Double Trouble

A well-drafted agreement can keep you out of court if your partnership breaks up.
Magazine Contributor
6 min read

This story appears in the November 1996 issue of Entrepreneur. Subscribe »

If not for the divorce, the business partners might still be together. The two men had scraped together enough money to open a small pool supply store, which they built over 20 years into a profitable chain of 65.

But suddenly things got ugly. In the throes of a divorce, one partner decided he needed cash fast. Hoping to sell his half of the company, he found a group of investors who wanted the whole business. The other partner didn't want to sell; he offered to buy his partner out for less than the partner wanted. Instead, the partner who wanted out persuaded a judge to order the partnership dissolved, the assets sold, and his former partner fired for interfering with the takeover.

Partnership disputes are nearly as common as partnerships. As the partners above learned, they often land in court. Better to avoid problems by anticipating what can go wrong and drafting a partnership agreement for all partners to sign.

Many partnerships fail to do this. In family businesses, for example, where decisions are often made informally, it's hard to imagine the tensions that plague thousands of other family businesses could ever crop up in yours. If you've just started a business, handling legal details may be far down on your list of things to do.

You may think any problems can be resolved amicably as they arise. However, partnerships wed personalities with goals and management styles that often differ markedly. One partner may want to sell out when the other doesn't have the money to buy. One may want to expand the operation dramatically, while the other would rather coast. If you agree in advance how to resolve these disputes, there's less chance a judge will have to sort it out.

Legal Underpinnings

Typically, when a business with more than one owner hasn't filed papers to form a corporation or limited liability company, courts treat it as a partnership. Partnerships in every state but Louisiana are governed by the Uniform Partnership Act, a set of laws adopted nearly 80 years ago.

The Uniform Partnership Act includes two traps for the uninformed. One concerns a partner's right to get out. Unless there's a partnership agreement to the contrary, a partner may quit or retire at any time, compelling the remaining partners to pay fair value for his or her interest. If the remaining partners don't have enough money available, they may be forced to liquidate the business.

The second trap concerns price. Although the law requires the remaining partners to pay "fair value," it doesn't specify how that value is determined. Typically, the partner who wants out expects more than the others are willing to pay. If the partners can't agree, they may have to ask a judge to set the price. Like any lawsuit, this is likely to be expensive and time-consuming. It's also unpredictable because most judges have little experience in determining the value of a partnership interest.

Avoid such problems by drafting and signing a partnership agreement that sets out how business decisions are made, how disputes are resolved and how to handle a buyout. In many cases, the process of negotiating terms helps the partners understand each other and design a structure they're all happy with.

Consult an attorney experienced with small businesses for help in drafting the agreement; a small investment at this stage can save you major headaches later. The attorney will suggest terms to consider. Here are some to get you started:

  • How is ownership interest shared? Two owners need not share ownership and authority 50-50. Depending on the assets and time each contributes, you may decide on some other proportion. But make sure that proportion is stated clearly in the agreement.

  • How will decisions be made? Typically, partnerships operate on consensus. In case of major disagreements, though, provide for voting rights. Beware of the possibility of deadlock when two partners own the business 50-50. Some businesses with two partners avoid deadlock by providing in advance for a third partner, a trusted associate who may own only 1 percent of the business but whose vote can break a tie.

  • When may a partner retire? At what age must a partner sell his or her interest to the others? If one partner decides to retire at 50 and live off the proceeds of the sale, it can be a hardship for the others. Likewise, if an aging partner wants to hang around and draw a full salary, it can cause resentment among younger, harder-working partners. The agreement might provide that payment for the partnership interest would be less if a partner quits before a specified retirement age.

  • When one partner withdraws, how is the purchase price determined? You might agree on a neutral third party, such as your banker or accountant, to select an appraiser to determine the price of the partnership interest. Another option is stating a formula, such as a percentage of book value or a multiple of net profit. Be sure to review the formula periodically; it may cease to be appropriate as the business matures.

  • When will the price be paid? Requiring the entire purchase price up front could devastate cash flow. Typically, partners agree that the money be paid over three, five or 10 years, with interest. Since it's impossible to know the market interest rate for a breakup that could be decades away, most agreements specify a floating rate tied to some index such as a percentage of the prime rate.

  • Where will the money come from? A partner's unexpected death or withdrawal can leave the others strapped for cash. Some firms take out life insurance on each partner so if one dies suddenly, there will be money to buy that partner's share from the estate.

  • May a partner retire gradually? Consider providing for a consulting agreement or partial retirement at a percentage of former salary.

  • May a partner who withdraws compete with the partnership? A partner who drops out could become a fierce competitor. Consider a reasonable noncompete agreement (see last month's "Legal Aid").

Once you negotiate and sign the partnership agreement, don't dwell on it: Put it away, and get on with your business.

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