partnership agreement in place offers benefits and certainty to all parties concerned. Areas such as how profits are distributed, how decisions are made can be set out and agreed upon, and if differences or misunderstandings start to arise between the parties, a partnership agreement provides documented evidence as to what was agreed between all parties at the outset.

2. To prevent future costs for the partners

Having a partnership agreement can significantly reduce future costs that may be incurred in resolving a dispute between parties.

For example, if something goes wrong, the agreement may provide a process to follow. A likely dispute may include the value of various assets, intellectual property, or the procedure to follow on a party’s retirement.

Establishing “who owns what” in this context can be challenging and costly. A partnership agreement would therefore seek to minimise these costs.

3. A partnership agreement will override the default provisions of The Partnership Act 1890 (The Act)

As mentioned above, if you enter into a partnership without a partnership agreement, the partnership will automatically be governed by the Act.

Although the statute provides a comprehensive framework to govern a partnership, the general provisions of the Act may not be desirable for your business and your intentions as a party. We set out below the standard positions set out by the Partnership Act in greater detail.

What are the standard provisions of the Act in the absence of a partnership agreement?

1. All parties are entitled to share equally the capital and profits of the business and contribute equally to the losses

In the absence of a specific provision set out within a partnership agreement, section 24 of the Act provides that profits and losses are to be divided between parties equally.

This may not be the intention or desired outcome for all businesses, and a partnership agreement is the only way to avoid this.

This may be an issue for parties where, for example, there is a “sleeping partner” or a party that intends to receive a ‘pro-rata’ share of the profits and has contributed more working capital for the partnership. If this is the case, the party may likely wish to receive a higher profit share.

2. Joint liability of the partners

Every partner under the statutory position will be jointly liable for any debts and obligations the business incurred while he or she is a party; furthermore, their estate may be held liable after their death.

In addition, the Act also makes each party liable for any wrongful act or omission by any other party and the misapplication of any money.

It is, however, important to note that under Section 17 of the Act, a person who is admitted as a partner does not become liable to the creditors of the business for anything that took place before he or she became a partner.

This means that if the partners have run up debts prior to a new partner joining, then the new partner will not be liable for those debts.

3. Joint responsibility for decision making

The Act sets out that all parties share the responsibility for the business and for the decisions which may affect the business. Therefore, each party has the right to equally contribute to matters that affect the day-to-day running of the business.

Decisions are to be made on the basis of a simple majority, with each partner entitled to one vote. Decisions that change the nature of the business or are based on the introduction of a new partner will require unanimous consent.

This is often a point of contention, where a party contribute more time or capital to the business, often wanting greater’ voting rights’ in return. Again, this can be addressed in a partnership agreement, which may, for example, list certain matters that require the consent of a particular party (often the ‘founding partner’).

4. Any partner can bring the partnership to an end by giving notice at any time

Section 26 of the Act provides that a partner may dissolve the entire partnership by serving notice to the other partners with immediate effect at any time. This is called a ‘partnership at will’. As with many businesses, it is not always possible to cease trading with immediate effect.

For this reason, carefully drafted notice provisions within a partnership agreement should allow time for the remaining partners to decide on the next steps and, where necessary, raise money to buy out the outgoing partner as well as giving time to contact clients and customers to preserve continuing business relationships.

5. Dissolution and retirement

The Act states that the effect of dissolution is that the business stops trading, the partnership’s assets must be realised, its liabilities must be paid, and any surplus returned to the partners in equal amounts. Instead, it may be more appropriate for the business to include provisions for an orderly retirement of an individual partner.

As mentioned above, there may also be an option for the continuing partners to buy out the outgoing partner’s interest. There should then be detailed provisions within the partnership agreement to establish the businesses’ value, how to value the outgoing partner’s share, how the purchase price must be paid and whether insurance exists to make up part of the purchase price.

6. Death and bankruptcy of a partner will dissolve the partnership

The statutory provisions of the Act provide that if any partner dies or is declared bankrupt, the entire partnership is dissolved, and the partnership’s assets must be realised and liabilities paid (as mentioned above). Often this is not the desired outcome as the remaining partners may wish to continue trading.

If so, then there will need to be an express provision within the partnership agreement that, upon the death or bankruptcy of any partner, the partnership (or business) will continue.

7. Restrictive covenants

These clauses are designed to prevent certain actions by partners to serve the best interests of the business. The primary types of restrictive covenants are non-solicit, non-disclosure and non-compete, which ideally should all be included in your partnership agreement.

A non-solicit clause prevents a partner from stealing clients when he or she leaves. A non-disclosure clause protects confidential information when a partner leaves the business, and a non-compete clause prevents a partner who leaves the business to start or work for a competing business for a certain amount of time within a specific geographic boundary.

8. Expulsion

When partners form the partnership, they usually share a common business plan, with strong relations and with good intentions. Unfortunately, in some cases, as time goes on, partners’ objectives and visions start to differ.

If a partner is becoming disruptive or is not fulfilling their obligations, there may be no other choice than to remove said partner. However, without a partnership agreement, the partners will have to rely on the default provisions in the Act.

In the absence of an express provision in respect of expulsion, the Act provides that the partners cannot expel a partner. This can have serious implications, for example, if a partner commits a serious breach of duty, is convicted of a criminal offence or ceases to belong to a compulsory regulatory body.

Conclusion

In times of commercial uncertainty, which is often the main cause of disputes and disagreements, it is important that there is a clear procedure on how the company is run and how disputes are to be addressed.

At SO Legal, our commercial and corporate team will work with you to meet the needs of you and your business. Our solicitors can draft a partnership agreement, whether you have been operating as a business for some time or if you are just starting up.

Contact our solicitors 

SO Legal has offices across the South East. Our solicitors in Brighton, Eastbourne, Hastings, London and Uckfield can help you understand partnership agreements.