We once had a client who came in for a consultation with a story we've seen many times before - he and a close friend had started a business together. Initially, things were going really well: they had a great business model, were opening up an underserved market in Salt Lake City, and had excellent profit margins. After a year, profits began to decline. When our client took a closer look at his books, he realized that his friend was spending significant amounts of money on expensive lunches, golf outings, and even personal expenditures.
When our client broached the subject at their next partnership meeting, his partner brushed it off as simply the cost of doing business. He refused to stop using the corporate account as his own personal piggy bank. This caused a rift in their relationship, and brought their once-successful business to a grinding halt. Eventually, the business was forced to close, leaving both partners out of quite a bit of money.
Though the lesson was learned the hard way, the client regretted never drafting a partnership agreement with his friend. Many partnerships choose to forego the agreement for a myriad of reasons: to save on expense, to avoid negotiating with a close friend or family member, or because they simply don't understand the value of putting the agreement on paper. At the time, our client didn't realize that having a partnership agreement could have limited the amount of money each partner could spend without the other's approval. This would have prevented one partner unilaterally taking on debt in the name of the company.
What is a Partnership Agreement?
A partnership agreement is the governing document for a company. It explains how the company will be run, outlines how profits and liabilities will be distributed, and places limits on what partners can do. In an LLC, a partnership agreement is commonly referred to as an operating agreement. In a corporation, the governing document is the bylaws.
A good partnership agreement will outline who is permitted to open bank and credit accounts, take on debt, and purchase real estate. It will also define the rights of individual owners, create mechanisms for resolving disputes, and provide a way out in the event of gridlock.
Ideally, business owners should create a partnership agreement that is tailored to their specific business rather than using a boilerplate document that can be found online. Online templates can provide a starting point, but oftentimes have hidden language that can be devastating for business owners. For example, one former client used a partnership agreement found online that had language stating that the partners would share profits through a sixty-forty split instead of fifty-fifty. Luckily, partnership agreements are flexible and can be easily changed under the right circumstances. However, it is always better to get it right the first time, because you never know when a dispute will arise. Changes to partnership agreements are much more difficult when the owners are not talking to one another.
Regardless of the type of entity business owners may consider, having a clear partnership agreement is a preventative measure that can save business owners a lot of headaches. In some cases, the agreement may even prevent the business from folding altogether. Cost is often the reason many business owners choose not to have a partnership agreement drafted. However, in most circumstances, the cost is no more than $1,000.00 and can be bundled with setting up the company. Whether you are partnering with a total stranger, a close friend, or family member, having a partnership agreement in place is critical. It will bring peace of mind, can save you thousands of dollars in litigation fees, and could even save your business from having to close because of a dispute.