Get your partnership on the right legal footing

February 16, 2010

This article was written for Better Business

The decision to take on a business partner is often one of the first an entrepreneur will take. There can be many commercial benefits to doing so. However, unless steps are actively taken to manage the relationship between business partners from the outset, there is potential for disagreement and inefficiency, which can ruin an otherwise healthy business. This article considers some of the key issues which arise when formalising and managing the relationship between business partners, in the context of limited liability partnerships in particular.

Many partnerships come about more by accident than intention. Legally, a partnership exists whenever a business is carried on by two or more persons in common with a view to profit. No formal incorporation process is required. Some businesses prefer the relative informality and confidentiality of partnerships (since partners are free to organise themselves as they wish and do not have to place any documents on the public record), but most entrepreneurs prefer to operate through business vehicles which offer limited liability, to protect their personal assets in the event that the business fails. Every partner in a partnership is personally responsible for the debts and obligations of the partnership. This means that a rogue partner could bankrupt his innocent fellow partners.

Existing partnerships and those thinking about going into business together typically choose from two main alternatives to partnership: the limited liability partnership (or 'LLP') and the private limited company (the 'Ltd'). Each of these separates the assets of the business from those of its owners, greatly reducing the risk of personal bankruptcy.

The issue of taxation is an important factor when choosing between an LLP or Ltd. This is a complex area and specialist advice is necessary, but, in summary, partnerships and LLP's are 'tax transparent' that is, the partnership or LLP does not pay tax directly, but instead the partners pay income tax on the profits they receive (with income tax rates ranging from 0% to 50%, depending on the partner’s income). By comparison, Ltds pay corporation tax on the profits of the business (at rates ranging from 21% to 28%, depending on the profits of the business) and the Ltd’s shareholders also pay income tax on any dividends they receive. Partners in an LLP and shareholders in a Ltd pay capital gains tax (of between 0% and 18%, depending on the size of the gain) on the profits arising from the sale of any interest in the LLP or any shares in the Ltd. As a very general rule, LLP's (and partnerships) are the preferred option if the intention is to distribute all of the profits made each year, whereas the Ltd is a more popular option if the owners want to retain profits to build up the capital value of the business, perhaps with a view to selling the company in the future.

Assuming that the LLP route is chosen, it is absolutely essential that the arrangements between the partners are formalised in a written document. For partnerships this is known as a partnership agreement. For LLP's it is known as a members’ agreement (technically, the partners in an LLP are called members, although the term 'partner' is used synonymously and is generally the preferred title on business cards, etc.). The members agreement is a relatively complex document and should be drafted by a professional. Investing money early on in preparing the members agreement will likely save large amounts of time, money and stress in the future. In the absence of a members’ agreement the LLP and its partners will be subject to default rules, which will almost certainly be inadequate. For example, the default rules do not provide any way of removing a partner.

Setting out how profits are to be shared between partners is among the most important provisions of a Members Agreement. The partners can decide precisely how profits are to be shared, as LLP's offer near infinite flexibility. Some of the most common ways of sharing profits are (i) to have equal shares, (ii) to have fixed proportions (say, 75:25), (iii) to share depending on how much profit a particular partner creates in a year (often called an 'eat what you kill' approach), or (iv) an entirely discretionary process decided by agreement on an annual basis (although some fallback position would need to be put in place, in case no agreement could be reached). Professional services firms have traditionally adopted a system known as lockstep, whereby those with the longest service get the biggest share of profits. Such systems are waning in popularity, given the obvious unfairness to younger, high-performing partners, and the potential for age discrimination issues to arise. Nonetheless, variations on lockstep, whereby long service is rewarded, but is not the sole determinant of profit share, remains a viable and popular option.

A common mistake made by partnerships (both big and small) is to confuse drawings with profits. Drawings are the sums of money paid out to partners each month as a kind of salary. These drawings are paid out of anticipated profits. At the end of the financial year the LLP's accountants will work out what the profits were for the previous year, deduct the amounts drawn by the partners in advance of those profits, and the partners may then either draw out any surplus profits (if there is cash available to do so), or retain the surplus in the LLP for investment (although retained profits will still be taxed as though taken out of the LLP as income).

Clearly, the amount of drawings which the LLP can pay out each month will depend more on its cashflow than on the year’s profit figure, which will only be known some time after the firm’s financial year end. Firms sometimes fail due to a lack of cash if drawings are being paid out of an overdraft, this is a sure sign that corrective action needs to be taken.

The partners can also choose how the LLP is to be managed. Unlike Ltds there is no board of directors which has statutory rights and obligations. A small LLP may operate day to day on the basis of consensus, but this carries the risk of deadlock. An alternative is to have majority voting, perhaps with the number of votes each partner has being based on the relative size of their profit shares. Provided this is thought about at an early stage, most management issues can be dealt with in a straightforward fashion. If one partner is particularly good at day to day management, then it will make sense to delegate certain decisions to that partner (or possibly a group of partners). Major issues, such as substantial expenditure, or deciding whether to sell or wind up the business, should be reserved to a vote of all partners. There will inevitably be some trial and error in choosing the best management structure and, as a business grows and new people are introduced, it is likely that the management structure will evolve to meet the changing needs of the business.

Another other key element of a members’ agreement deals with what happens should the relationship between partners break down, or if a person decides they would like to leave the LLP. If someone wishes to resign from the LLP then it is important to have specified in advance what the appropriate notice period is. This will be a balance between the desire on the part of the departing partner to leave as soon as possible and the need for the LLP to have a period to handover the work done by that partner to others within the business. Notice periods of three to six months are common, but there is no hard and fast rule. Many professional partnerships impose notice periods of a year or more, whereas, at the other extreme, many LLP's with roots in the United States have no notice period whatsoever.

Although thankfully rare, LLP's occasionally face the situation where a partner has committed a criminal act. There may also be circumstances where a partner has committed an act which is not criminal, but which has clearly harmed the LLP perhaps by diverting business to a company he wholly owns, or by ceasing to hold a necessary regulatory approval. Typically, members’ agreements provide that in these circumstances a partner can be expelled immediately.

It is also possible to remove a partner without there being any fault. Unlike employees, partners do not enjoy employment rights there is no equivalent to unfair dismissal. So, in most circumstances, a partner can be removed simply because it is considered to be in the best interests of the business to do so (although it is still unlawful to discriminate against a partner on the grounds of age, sex, race, and so on). Often partners who are asked to leave on a ‘no fault’ basis are compensated in some fashion perhaps by paying them their notice monies immediately, plus a little extra.

Irrespective of whether a partner leaves voluntarily or involuntarily, the business should be protected against the former partner setting up in competition with it, or poaching employees. Restrictive covenants are common in members agreements, and these prevent former partners from harming the business for a period of time after they have left. The key to such restrictions is that they must be reasonable in their nature, geographical extent and duration what is reasonable will depend on the circumstances of the particular business.

Finally, the key to a successful business partnership, irrespective of the legal form that the relationship takes, is trust and communication. For the most part, the legal documentation should be there to support the relationship between business partners, by making sure that difficult decisions (such as profit sharing) are addressed at the outset and the partners can focus instead on growing the business. Should the relationship break down, having a clear understanding of each person’s rights and responsibilities will lessen the pain for both parties.


Related pages:

Partnership and LLPs more

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Daniel Sutherland
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dsutherland@foxwilliams.com

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