A partnership agreement is a legally binding document that outlines the terms and conditions of a business partnership. Individuals intending to enter a joint business venture need this document as a legal basis to regulate all significant legal, financial, and strategic business matters.
The text below provides a detailed explanation of a partnership agreement in business and how it can provide you and your business partner with peace of mind.
Let's begin.
What is a Partnership Agreement?
A partnership agreement is a legally binding document that outlines partners' rights, responsibilities, and liabilities in a business venture.
It is one of the most commonly used documents because it allows partners to agree on several critical matters before entering into joint endeavors.
Some of those critical matters are:
Defining their specific roles in the partnership
Determining how profits and losses will be shared
Establishing decision-making processes
Outlining dispute resolution procedures
Specifying conditions under which partners can exit or dissolve the business
Although this agreement is not required, without it, state law provisions would determine all of these points, which might not align with the preferences and needs of the partners.
Therefore, a partnership agreement is a more rational and secure option for partners, both from a legal and economic perspective, as it helps them avoid potential misunderstandings and disputes down the line.
Partnership vs. Corporation
Partnerships and corporations are two different legal frameworks for organizing businesses, each with specific organizational structures and legal regulations.
On the one hand, partnerships involve two or more individuals sharing ownership and responsibilities, often on a 50/50 basis, but the exact ratio can be negotiated.
Partnerships are relatively easy to establish and more flexible regarding decision-making processes. Partners share profits and losses personally and are jointly liable for the business's debts and obligations.
On the other hand, a corporation is a separate legal entity from its owners (shareholders). It provides limited liability protection to shareholders, meaning their personal assets are generally protected from the corporation's debts and liabilities.
Corporations require more formalities, such as issuing stock and trading it on the market, electing a board of directors, and holding regular meetings. They also have different tax obligations than partnerships and can raise capital by selling shares.
When and Why Do You Need a Partnership Agreement?
First and foremost, a partnership agreement is needed when you decide to start a business with one or more partners and want to establish the basic rules and principles on which your business will operate. In this case, this document will outline all your rights, duties, responsibilities, and procedures necessary for a functioning business.
When the partnership is comprehensive and covers all aspects of the business in detail, the risk of misunderstandings or potential disputes is minimal.
On the other hand, a partnership agreement helps integrate new partners. As the business grows, the need for new ideas and resources also grows, and new partners can provide these.
In this case, the partnership agreement regulates how new partners can be added, and it defines their rights and obligations, as well as their financial or non-financial contributions.
What Is Included in a Partnership Agreement?
Including the following elements in a partnership agreement ensures that partners cover all essential aspects of their future business partnership.
Let's delve into each of these:
Partnership Structure
Firstly, clarify the structure of your prospective business by determining whether it will operate as a general partnership, where partners assume personal liability for debts and obligations, or a limited partnership, where the partner's liability is limited. Additionally, the partners who will be part of the partnership agreement must be clearly identified.
Capital Contributions
Next, specify what each partner will contribute to the business—money, assets, skills, experience, or other resources. If monetary contributions are involved, clarify the timeframe for each partner's contribution and outline the consequences if contributions are not made.
Profit and Loss Distribution
To ensure transparency and fairness, clearly define how the company's profits and losses will be shared. This distribution can be based on percentages, aligned with each partner's contributions, or agreed upon through specific terms outlined in the agreement.
Responsibilities of Each Partner
It's vital to define each partner's roles and responsibilities within the business. These duties can encompass managing finances, supervising inventory, or formulating strategic initiatives.
Dissolution and Withdrawal of Partners
The partnership agreement should also include procedures for admitting new partners, conditions under which a partner can withdraw or be expelled, how the partnership will be dissolved, and how its assets and liabilities will be distributed.
Clauses
Clauses are an essential part of a partnership agreement as they protect the business's operations. These include non-compete clauses, which prevent partners from engaging in competing business, confidentiality clauses to protect shared information, and jurisdiction clauses to determine the legal framework for resolving disputes among partners.
How to Create a Partnership Agreement in 8 Steps
To create a partnership agreement, you can use our Contracts.net partnership agreement builder to get a document. After that, you need to fill in the following information:
#1. Gather Partnership information
First, enter personal information about partners, such as their names, addresses, and contact details. Then, provide details about the company, including its name, address, and business area.
Next, decide on the type of partnership, whether it is a general partnership, limited partnership, or a limited liability partnership. Each type of partnership has different levels of responsibility, tax treatment, and management structure.
#2. List Partner Contributions
Here, you should list each partner’s initial contributions to the business, whether financial or non-financial. Financial contributions include money and assets, while non-financial contributions can be experience, know-how, or a vast network of connections beneficial for the business.
For non-financial contributions, it is helpful to estimate their approximate monetary value to determine each partner's share in the company.
#3. Set Up Capital Accounts & Profit and Loss Sharing
Since businesses operate through bank accounts, provide details of the accounts, such as account numbers and the banks where they are held. Next, establish the rules for sharing profits and losses. Partners are free to agree on any ratio for sharing profits and losses, but it usually depends on their contribution to the partnership and their level of liability.
#4. Define Partner Liabilities
This section should specify each partner's liability level, which usually depends on the type of partnership. In a general partnership, all partners have unlimited liability, meaning their personal assets can be used to cover business debts.
