Partnership Primer

Your word may be your bond, but you'll feel better about your new partner if you get it in writing. Here's the fine print.

By Michael Spadaccini • Jul 21, 2005

Opinions expressed by Entrepreneur contributors are their own.

A partnership is a business form created automatically when twoor more persons engage in a business enterprise for profit.Consider the following language from the Uniform Partnership Act:"The association of two or more persons to carry on asco-owners of a business for profit forms a partnership, whether ornot the persons intend to form a partnership." Apartnership--in its various forms--offers its multiple ownersflexibility and relative simplicity of organization and operation.In limited partnerships and limited liability partnerships, apartnership can even offer a degree of liability protection.

Partnerships can be formed with a handshake--and often they are.In fact, partnerships are the only business entities that can beformed by oral agreement. Of course, as with any important legalrelationship, oral agreements often lead to misunderstandings,which often lead to disputes. Thus, you should only form apartnership that is memorialized with a written partnershipagreement. Preferably, you should prepare this document with theassistance of an attorney. The cost to have an attorney draft apartnership agreement can vary between $500 and $2,000 depending onthe complexity of the partnership arrangement and the experienceand location of the attorney.

How Partnerships Are Managed

Partnerships have very simple management structures. In the caseof general partnerships, partnerships are managed by the partnersthemselves, with decisions ultimately resting with a majority ofthe percentage owners of the partnership. Partnership-stylemanagement is often called owner management. Corporations,on the other hand, are typically managed by appointed or electedofficers, which is called representative management. Keep inmind that a majority of the percentage interest in a partnershipcan be very different from a majority of the partners. This isbecause one partner may own 60 percent of a partnership, with fourother partners owning only 10 percent each. Partnerships (andcorporations and LLCs) universally vest ultimate voting power witha majority of the percentage ownership interest.

Of course, partners and shareholders don't call votes everytime they need to make some small business decision such as signinga contract or ordering office supplies. Small tasks are managedinformally, as they should be. Voting becomes important, however,when a dispute arises among the partners. If the dispute cannot beresolved informally, the partners call a meeting and take a vote onthe matter. Those partners representing the minority in such a votemust go along with the decision of the partners representing themajority.

Partnerships do not require formal meetings like corporationsdo. Of course, some partnerships elect to have periodic meetingsanyway. Overall, the management and administrative operation of apartnership is relatively simple, and this can be an importantadvantage. Like sole proprietorships, partnerships often grow andgraduate to LLC or corporate status.

Varieties of Partnerships

There are several varieties of partnerships. They range from thesimple general partnership to the limited liabilitypartnership.

  • The general partnership. By default, a standardpartnership is referred to as a general partnership. Generalpartnerships are the simplest of all partnerships. An oralpartnership will almost always be a general partnership. In ageneral partnership, all partners share in the management of theentity and share in the entity's profits. Matters relating tothe ordinary business operations of the partnership are decided bya majority of the partners. Of course, some partners can own agreater share of the entity than other partners, in which casetheir vote counts according to their percentage ownership--muchlike voting of shares in a corporation. All partners areresponsible for the liabilities of a general partnership.
  • The limited partnership. The limited partnership is morecomplex than the general partnership. It is a partnership owned bytwo classes of partners: general partners manage theenterprise and are personally liable for its debts; limitedpartners contribute capital and share in the profits but normallydo not participate in the management of the enterprise. Anothernotable distinction between the two classes of partners is thatlimited partners incur no liability for partnership debts beyondtheir capital contributions. Limited partners enjoy liabilityprotection much like the shareholders of a corporation. The limitedpartnership is commonly used in the restaurant business, with thefounders serving as general partners and the investors as limitedpartners.

A limited partnership usually requires a state filingestablishing the limited partnership. Some states, most notablyCalifornia, allow the oral creation of a limited partnership. Ofcourse, establishing a limited partnership with nothing more thanan oral agreement is unwise. Oral limited partnership agreementswill very likely lead to disputes and may not offer liabilityprotection to limited partners.

Limited partnerships have fallen out of favor recently becauseof the rise of the limited liability company. Both forms sharepartnership-style taxation and partnership-style management, butthe LLC offers greater liability protection because it extendsliability protection to all its managers. Thus, today LLCs areoften selected instead of limited partnerships.

Because of the complexity of limited partnerships, the formationof one is not something you should undertake on your own. Theformation of a limited partnership is best left to a qualifiedattorney.

  • The limited liability partnership. Yet another form ofpartnership is the limited liability partnership. A limitedliability partnership is one comprised of licensed professionalssuch as attorneys, accountants and architects. The partners in anLLP may enjoy personal liability protection for the acts of otherpartners but each partner remains liable for his own actions. Statelaws generally require LLPs to maintain generous insurance policiesor cash reserves to pay claims brought against the LLP.

Partnership Agreements

Your partnership agreement should detail how business decisionsare made, how disputes are resolved, and how to handle a buyout.You'll be glad you have this agreement if for some reason yourun into difficulties with one of the partners or if someone wantsout of the arrangement.

