When you decided to launch your new venture, a lot of the excitement probably wasn’t about how awesome it would be to have your very own partnership agreement.
Profits, freedom, success–those probably got more attention.
But if you’re going into business with a partner, having a solid partnership agreement that contains some essential items is critical. Many co-founders neglect this and it creates all sorts of unnecessary headaches and strife–and ruined friendships sometimes–down the road.
If you’ve ever seen The Social Network and know the story of Facebook founders Mark Zuckerberg and Eduardo Saverin you understand what a bad partnership break up can look like. Lots of acrimony and lots of litigation.
Why Partnership Agreements Get Overlooked
Beyond not being particularly exciting, there are two primary reasons good partnership agreements get neglected.
One is that they’re awkward to develop sometimes.
You and your co-founder(s) presumably are working together because you have some degree of trust and compatibility and are making positive assumptions about each other’s future behavior. A partnership agreement forces you to discuss possible bad behavior. Awkward.
The second is that they can create nervousness and apprehension because you need to consider–explicitly–failure.
What will happen if the business doesn’t succeed or doesn’t succeed as much as you hoped? Launching something new takes energy and optimism and considering failure isn’t something many founders want to spend too much time considering.
But that doesn’t mean you can neglect this critical aspect of business management.
Some states have laws that govern some of these issues in the absence of an operating agreement, and some don’t. Either way, you’ll be facing more confusion and wasted time and effort without an agreement in place.
Not putting together a real partnership agreement doesn’t make these issues disappear–it just ensures you’ll deal with them later, and be less prepared to do so.
What Is A Partnership Agreement?
When you set up a business structure with more than one owner–a partnership, an LLC or a corporation–you need to have a written agreement that defines each partner’s rights and responsibilities and lays out the ground rules for how disputes will be handled.
The owners of a partnership are called partners and have a partnership agreement. The owners of an LLC are called members and have an operating agreement. The owners of a corporation are called shareholders and have a shareholders agreement.
These three agreements have minor differences, but are substantially similar. In a partnership agreement, you should have the following seven issues addressed.
The list isn’t comprehensive and there are many other details that you can consider, but if you’re not tackling these issues at a minimum, you need to take another look at your agreement.
Alongside complementary talents, shared vision and mutual respect, good partnership agreements make for good partnerships.
1. Management and Decision-Making
At the start of a partnership, decision-making tends to be pretty informal. But how are you going handle a disagreement about something important in the future?
The partnership agreement is where you define your decision-making processes and requirements. Treat these seriously.
If you casually set forth that major requirements need unanimity, are you really prepared to not move forward on things without that all-in vote? That can stifle progress and growth.
Do you have a tie-breaking mechanism in case an equal number of partners with equal authority are in disagreement?
You also have the option of assigning management roles in a partnership agreement. This can help dictate responsibility for certain decisions based on roles.
When assigning roles, make sure to keep time commitments in mind.
If one partner takes on responsibility for bookkeeping, is he really prepared to do all of that work and make that time commitment? Will the other partner or partners be taking on equal time commitments in their managerial roles?
2. Capital Contribution and Ownership
Money, of course, can be the source of a lot of friction. The capital contribution of each partner usually dictates ownership percentages.
But initial capital contributions don’t always solely decide ownership percentages. Will one partner be mainly investing money while the other partner will be doing much more work? This is often reflected in ownership stakes.
You need to also consider capital requirements and ownership beyond the initial contributions.
What happens if the initial capital runs out before the business turns a profit? Does the business simply fold and everyone quits?
Do the partners expect that they’ll contribute more funds at that point? At the same percentage as before? Will the partnership look for outside investors at this point?
Running out of cash is not an uncommon scenario for young businesses and should be addressed.
3. Salaries and Distributions
How and when do partners get paid for their participation?
This isn’t as simple as it sounds and encompasses two different items: distributions and salaries.
Salaries are regular compensation for work paid based on time periods and are not based on ownership or profits. Will you and your partners be earning salaries immediately for the time you’re committing from the get-go? Or will salaries only start after profits are made?
Speaking of profits, how will these get distributed to partners? Will they all be kept in the business to fuel growth, or will they be distributed partially or in total each year?
4. Disability, Death and Dissolution
A partnership’s existence relies upon the continued ownership of all partners. If a partner chooses to leave, dies or becomes incapacitated, the partnership would end unless all remaining partners agree to continue it.
What happens if you don’t have unanimous agreement among the remaining partners to continue at this point? The partnership ends, even though some partners may wish very much to continue.
One way partnership agreements regularly deal with this is by stating that in the event of a withdrawal or death, the partnership will buy back those shares and continue.
Speaking of withdrawals–are there any requirements or repercussions involved, or can any partner decide to withdraw at any time?
It’s not fun to think about, but tragedies happen. Much more frequently, a partner simply decides he or she wants out. Your partnership agreement needs to deal with these scenarios.
5. Transfer of Ownership
Can you or your partners sell you ownership stake to whomever you want? Does your ownership give you that right?
What if you don’t want to work with the new partner your original partner sold her stake to?
Your partnership agreement should address restrictions on transferability of ownership.
6. Dispute Resolutions
If there is a dispute between partners that can’t be resolved, your partnership agreement should address this situation by stipulating your preferred resolution mechanism (mediation or arbitration) that partners are required to use instead of litigation.
Good partnership agreements keep disputes from ending up in court.
7. Requirements To Amend
If you decide you want to alter or amend you’re partnership agreement in the future, what steps are required to do so?
It’s not uncommon for partners to want to change or update terms, but there has to be an agreed-upon process for doing so.
You don’t have to hire a lawyer to draft a partnership agreement.
The free small business mentoring program SCORE offers templates and resources, alongside for-profit online outfits such as RocketLawyer, Nolo, LegalZoom and others.
Nevertheless, you may want to consider having a lawyer help you draft your document–or at least review it. As you can see in this article, there are lots of details to consider when dealing with just an LLC.