I’ll set the stage: Two friends decide to start a business. They’ve been friends for years. They see eye to eye on just about every issue, including how the business should be formed and managed. They are ready to start selling, making money, and growing their idea into a sustainable business. They’ve decided that each partner has an equal stake in the business and will receive equal compensation. They want it to be simple, no lawyers, no accountants, no additional partners, etc. To seal the deal they cheers their beers to the future. You get the picture.
Get it in Writing Because The Future is Unpredictable
Both partners trust each other, and neither has any reason to believe that their relationship will deteriorate. What they haven’t taken into account is that circumstances change. Life isn’t predictable, and neither are the twists and turns that many businesses take.
Business lawyers often advise clients to “get it in writing.” It’s amazing at how many new businesses decide to form a business, decide on how it is to be operated and managed, and decide how profits are to be allocated with a simple shake of the hand (or cheers of a few pint glasses). Business booms, partners get greedy, and that trust and camaraderie goes out the door. Or the business fails, takes on too much debt, each partner starts to point a finger at the other and a lawsuit ensues. Or the partners’ motivation and goals start to drift apart, and they decide they no longer want to pursue a common business. Memorializing in writing the relationship between the partners, the day to day operations of the business, who will manage the business, and the allocation of profits of losses is an easy way to safeguard your business (and its partners) from future hassles.
That’s not to say that every business that started with a handshake between two buddies will inevitably break down. Rather, the point is that you can minimize risks upfront by taking some time to create a partnership agreement (or founders’ agreement). And importantly, through the partnership agreement you can iron out some difficult issues very early on in the partnership. This will help you ensure that you and your partners can effectively compromise on tough decisions later on.
Important Terms to Consider for Your Partnership Agreement
Among other things, here are a few of the most important issues to hash out with your business partner prior to launching your new business:
- Ownership interests. It’s important to decide what percentage of the business each partner will own. You can include details about a vesting schedule if you would like to structure your agreement so that a partner’s ownership percentage is contingent on his or her continued work for the company. Typically this section will include the allocation of assets and liabilities (commonly based on the percentage of ownership in the business). Will the partners execute an IP assignment agreement to transfer ownership of the IP to the business? If so, details should be included in the partnership agreement.
- Allocation of profits and losses. The partners will need to decide how profits and losses are to allocated among the partners. It’s common to allocate the profits and losses according to each partner’s ownership percentage; however, the rules are flexible on allocating profits and losses in a way that is not in accord with ownership interests (depending on the entity you choose to form). Many businesses choose to allocate profits and losses evenly so long as each partner is contributing equally to the company, e.g. requiring each partner to work at least 40 hours a week to receive his share of profits and losses.
- Business Bank Accounts and Initial Contributions. In this section, it’s important to spell out what initial contributions are to be made by the partners, when they are to be contributed, where and when bank accounts will be opened to hold the initial contributions, and any additional details regarding the management of the business bank accounts. It is also important to include distribution terms in this section to describe when partners will receive distributions (cash or property) from the company.
- Manager’s Duties. It’s standard to include details about voting rights, duties of the partners in terms of managing the company, and restrictions on expenditures. If you want to restrict how much money your partner can spend without first talking to you, this is the section where you detail these terms.
- Withdrawal. No one wants to think about it upfront, but it’s important to sort out how a partner can exit the business smoothly. You can avoid numerous hassles if you can decide on how a partner can withdrawal, how he or she is to be paid–either by the company or the other partner–for their ownership interest, and how the ownership interest in the company is to be valued. You can also include terms that take into account the death or disability of a partner, including what payment the partner’s family is entitled to, and how payments are to be made.
- Transfers of Interest. Can a partner transfer his or her interest to another person? You can restrict each partner’s ability to transfer his or her interest without unanimous consent of all the partners. This way you can avoid unexpectedly bringing on another person that may be a liability to your business. Transfer restrictions can be structured in a variety of ways. It is important to decide upfront what restrictions are important to you and your business.
- Dispute Resolution. One of the more important provisions is the dispute resolution provision. You’ll have to decide what form of dispute resolution best suits you and your business, e.g. arbitration vs. mediation, judicial versus extrajudicial dispute resolution. While more often than not disputes can be resolved internally, it’s important to decide upfront how unresolved disputes are to be handled in circumstances where partners have reached a stalemate.
While this list is not exhaustive, it will provide you and your business a solid foundation for a written partnership agreement. Careful planning and drafting upfront will help reduce your risks and liabilities down the road.
If you’re interested in learning more about partnership agreements or drafting a custom partnership agreement for your small business, please comment below or contact us.
If you've enjoyed reading this post, please share: