Do You Need a Partnership Agreement?

December 8, 2022by Brandon Banks

Starting a new business partnership is always exciting, especially with friends and family members sharing the same enthusiasm, hopes, and dreams. In many ways, weddings are like business partnerships. In marriage, people promise to be together “for better, for worse, for richer, for poorer, in sickness and in health, to love and to cherish, until parted by death.” In a business partnership, the partners appear to agree on how the business will operate, and they will resolve future problems quickly with a surplus of goodwill. Then the journey begins.

Couples quickly learn that their life together does not go as expected. One is an early riser, the other a night person. One enjoys quiet evenings at home; the other prefers nights out with friends. One likes the Miami football team, and the other hates sports. Disagreements arise in the best marriages despite good intentions and open communications. Successful partners learn to compromise or avoid circumstances where conflict is inevitable. Other couples decide that the problems of living together are greater than the benefits and divorce.

Business partnerships are subject to the same tensions as married couples. Issues arise and must be settled. Partners who rely on simple or implied agreements may learn that each partner has a different interpretation of their relationship and memories of their understanding. Control and financial issues are especially challenging, affecting business objectives, strategy, operations, personnel, and finance.

The Dangers of Implied or
Simple Partnership Agreements

Several years ago, a young friend, Jeremy M., patented a biodegradable cover for containers of all shapes and sizes. He targeted fast-food units since a single case of the new caps replaced six to eight of the conventional caps, freeing up critical storage space in the restaurant. Lacking funds to finance the cover’s development, the inventor agreed to a simple 50-50 partnership with a family friend in return for funding the company.

Entrepreneurs often form partnerships with investors, though most formalize their agreements in writing. My friend, eager to start the new business, trusted the older partner and agreed that a simple one-page contract between the two was sufficient.

The company’s initial marketing efforts quickly generated interest from national soft drink companies. One proposed to purchase the company for $2 million, retaining the inventor with a six-figure salary and a perpetual 3% royalty on gross sales. Since his partner had invested less than $100,000 at the time, my friend was confident that he would accept a 10X return on his investment.

However, the investor calculated that the startup was worth at least $10 million, well above the $2 million price offered, and refused to sell. When he agreed to fund the company, he believed the inventor was committed to building a significant business. The inventor’s interest in an early sale contradicted their intended purpose.

Since the partnership was 50-50, the inventor could not force the investor to accept the soft drink company’s offer. For months, the two partners argued over the sale, each side unwilling to seek a compromise. The soft drink company withdrew its offer several weeks later, leaving the partners’ relationship in tatters.

The 50-50 provision of their simple partnership agreement meant neither partner could act without the other’s assent. They were stalemated, each feeling betrayed by the other. The toxic relationship discouraged other suitors for the patent, effectively leaving the two partners unable to move forward with new investors or return to its pre-partnership stage. Everyone lost.

Better Safe than Sorry

Unfortunately, Jeremy’s experience in a partnership is not unique. Even so, a single clause dictating an issue resolution process would have had different results.

According to Forbes magazine, 70% of business partnerships fail.[i] The causes include differing values, unequal commitment, personality clashes, and communication failures.[ii] Written partnership agreements do not guarantee success. Nevertheless, they facilitate problem resolution that might turn a difficulty into a disaster.

A well-developed written partnership agreement serves many purposes, including a

  • Reference source. The lack of documentation requires partners to rely on unreliable personal memories, perspectives, and interpretations to reconstruct the past. A written document puts an irrefutable “stake in the ground” to confirm the terms and parties to the agreement.
  • Operations Manual. Establishing partner roles and responsibilities and their amendment process facilitates decision-making and minimizes internal distractions that might threaten its operating and financial success.
  • Capital Plan. The partnership agreement identifies individual partners and their capital contributions, percentage of ownership, existing and possible financial liabilities, and distribution of profits and losses. Processes for Partner additions, withdrawals, or replacement are in the plan.
  • Contingency Plans. Partnerships regularly experience disagreements over roles and responsibilities, the sale or dissolution of the partnership, and individual partners’ divorces, bankruptcies, or deaths. The agreement defines roles, responsibilities, and processes when such issues occur.

While there may be successful partnerships based on handshakes alone, they are few and far between. Working with partners typically requires controlling one’s ego and risking their pocketbook. Few people successfully manage their emotions when the wheels fall off. It is nice to have a predetermined, pre-agreed plan to go forward.

The Value of an Attorney

Do-It-Yourself (DIY) partnership agreements may be sufficient to satisfy the laws of your state, but they are unlikely to provide the protections of a professionally developed partnership agreement for several reasons:

  1. Businesspeople and laypeople typically need to gain experience with the legal side of partnerships. Jeremy and his partner should have considered the problems of their equal shares and the lack of role definition. A competent business lawyer knows the potential partnership problem areas to cover in the agreement.
  2. Laws governing partnerships vary from state to state. In some cases, a lack of proper language can expose a partnership to unfavorable state laws. Relying on an online generic partnership agreement carries the same risk. Also, a partnership’s policies might inadvertently expose a withdrawing partner or heirs to excessive income, gift, or estate taxes.
  3. A poorly written partnership agreement may be worse than no agreement. Language in all contracts is vital since words and phrases have legal definitions from previous court cases. Using the wrong words or words n the wrong places can have unfortunate consequences.

Hiring an attorney is always personal and varies with the client’s willingness to accept risk. When deciding whether to engage a business attorney, consider the possible outcomes of the partnership. What is the cost of future partner disagreements if they cannot be resolved? What is the value of an established, formal process to eliminate stalemates? I know what Jeremy would choose with his experience.

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