Two close friends decide to start a company. They agree on just about every issue, including how the business should be formed and managed. They are ready to launch, make money, and grow their idea into a sustainable business. Each partner has an equal stake in the company, and they’ve decided that each will receive equal compensation as well. They want it to be simple, no lawyers, no accountants, no additional partners, etc. You get the picture, right?
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 is not predictable, and neither are the twists and turns that many businesses (and their owners) take.
Business lawyers often repeat the phrase: “you should have it in writing." It’s amazing at how many new businesses decide to form the company, decide on how it will be operated and how profits are to be allocated with a simple shake of the hand. Business then booms, partners get greedy, and that trust and camaraderie goes right out the door. Or the business fails; takes on too much debt, and each partner starts to point a finger at the other, resulting in a lawsuit. Memorializing your partnership agreement in writing, including the day to day operations of 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 in the end. Rather, the point is that you can minimize risks upfront by taking some time to create a partnership agreement (or founder’s agreement).
Important Terms in a Partnership Agreement 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 interest each partner will hold in the company. In this portion of the agreement it is standard to include how many units or stock each partner will receive. In addition, 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 company).
Allocation of profits and losses. The partners will need to decide how profits and losses are to be 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 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 contributions, and any additional details regarding the management of the business bank accounts and its funds. It is also important to include distribution (or compensation) terms in this section. Assuming the partners want to get paid (someday down the road), it is important to detail how and when compensation will be paid.
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 his 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.
Dispute Resolution. One of the more important provisions is the dispute resolution provision. You’ll have to decide what form of arbitration best suits you and your business, e.g. 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. We advise putting together an operating agreement (LLC) or bylaws (Corporation) once your company is properly formed.