Protecting Yourself in a Business Partnership - Five Tips From a Business Litigator

Business partners frequently enter the relationship far too lightly, without sufficient discussion, as a matter of convenience, with rose-colored glasses, and without consulting with legal counsel.
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Business partners frequently enter the relationship far too lightly, without sufficient discussion, as a matter of convenience, with rose-colored glasses, and without consulting with legal counsel. As a business litigator, I have seen more than my fair share of partnership disputes - and, as a result, ruined friendships, marriages permanently destroyed, and years of professional relationships tarnished. There is a good reason partnership disputes are frequently referred to as "business divorce." This type of litigation is almost always costly, protracted, highly contentious, and emotionally charged, much like an actual divorce. And it is largely avoidable.

Failing to memorialize the agreement in hopes that everything will work out and you will always "be fair" with one another is a mistake. After a partnership sours is not the time to talk about the terms of a sale. A little bit of work upfront can save tens of thousands of dollars, and years of frustration, on the back end. So if you discuss nothing else, discuss these items with business partners:

1. Business Form, Roles and Decision-Making. As a preliminary matter, the partners should discuss with their attorneys and tax professionals the best business structure for them. Typically, a limited liability partnership is desirable because of the protection the LLP affords limited partners from the actions of the general partner, but other entities (such as an S Corporation) can also be appropriate, depending on the circumstances. Partners should also take care to discuss early on what roles each partner will assume, including by specifically delegating management responsibilities if appropriate, setting expectations or benchmarks, and determining how decisions will be made, especially in instances when the issue is an important one and there is no consensus.

2. Capital Contributions. Identify the sources of capital and the circumstances in which you will require the company to seek outside investment or require owners to infuse the capital themselves. Where one partner provides the capital and the other provides sweat equity, this relationship should be memorialized. The goal is to set forth the expectations on each partner as clearly as possible.

3. Compensation. Most partners are quick to agree to percentages of ownership. However, they frequently overlook other important terms relating to their interests, including vesting schedules (common in start-ups), reservations of stock for investors or future employees, equity adjustments, allocations of profits and losses (for instance, whether they will be proportionate to equity or divided in equal shares), designation of business assets, and even a definition of profits, particularly as it pertains to calculations for reinvestment and partner distribution.

4. Exit Strategy and Forced Exits. A significant number of disputes arise when one partner wants to sell the company or cash out, and the remaining partners do not. For that reason, it is imperative that all partnership agreements consider conditions giving rise to the termination of the business relationship and the exit itself when they are on the same terms, and willing to cooperate and be reasonable. And because accidents happen to young and old alike, partners would also be wise to consider the effect of partnership interest in the event of the death or disability of a partner. In such instances, a right of first refusal and a buy-sell agreement may be advisable. Additional provisions forcing an exit may be necessary based on the industry. For example, partners or members in a restaurant or bar typically agree to a buy-sell provision triggered by evidence of alcohol or drug problems because these types of problems can impede the restaurant or bar's ability to obtain or renew a liquor license, which can adversely impact its profitability.

5. Dispute resolution. Because of the cost and time required for litigation, and given that most disputes concern the amounts due to a departing partner, partners should discuss resolutions to deadlock and alternative means of resolving disputes. For instance, the partners could agree to early mediation or arbitration clauses, they could mutually pre-select a forensic accountant (or firm) to determine valuation whenever the need may arise so as to not fight about valuation on the back end, or they may elect to assign formulas for determining ownership interests to avoid the need for a forensic accountant.

While this is by no means an exhaustive list, it highlights the most common issues arising out of partnership disputes. Getting ahead of these issues could save more than a few headaches down the road. As is always the case, you should consult with an attorney licensed in your state and familiar with your industry before forming or entering into any agreement.

The foregoing is provided for informational purposes only, is not an advertisement, does not constitute legal advice or legal opinion, and does not create an attorney-client relationship. The content may not apply to the specific facts or a particular matter. You should not act or rely on any information contained in this article without first seeking the advice of an attorney licensed to practice in your jurisdiction.