Associate Solicitor Jonathan Masucci takes a look at the benefits of creating a formal Partnership Agreement.
Along with sole proprietorships and limited companies, partnerships are a common form of business entity in the UK.
The partnership model essentially allows two or more people to go into business together, with fewer formalities and publicity than there would be if they formed a limited company and without needing to register at Companies House.
However, creating a partnership without the use of a formal Partnership Agreement can be a somewhat risky move, especially if anything should go wrong. In this post, we will explain what Partnership Agreements do and cover some of the reasons to put one in place.
Whether you decide to proceed with setting up a partnership, or other form of business structure, it is always important to seek professional legal and accountancy advice at an early stage, with regards to the most efficient way to structure your business.
What is a business partnership?
The main difference between forming a partnership or a limited company is that a limited company would be a completely separate legal entity from the business owners.
Limited companies can be more complicated in structure than partnerships, and are more involved to set up and maintain. They must be registered and are required to publish their accounts, as well as pay corporation tax to HMRC.
Many business owners opt for partnerships because there are no filing requirements, and also there are often significant tax advantages (partners take their earnings from the company profits rather than taking home a salary via PAYE, and are not required to make National Insurance contributions). Partnerships are tax transparent - which is to say that taxes are paid by the individuals on their own behalf, rather than by the partnership as a business entity.
Partnerships are a great choice in many situations, and if the business proves to be successful it can generate great financial rewards for the business owners. However, there can be risks with this model - and this is why it always makes sense to establish a written Partnership Agreement.
What does a Partnership Agreement do?
It is not required by law to create a formal Partnership Agreement. However, if business owners enter into a partnership without one, their arrangement will be governed by the Partnership Act 1890 (the “1890 Act”).
Unfortunately, this 130-year-old legislation has been known to create issues in many modern partnerships. For example, if one partner resigns, goes bankrupt, passes away, or otherwise leaves the partnership, under sections 26, 33 and 34 of the 1890 Act the partnership will simply end - regardless of the wishes of the remaining partners who may have been entirely prepared and willing to carry on without them.
Partnerships today can come in many various forms, and this old legislation is not always well-suited to govern the full scope of modern arrangements. For this reason, creating a Partnership Agreement is a very good idea, and it will allow the creation of new rules that work more usefully for a business in the 21st century.
One key consideration is liability. Under the Partnership Act, partners would be considered equally liable in a personal capacity, for debts - which means that a bad judgement call by one partner could spell major trouble for the others.
It makes little sense for one partner's mistake to potentially bankrupt others who may have had nothing to do with their deal. By contrast, a well-drafted Partnership Agreement can be created in such a way that these issues of liability are handled much more sensibly.
A bespoke Partnership Agreement can allow more control over how finances are managed. By default, the 1890 Act provides that all partners must have equal control and ownership of assets. For some partnerships, this might not be very useful - in situations where one partner has invested much more capital and work than the others to make the business successful, it may not be desirable for the other partners to still receive an equal share of profits.
How to create a Partnership Agreement
The first thing to do when seeking to put a Partnership Agreement in place is to enlist the help of an experienced business law solicitor. They will be able to help clarify what exactly needs to go into the document and draft it in line with your best interests.
One thing you will need to decide is the percentage stake that each partner will have in the business. As the distribution of profits is a common point of contention in partnership disputes, it is a good idea to include provisions around how and when partners get paid - whether a regular draw or an annual payout at the end of the financial year.
Another decision you will need to make is how to handle events such as a partner’s retirement, death or expulsion from the partnership. If no special provisions are written, then the partnership will simply dissolve as per the Partnership Act. The Agreement can also specify what kind of buyout scheme would be in place if a partner wished to leave.
It is important to think about how decision-making should be handled. The 1890 Act would give all partners equal say in every decision, but you may wish to take a different approach. For example, you may feel that it would be better to have unanimous consent for some larger decisions, but give some partners more autonomy on smaller or more specialised matters. In this case, the Partnership Agreement should spell out what constitutes big or small decisions and who will be empowered to make them.
The Agreement can also contain rules and procedures for admitting new partners in the future, as well as specifying preferred routes of dispute resolution in the event of disagreements. This might mean making it a matter of policy that disputes are handled via arbitration or mediation rather than going directly to the courts.
For many partnerships, the creation of a Partnership Agreement is a very good idea. It allows for more nuanced control than would be possible under the 1890 Partnership Act, and it means that many potential events and issues can be anticipated with the appropriate precautions in place.
With a Partnership Agreement, many common pitfalls can be easily addressed before they become problematic - allowing your business to flourish and bring success to all of its partners.
For further advice on this and any other Commercial Law issue, please contact a member of our Commercial Law team.