The Yin and Yang of Business Models: The Partnership (Part 2 of 3 series)

The business partnership model

Our last blog focused on the sole proprietorship business model. For small scale entrepreneurs, especially those just “getting their feet wet,” starting and operating a business by themselves is a viable choice. However other, obvious circumstances will require the partnership structure.

Similar to sole proprietorships, partnerships have the advantages of being relatively easy to set up and register, and retain profits without the added tax layer which applies to corporations. Unfortunately, they also expose the partners to loss and liability in that their personal assets are vulnerable and can be used to pay down business related debt, exactly as is the case with sole proprietorships. Profits are obviously divided between the partners, but on the other hand so are losses and liabilities, at least in what is termed a general or equal partnership.

Then Why Partner?

If sole proprietorship and partnership are so similar, then why partner? Well, clearly, two or more people want to share in the ownership of a business. They might be friends, people with a similar passion or just acquaintances who recognize in the other(s) a set of business or technical skills to complement their own. There is also the comfort of having others to share in the decision making process, provide a social context, and of course, better potential for raising the capital required to establish and operate the enterprise.

Not all Partnerships are Created Equally

Not all arrangements are structured as 50/50 propasitions, referred to as general partnerships, in which both partners have equal rights, responsibilities and profit sharing terms. An alternative is the limited model, in which one partner (sometimes casually termed a “silent partner”) contributes financially but is not involved in day to day management (hence the silent aspect). Limited partners are liable only to their investment and no more. The controlling partner, on the other hand, bears the major responsibility for debt and contractual obligations. If this arrangement is suitable for each of the prospective associates and they remain happy in their roles, it can be a practical and sustainable organizational strategy.

With this contract, I thee wed… What about a ‘prenuptial’ business agreement?

It seems that almost everyone has a horror story to tell about a failed partnership, usually featuring life-long friends who started a co-venture but only a few years later, are no longer talking to one another, or worse, are embroiled in legal action. Partnerships, like marriages (which are in a sense romantic partnerships) can, and do, live happily ever after. But unpredictable events, changing circumstances and “life” all happen, sometimes with disastrous consequences to these people who began with the best of intentions.

What to do?

The old cliché that an ounce of prevention is worth a pound of cure certainly rings true here. And there are two essential ways to accomplish it. First is to take advantage of professional development: there are methods that can help partners to anticipate and resolve harmful and divisive issues before they reach a critical mass. These educational preventatives can be a significant factor for the long-range health of the venture, but there are times when only clearly defined terms and a solid, legal foundation will provide resolution; and sometimes, like marriage, dissolution is the only recourse. This is when having a legal agreement in place can prevent those horror stories.

Here’s a scenario that can occur when there’s no agreement in place: after a number of years successfully operating their business together, one partner wishes to sell:

• What are the terms for the dissolution of the company?
• Can this partner sell to a third party?
• Does the remaining partner have the right of first refusal?
• How will the worth of the selling partner’s share be valued?
• What about profit sharing? Debt repayment?
• What are the terms of the buyout financing?

Think of it as a ‘prenup’ for a business partnership

Without a legal agreement, no one has the answers. So, if the selling partner has an interested buyer but the remaining partner doesn’t want to find himself in business with a stranger and objects to the sale, how can this be fairly resolved? Both people have legitimate cases which unfortunately conflict with each other. This is a zero sum situation and it likely won’t end well.

The time for discussion of these issues is not the morning when a partner announces his wish to leave. Clearly, the time for setting these arrangements is when the partnership is being established; think of it as a prenuptial business agreement. If the partners can’t agree to arrangements at that time, they certainly won’t later when they are under duress. This is where the advice and guidance of a lawyer skilled in such business contracts is not only invaluable, but just might preserve that life-long friendship.

If you are considering establishing a partnership, or are already involved in one but without an agreement, please contact Howard Nightingale Professional Corporation to discuss making the right choice in your business venture.