You can create a partnership based
on an oral agreement, but it's much smarter to put it in writing.
BY
Michael Spadaccini |
June 2, 2005|
A
partnership is a business form created automatically when two or more
persons engage in a business enterprise for profit. Consider the following
language from the Uniform Partnership Act: "The association of two or more
persons to carry on as co-owners of a business for profit forms a
partnership, whether or not the persons intend to form a partnership." A
partnership--in its various forms--offers its multiple owners flexibility
and relative simplicity of organization and operation. In limited
partnerships and limited liability partnerships, a partnership can even
offer a degree of liability protection.
Partnerships can be formed with a handshake--and often they are. In fact,
partnerships are the only business entities that can be formed by oral
agreement. Of course, as with any important legal relationship, oral
agreements often lead to misunderstandings, which often lead to disputes.
Thus, you should only form a partnership that is memorialized with a written
partnership agreement. Preferably, you should prepare this document with the
assistance of an attorney. The cost to have an attorney draft a partnership
agreement can vary between $500 and $2,000 depending on the complexity of
the partnership arrangement and the experience and location of the attorney.
How Partnerships Are Managed
Partnerships have very simple management structures. In the case of general
partnerships, partnerships are managed by the partners themselves, with
decisions ultimately resting with a majority of the percentage owners of the
partnership. Partnership-style management is often called owner
management. Corporations, on the other hand, are typically managed by
appointed or elected officers, which is called representative management.
Keep in mind that a majority of the percentage interest in a partnership can
be very different from a majority of the partners. This is because one
partner may own 60 percent of a partnership, with four other partners owning
only 10 percent each. Partnerships (and corporations and LLCs) universally
vest ultimate voting power with a majority of the percentage ownership
interest.
Of
course, partners and shareholders don't call votes every time they need to
make some small business decision such as signing a contract or ordering
office supplies. Small tasks are managed informally, as they should be.
Voting becomes important, however, when a dispute arises among the partners.
If the dispute cannot be resolved informally, the partners call a meeting
and take a vote on the matter. Those partners representing the minority in
such a vote must go along with the decision of the partners representing the
majority.
Partnerships do not require formal meetings like corporations do. Of course,
some partnerships elect to have periodic meetings anyway. Overall, the
management and administrative operation of a partnership is relatively
simple, and this can be an important advantage. Like sole proprietorships,
partnerships often grow and graduate to LLC or corporate status.
Varieties of Partnerships
There
are several varieties of partnerships. They range from the simple general
partnership to the limited liability partnership.
The general partnership. By default, a standard
partnership is referred to as a general partnership. General
partnerships are the simplest of all partnerships. An oral partnership will
almost always be a general partnership. In a general partnership, all
partners share in the management of the entity and share in the entity's
profits. Matters relating to the ordinary business operations of the
partnership are decided by a majority of the partners. Of course, some
partners can own a greater share of the entity than other partners, in which
case their vote counts according to their percentage ownership--much like
voting of shares in a corporation. All partners are responsible for the
liabilities of a general partnership.
The limited partnership. The limited partnership is more
complex than the general partnership. It is a partnership owned by two
classes of partners: general partners manage the enterprise and are
personally liable for its debts; limited partners contribute capital
and share in the profits but normally do not participate in the management
of the enterprise. Another notable distinction between the two classes of
partners is that limited partners incur no liability for partnership debts
beyond their capital contributions. Limited partners enjoy liability
protection much like the shareholders of a corporation. The limited
partnership is commonly used in the restaurant business, with the founders
serving as general partners and the investors as limited partners.
A
limited partnership usually requires a state filing establishing the limited
partnership. Some states, most notably California, allow the oral creation
of a limited partnership. Of course, establishing a limited partnership with
nothing more than an oral agreement is unwise. Oral limited partnership
agreements will very likely lead to disputes and may not offer liability
protection to limited partners.
Limited partnerships have fallen out of favor recently because of the rise
of the limited liability company. Both forms share partnership-style
taxation and partnership-style management, but the LLC offers greater
liability protection because it extends liability protection to all its
managers. Thus, today LLCs are often selected instead of limited
partnerships.
Because of the complexity of limited partnerships, the formation of one is
not something you should undertake on your own. The formation of a limited
partnership is best left to a qualified attorney.
The limited liability partnership. Yet
another form of partnership is the limited liability partnership. A limited
liability partnership is one comprised of licensed professionals such as
attorneys, accountants and architects. The partners in an LLP may enjoy
personal liability protection for the acts of other partners but each
partner remains liable for his own actions. State laws generally require
LLPs to maintain generous insurance policies or cash reserves to pay claims
brought against the LLP.