In a limited partnership, there are two subcategories: general partners and limited partners. General partners take on all the risk in the operating business and its results, while limited partners have liability only up to their investment amount.
There are also limited liability partnerships where partners have limited liability, meaning their personal assets cannot be used to repay business debts. However, this rule doesn't apply if the partner commits serious misconduct (such as fraud or personal negligence) or abuse of authority that harms the partnership.
#5. Establish the Management Structure
Decide which partner will have what role in managing the business. Most commonly, partners share management duties equally. They can also agree that one partner has more authority in decision-making while the other takes on a more passive role, primarily providing financial support for operating the business.
#6. Define the Plan for Changes
In this section, you should define what will happen if a partner retires, wants to sell their share, dies, or if a new partner joins, and how it will affect the ownership structure.
When a partner exits the partnership, it's customary to first offer another partner to buy their share, often at a favorable price. If they choose not to use these rights, the share can be sold to third parties.
#7. Outline Disputes Resolution Procedures
Here, partners should determine how disputes will be resolved if they arise. They can agree to resolve disagreements through mediation or include an arbitration clause, where an arbitrator will decide on their dispute. If they do not specify a dispute resolution method, disputes will be settled through court.
#8. Sign the Partnership Agreement
After completing our builder form and making enough copies for partners, the next step is to sign each copy as evidence that partners agree with its provisions. The presence of a notary public further adds to its validity.
3 Important Advantages of a Partnership Agreement
Let's explore the advantages of creating a partnership agreement:
Clarity and definition
A partnership agreement clearly outlines each partner's roles, responsibilities, and expectations within the business.
For small businesses, partnership agreements present a solid foundation because they enable partners to collectively assess and define what each brings to the partnership (knowledge, expertise, and capital) and regulate the partnership's future organization and vision for growth.
This clarity helps prevent misunderstandings and disputes by establishing a decision-making and operational management framework.
Smaller financial burden
Partnerships facilitate the sharing of financial responsibilities, including startup costs, operational expenses, and investments.
This arrangement reduces the financial strain on individual partners compared to sole proprietorships or corporations, where one person bears all financial risks.
Shared financial resources can also provide greater stability and flexibility for business expansion.
Less paperwork
Unlike corporations, partnerships typically have fewer formalities and paperwork requirements for formation and ongoing operations, which simplifies administrative tasks such as tax filings, record-keeping, and compliance with regulations.
Partnerships are generally more accessible and less costly to establish and maintain than structured business entities.
3 Notable Disadvantages of a Partnership Agreement
Like any organizational structure, partnerships have disadvantages that should be considered:
No solo decision-making
Decisions in a partnership are typically made jointly by all partners, which can lead to slower decision-making processes, especially if partners have divergent opinions or struggle to reach consensus.
Disagreements over business strategies, investments, or daily operations can arise, potentially causing friction and delays.
Disagreements
Partnerships involve shared responsibilities and decision-making, sometimes leading to conflicts among partners. Differences in goals, management styles, or financial expectations can strain relationships and impact business effectiveness.
As a result, resolving disputes can be challenging and may necessitate mediation or legal intervention, disrupting business operations.
Not a separate legal entity
Unlike corporations, partnerships do not exist as separate legal entities distinct from their partners. In other words, partners are personally liable for the partnership's debts, obligations, and liabilities.
Personal assets may be at risk in the event of legal claims or financial difficulties, depending on the type of partnership agreement (general partnership vs. limited liability partnership).
3 Mistakes To Avoid When Making a Partnership Agreement
The three most common mistakes the parties should avoid when creating a partnership agreement are as follows:
Partnership Agreement Mistakes
Failure to include all necessary terms. Detailed inclusion of relevant details allows partners to anticipate and regulate actions for various situations, which prevents future misunderstandings, disagreements, and conflicts. This thoroughness fosters continuity in operations, saving time and energy that would otherwise be spent on resolving issues.
Lack of legal review. Partnership agreements should be drafted or reviewed by an attorney specializing in business law. Without proper legal oversight, agreements may contain ambiguous or unenforceable clauses, leaving partners vulnerable to disputes or legal challenges. With legal expertise, parties ensure compliance with laws and regulations.
Failure to update. A partnership agreement should evolve with the business and partners' circumstances. Therefore, it is important to maintain its relevance and effectiveness by periodically reviewing and revising it. Not updating the agreement regularly to reflect changes can lead to inconsistencies and misunderstandings.
Final Thoughts
When deciding to start a business together or expand an existing one through partnership, regardless of existing trust and closeness, your business plans should be formalized through a detailed partnership agreement.
This agreement not only defines the relationship and structure of the partnership but also ensures clarity in roles, resource allocation, costs, profit-sharing, and the overall organizational framework of your future business.
By establishing this structure early on, you pave the way for sustained growth and minimize the risk of internal conflicts that could otherwise hinder your company's progress or potentially lead to its dissolution.
What is a Partnership Agreement FAQs
Yes, a partnership agreement should always be in writing.
To write a partnership agreement, you can use our partnership agreement builder tool, which makes sure you get a professional and comprehensive document.
A partnership agreement outlines the rights and responsibilities of partners in a business venture, while an operating agreement specifically applies to LLCs, detailing management, membership, and operational procedures.