The agreement should address the purpose of the business and theauthority and responsibility of each partner. It's a good ideato consult an attorney experienced with small businesses for helpin drafting the agreement. Here are some other issues you'llwant the agreement to address:

1. How will the ownership interest be shared? It'snot necessary, for example, for two owners to equally shareownership and authority. However you decide to do it, make sure theproportion is stated clearly in the agreement.

2. How will decisions be made? It's a good idea toestablish voting rights in case a major disagreement arises. Whenjust two partners own the business 50-50, there's thepossibility of a deadlock. To avoid a deadlock, some businessesprovide in advance for a third partner, a trusted associate who mayown only 1 percent of the business but whose vote can break atie.

3. When one partner withdraws, how will the purchase price bedetermined? One possibility is to agree on a neutral thirdparty, such as your banker or accountant, to find an appraiser todetermine the price of the partnership interest.

4. If a partner withdraws from the partnership, when willmoney be paid? Depending on the partnership agreement, you canagree that the money be paid over three, five or ten years, withinterest. You don't want to be hit with a cash flow crisis ifthe entire price has to be paid on the spot in one lump sum.

How Partnerships Are Governed

Partnerships are governed by the law of the state in which theyare organized and by the rules set out by the partners themselves.Typically, partners set forth the governing rules in a partnershipagreement.

Often the governance rules determined by the partners differfrom the governance rules set by state law. In most cases, therules of the partners override state law. For example, state lawtypically dictates that a partnership's profits are to bedivided among partners in proportion to their ownership interests.However, the partners are free to divide profits by a formulaseparate from their ownership interests, and the decision of thepartners will override state law. Thus, the governance rules instate law are default provisions that apply in the absence of anyrules set by the partners in a partnership agreement.

This fact underscores the need for a partnership agreement.Otherwise, the partnership will by default be governed by statelaw. The laws set forth by state law may not be appropriate forevery partnership. For the most part, however, the default staterules are fair and well-balanced.

An Important Concept: The Law of Agency

Agency refers to one's status as the legalrepresentative (the agent) of an entity or another person.The party on whose behalf an agent acts is called aprincipal. One is said to be the agent of a partnership orother entity if one has the legal authority to act on behalf ofthat entity.

An agent can bind a partnership to contracts and otherobligations through his actions on behalf of a partnership. Ofcourse, when an agent acts on behalf of a partnership or anothercompany, the company is bound by the acts and decisions of thatagent. A third party dealing with an agent of a company can relyupon the agency relationship and enforce the obligations undertakenby the agent--even if the agent made a foolish or selfish decisionson the company's behalf. If the agent acts within the scope ofthe his authority, the partnership becomes bound by the actions, nomatter how foolish.

The law of agency applies to corporations and LLCs as well as topartnerships. However, a discussion of the law of agency isparticularly pertinent to partnerships because in a generalpartnership, all of the partners usually have the status of agentwith respect to the general partnership. The law of agency appliesdifferently to corporations. Shareholders in a corporation are notnecessarily officers and directors of that corporation, and agentstatus will not automatically apply to them. So, partners in apartnership must be careful to delineate authority and keep abreastof their co-partners' decisions.

That said, partnerships can grant specific authority to specificpartners, if such a grant appears in the partnership document.Without and agreement to contrary, however, any partners can bindthe partnership without the consent of the other partners, asdescribed above.

Summing Up: The Pros and Cons

Pros:

  • Owners can start partnerships relatively easily andinexpensively.
  • Partnerships do not require annual meetings and require fewongoing formalities.
  • Partnerships offer favorable taxation to most smallerbusinesses.
  • Partnerships often do not have to pay minimum taxes that arerequired of LLCs and corporations.

Cons:

  • All owners are subject to unlimited personal liability for thedebts, losses and liabilities of the business (except in cases oflimited partnerships and limited liablity partnerships).
  • Individual partners bear responsibility for the actions ofother partners.
  • Poorly organized partnerships and oral partnerships can lead todisputes among owners.

All portions of this article were excerpted from Entrepreneur Magazine's Ultimate Book on FormingCorporations, LLCs, Sole Proprietorships and Partnerships,except for "Partnership Agreements," which was excerptedfrom Start Your Own Business.

Editor's Pick

Have More Responsibilities at Work, But No Pay Bump? Use This Script to Get the Raise You Deserve.
Black and Asian Founders Face Opposition at All Levels — Here's Why That Has to Change
Business News

Frontier Airlines Just Announced Its All-You-Can-Fly Summer Pass for $399. What's the Catch?

As travel begins to pick up, the airline hopes unlimited travel will jumpstart its business.

Thought Leaders

5 Small Daily Habits Self-Made Millionaires Use to Grow Their Wealth

We've all seen what self-made millionaires look like on TV, but it's a lot more subtle than that. Brian Tracy researched what small daily habits these successful entrepreneurs adopted on their journey from rags to riches.

Leadership

Here's Why You Should Steal Someone Else's Leadership Style

To become the best leader you can be, you must start by being a version of the leaders you most admire.

Starting a Business

Free Event | February 9: Solopreneur Office Hours with Terry Rice

Running a one person business is challenging, but we're here to help you. Tune in as our expert, Terry Rice, answers your most pressing questions.

Business News

Mark Cuban's Grocery Store Hack Will Help You Score Cheaper Produce

The billionaire talked about his early days in Dallas when he was strapped for cash.