Partnership Agreements
Your
partnership agreement should detail how business decisions are made, how
disputes are resolved, and how to handle a buyout. You'll be glad you have
this agreement if for some reason you run into difficulties with one of the
partners or if someone wants out of the arrangement.
The
agreement should address the purpose of the business and the authority and
responsibility of each partner. It's a good idea to consult an attorney
experienced with small businesses for help in drafting the agreement. Here
are some other issues you'll want the agreement to address:
1. How will the ownership interest be shared? It's
not necessary, for example, for two owners to equally share ownership and
authority. However you decide to do it, make sure the proportion is stated
clearly in the agreement.
2. How will decisions be made? It's a good idea to establish
voting rights in case a major disagreement arises. When just two partners
own the business 50-50, there's the possibility of a deadlock. To avoid a
deadlock, some businesses provide in advance for a third partner, a trusted
associate who may own only 1 percent of the business but whose vote can
break a tie.
3. When one partner withdraws, how will the purchase price be determined? One possibility is to agree on a neutral third party, such as your banker
or accountant, to find an appraiser to determine the price of the
partnership interest.
4. If a partner withdraws from the partnership, when will money be paid? Depending on the partnership agreement, you can agree that the money be
paid over three, five or ten years, with interest. You don't want to be hit
with a cash flow crisis if the entire price has to be paid on the spot in
one lump sum.
How Partnerships Are Governed
Partnerships are governed by the law of the state in which they are
organized and by the rules set out by the partners themselves. Typically,
partners set forth the governing rules in a partnership agreement.
Often
the governance rules determined by the partners differ from the governance
rules set by state law. In most cases, the rules of the partners override
state law. For example, state law typically dictates that a partnership's
profits are to be divided among partners in proportion to their ownership
interests. However, the partners are free to divide profits by a formula
separate from their ownership interests, and the decision of the partners
will override state law. Thus, the governance rules in state law are default
provisions that apply in the absence of any rules set by the partners in a
partnership agreement.
This
fact underscores the need for a partnership agreement. Otherwise, the
partnership will by default be governed by state law. The laws set forth by
state law may not be appropriate for every partnership. For the most part,
however, the default state rules are fair and well-balanced.
An Important Concept: The Law of Agency
Agency refers to one's status as the legal representative (the agent) of an
entity or another person. The party on whose behalf an agent acts is called
a principal. One is said to be the agent of a partnership or other
entity if one has the legal authority to act on behalf of that entity.
An
agent can bind a partnership to contracts and other obligations through his
actions on behalf of a partnership. Of course, when an agent acts on behalf
of a partnership or another company, the company is bound by the acts and
decisions of that agent. A third party dealing with an agent of a company
can rely upon the agency relationship and enforce the obligations undertaken
by the agent--even if the agent made a foolish or selfish decisions on the
company's behalf. If the agent acts within the scope of the his authority,
the partnership becomes bound by the actions, no matter how foolish.
The
law of agency applies to corporations and LLCs as well as to partnerships.
However, a discussion of the law of agency is particularly pertinent to
partnerships because in a general partnership, all of the partners usually
have the status of agent with respect to the general partnership. The law of
agency applies differently to corporations. Shareholders in a corporation
are not necessarily officers and directors of that corporation, and agent
status will not automatically apply to them. So, partners in a partnership
must be careful to delineate authority and keep abreast of their
co-partners' decisions.
That
said, partnerships can grant specific authority to specific partners, if
such a grant appears in the partnership document. Without and agreement to
contrary, however, any partners can bind the partnership without the consent
of the other partners, as described above.
Summing Up: The Pros and Cons
Pros:
·
Owners can start partnerships relatively easily and inexpensively.
·
Partnerships do not require annual meetings and require few ongoing
formalities.
·
Partnerships offer favorable taxation to most smaller businesses.
·
Partnerships often do not have to pay minimum taxes that are required of
LLCs and corporations.
Cons:
·
All owners are subject to unlimited personal liability for the debts, losses
and liabilities of the business (except in cases of limited partnerships and
limited liablity partnerships).
·
Individual partners bear responsibility for the actions of other partners.
·
Poorly organized partnerships and oral partnerships can lead to disputes
among owners.
All portions of this article were
excerpted from
Entrepreneur Magazine's Ultimate Book on Forming
Corporations, LLCs, Sole Proprietorships and Partnerships, except for "Partnership Agreements," which was excerpted from
Start Your Own Business. |