Five Things You Should Think About Before Going Into a Partnership
Going into a partnership with another person has clear advantages. But there are also pitfalls. You can have the best of both worlds with a little planning.
When we talk about “partnership” in this context, we are speaking not just of actual legal partnerships, but any joint undertaking with one or more additional people, perhaps an LLC or closely held corporation, that will create potential problems.
1. Know how you’re going to take it apart, before you put it together.
The most important thing to think about before going into a partnership is how you’re going to take it apart if things go wrong, or even if one of the partners just wants to retire. Business divorces are just about as nasty as personal ones – and can be even more expensive.
The first thing we advise clients to do who want to form of business association, be it a partnership and LLC or a small corporation, is to have a written agreement that specifies in advance how the business will be taken apart if there is a parting of the ways. This usually means a buy-sell agreement that determines what the price of the business or its various assets will be and what the mechanism is for deciding who will be allowed to buy the other party out and on what terms.
2. Know how you will handle the death of a partner.
What happens if one of the partners dies? How will that person’s interest be handled? Will his or her heirs become partners in the business? In most cases, that is not a good solution. There should be a buy-sell agreement that determines in advance what the interest of the deceased partner will be worth and how it will be paid.
For partners young and healthy enough to be good insurance risks, funding a potential buy-sell with life insurance is a great idea. The amount of the insurance is set based upon what the partner’s interest is expected to be worth. In the event of a death, the deceased partner’s family receives the insurance proceeds and the remaining partner(s) get the business. It may make sense to agree that there will actually be more insurance available than is needed to pay the deceased partner’s estate. The extra cash helps the business to sustain itself until the value added by the deceased partner can be replaced.
3. Don’t let an unequal partnership become an unfair one.
If partnerships are unequal (where one partner has greater ownership interests), how can the minority partner(s) avoid being run over in all business decisions? A good contract between the parties should specify certain things that the majority cannot do without minority consent. For example, they cannot fire or reduce the compensation of the minority partner absent good cause defined in the contract.
4. Decide in advance how additional capital will be raised.
One of the toughest decisions of the small business faces is how to raise additional capital when the need arises. When going into a partnership, the agreement should state clearly the obligation on each partner for putting in additional money, or signing a personal guarantee for a loan. If one partner has considerably more resources than the other, the agreement can provide that both parties are obligated to contribute, but not necessarily in equal amounts. If one party has contributed more than another, that can be carried on the books of the business as an interest-bearing loan, to make it fair to everyone.
5. Prevent theft by separating functions.
Partners want to trust one another, and want to trust their employees. But a little caution goes a long way. Avoid having the same person both writing checks and reconciling the bank account. It is much easier to get away with taking money if you are in control of both ends of the bank account.
Setting up and maintaining a small business, like everything else, take some time, effort and planning. But dealing with these five issues of going into a partnership can save a world of heartache and expense later.