Starting a Business with a Partner
By Michael D. Cross, Jr., J.D.
Setting up a business with a partner, instead of on one’s own, can be a very positive step. Each partner can share the capital requirements and the risks and combine their respective talents to make the venture a success. Each partner can even take an occasional vacation knowing that her partner is on the job. The following is a brief discussion of considerations involved in owning a business with another person. It is important to note that although this discussion refers primarily to “partnerships”, the owners should form a business entity such as a corporation or a limited liability company so as to limit the extent to which the owners’ personal assets are subject to business liabilities. (See Choice of Business Entity Considerations (Part I), also available on this website.) The principles set forth in this discussion, however, generally apply without regard to the legal form of the entity.
When starting a business, it is extremely important not to go into business on a “handshake”. Instead, the owners should enter into a written agreement setting forth the terms of their understanding so that everyone is clearly aware of their rights and responsibilities. This written agreement, sometimes referred to as a buy/sell agreement, partnership agreement, shareholder agreement, or operating agreement (and referred to as a partnership agreement throughout this discussion), also causes all owners to address and resolve important issues prior to beginning the business that left unconsidered could cause serious problems later in the operation of the business.
The first consideration partners often address involves how to divide ownership and control. Note that this issue involves the right to receive profits and the right (and the responsibility) to control the management of the business. In considering this issue, try to reach a common understanding of each partner’s respective role in the business. One partner may have experience in the industry while another has capital to invest. It may be appropriate, therefore, that one partner have day-to-day control and the upper hand in business decisions while another controls the checkbook. The partner contributing more capital may be entitled to a greater ownership share, while the partner who will be putting in more time may want to receive a paycheck in addition to a share of the profits. Alternatively, if the partnership is being formed after one partner already has succeeded in getting the business up and running, the new partner may be required to earn her share over a period of time or contribute a certain sum of capital to the company.
The partnership agreement should provide ways of avoiding deadlock which can paralyze a business. Decisions over matters such as choice of suppliers, hiring and firing of employees, choice of business location and banking and professional relationships, should be divided up according to ability, interest, and experience. If the partners agree to make joint decisions on major actions such as a merger, expansion, sale of the business or a decision to take on additional partners, the agreement should provide for an outside person to cast the deciding vote in the event of a deadlock. The partnership agreement also should set forth the scope of the company’s business. Those operating a computer consulting firm, for example, do not want a partner to risk the company’s funds trading in the futures or commodities market.
The partners should discuss whether they will be required to make additional investments if the business needs funding in the future. As a practical consideration, the business will almost always require some additional funding, either because it fails to meet its targets when anticipated or because it is growing so quickly it needs capital to expand. The partners should be very careful in crafting the language regarding additional contributions of capital, as an unlimited requirement to contribute additional capital, though perhaps good for the business, may place undue hardship on individual partners. Additionally, if a liability should arise that exceeds the business’ value, absent an unlimited requirement to contribute additional capital, the partners might decide they should simply bankrupt the company and walk away. If an unlimited requirement to contribute additional capital exists, a creditor might step in and require the additional contributions to pay the liability. This, in effect, would result in personal liability being imposed on the partners even though they prudently formed a corporation or limited liability company. It is extremely important to consult with an attorney experienced in crafting partnership agreements to avoid this unpleasant scenario while drafting properly the agreement made by the partners.
In lieu of requiring or soliciting additional capital contributions, some businesses prefer to finance further operations by borrowing money from a lender. Many businesses seek such financing through SBA loans, factoring agreements, or private individuals. It is important that the partnership agreement establish limits or guidelines to regulate any borrowing that occurs. Many agreements require a super-majority or unanimous vote prior to taking on new debt.
From time to time, businesses seek capital from new investors to fund new or continuing operations. In such scenarios, the existing owner(s) and the investors will negotiate regarding the ownership interest each person will have after the investment takes place. Obviously, the owners probably will desire to maintain control over their business, while the investors want to make sure they receive a profit and that their contribution is put to good use. Although myriad possibilities exist, note that it is possible to structure the investment so that the investors have the first right to receive distributions, while the original owners maintain control and voting rights. With respect to payment terms and conditions, consider first that a partner may leave the partnership because she wants to retire, becomes disabled, or passes away. Additionally, a partner may be dismissed from the partnership because she has failed to work on behalf of the business, or because she has committed fraud or other intentional or negligent acts that harm the partnership.
In each situation, there must be a mechanism in place that sets forth the terms under which the partner must sell her interest upon departure. Moreover, in a small business in which the owners must work closely together, it is important to make certain that any new partner is acceptable to and can work with the other partners.
The price paid for a departing partner’s ownership interest often varies based upon the reason for which the partner is leaving. Partners that retire in good standing after a long tenure with the partnership should receive more for their interest then someone who has been removed from the partnership in chains and shackles after stealing from the company. Terms of payment should balance the ability of the business to pay, considering the loss of the partner’s contribution to the revenues, and the partner’s need for income. As always, it is important carefully to consider the tax implications of any provision regarding payment.
There are many methods of crafting provisions of an agreement regarding the purchase of a partner’s interest in a business, and comprehensive coverage of this is beyond the scope of this discussion. For more information and an in-depth discussion of buy/sell provisions, please see the article entitled Buy/Sell Provisions, which is also available on this website.
Partnership agreements often include restrictions on the abilities of owners to compete with the partnership or to solicit clients, customers and/or employees of the partnership. Many partnership agreements also restrict subsequent disclosure of information the partnership considers to be confidential and proprietary. The law does not favor such restrictions on trade or commerce; however, it is possible to craft enforceable provisions so long as the restrictions are reasonable in scope, geography, and time. “Reasonable” terms vary widely from industry to industry and from state to state, and determining what is reasonable often seems to be more of a subjective process than an objective one. For more information regarding restrictive covenants, please see Restrictive Covenants and Employment Agreements, also available on this website.
In closing, it is extremely important for business partners to address each of these issues at the very beginning of their relationship when each of the partners have similar goals and plans. An agreement regarding the purchase of a departing partner’s ownership interest, restrictions on competition, and other issues can be reached more easily in a manner that seems fair to all partners. This may not be true after several years pass. As time passes, various personal considerations and life-changing events may occur which change the partners’ motivations and concerns. Moreover, addressing these issues prior to starting the partnership often serves as a good test of whether the partners can succeed as business partners.
The information you obtain at this site is not, nor is it intended to be, legal advice. You should consult an attorney for individual advice regarding your own situation.