How to Craft an Airtight Partnership Agreement
A partnership, in the broad sense, is a business endeavor taken by two or more parties for profit. A partnership agreement, therefore, sets out the rights and duties for partners in business together; it outlines the “rules of the road” in much the same way that other contracts do, and certain terms are indispensable for success.
(Note: we can break a “partnership” down into implied partnerships, LLCs, corporations, and other for-profit entities, but for the purposes of this article, “partnership” will be a catch-all for these business endeavors.)
Contributions. A list of contributions by each partner to the partnership should come early on in the partnership agreement. It should read like a ledger, identifying the name of the partner, the type of contribution (capital, assets, or services, and whether it’s equity or debt), and the value of that contribution. If the contribution isn’t monetary, the partners may have to agree upon a fair market value. The contributions section should also discuss whether and at what rate partner loans will be repaid, and should identify any lines of credit to the partnership for future contributions.
Competition. The partnership agreement should identify whether partners can carry on competing businesses or capitalize on business opportunities that might otherwise interest the partnership. A conflict of interest often requires informed written consent, achieved by full disclosure of the business opportunity and a vote by disinterested partners.
Ownership. Ownership interests, voting rights, and distribution rights are not inextricable. It’s prudent to set three more ledgers – one for each type of right – in your partnership agreement; together these ledgers will identify each partner’s overall equity, voting power, and interest in distributions as they become available.
Voting. Once voting rights are established, the partnership agreement needs to define which actions require votes, the quorum (the minimum number of partners required to take a vote), and what constitutes a successful vote (this can be a majority, a super-majority, unanimity, or some other threshold).
Distributions. Payouts from net profits are affected by many things, including repayment of loan contributions, salaries for ongoing services, and tax considerations. How you structure distributions agreement is (for the most part) limited only by your imagination and sense of fairness. A provision for tax distributions is recommended; generally, this requires the partnership to pay partners at least enough to cover taxes on partnership income that is allocated to them in a given quarter or year.
Management, Decision-Making. This section identifies who among the partners will manage the business, and how managers will be replaced over time. The partnership agreement should list actions which any partner can take (e.g. petty purchases), those which only the manager(s) can take (e.g. entering contracts, taking on new debt), and those beyond even the manager’s power, which require a full partnership vote (e.g. amendment of the partnership agreement).
Addition and Removal of Partners. The partnership agreement must contemplate changes in ownership. Will your partnership have a reserve pool of shares to grant an incoming partner? Will existing partners be able to purchase additional shares to avoid dilution? If a partner is expelled for-cause, what happens to his or her partnership interest? If a partner voluntarily sells off or retires, does the partnership have a right of first refusal to repurchase those interests? As a team, you must identify these contingencies and set rules accordingly.
When discussing the death or disability of a partner, you quickly enter the realm of business succession planning, which is another area of law altogether. As a helpful starting point, consider taking out life and health insurance policies on each partner to help fund buybacks or care plans.
Winding Up. Sometimes dissolution is unavoidable (e.g. judicial decree, bankruptcy); sometimes it’s voluntary (e.g. by vote). You’ll want to identify when the partners can dissolve the partnership and who will carry out the “winding up” process.