In this article, we are going to tell you the 5 things that should be included in a partnership agreement.
Because partners can legally bind each other, it is critical to sign a partnership agreement. And there are a number of important clauses that should be included in a partnership agreement.
Like any contract, a partnership agreement will set out the rules that are agreed to, and what happens if the partnership is dissolved.
In this article, Farrah Motley, director of Prosper Law and an Australian business lawyer, identifies the five most important things you should include in a partnership agreement.
The partnership agreement should set out the contributions from each partner
Contributions of partners to the business are different in every partnership. They may be monetary or in-kind. Partners may contribute an existing customer base, goodwill, and a network. Some provide capital, and others may contribute operational or management expertise.
The capital contribution of each partner is not necessarily equal. One partner may contribute more money, while another may contribute more property or equipment. The key is to ensure that each partner’s contribution is fair and equal.
Contribution to the formation and continuity of the business
A partnership agreement must state what each partner brings to the business. Outline what each person will contribute in terms of time, money, and responsibility. Clarifying these expectations from the start can help you avoid problems later on.
Mention what each partner will put forth as incoming contributions. These may be needful before the business becomes profitable. For example, if the initial contributions are insufficient, the agreement can state the need for more contributions from each partner. The extra contributions may be financial or non-financial.
Value of the contribution
Outline the stake of each partner in the business. Stating the value shows how much each partner is investing in the business. Stating the value also helps if a partner wants to sell his share, it is easy to determine how much he is owed.
Equal contributions usually result in equal shares. But different contributions need a calculation to determine each partner’s percentage in the business. The ideal thing is to state a calculation method to value contributions.
Contribution by new partners
Rights of each partner described in the partnership agreement
In a business, there are many tasks to do. Some management roles may overlap (or only need temporary oversight). Responsibilities tend to overlap when there is a communication gap, and each partner’s duties are not defined.
It is generally assumed that each partner has the authority to make decisions or enter into agreements. But that’s not true. The lack of clear direction or management can lead to disorganization and confusion, and that’s a recipe for disaster.
Roles and responsibilities
Set the specific rules for each partner’s authority. List all management areas of the business. On that basis, assign roles and responsibilities to each partner.
Moreover, duties like accounting, payroll, and even human resources should be set in the agreement. This is an effective way to avoid overlapping responsibilities and ensure everyone is on the same page.
The agreement must provide a mechanism for decision-making. Specify whether decisions are to be made by consensus, democratic means, or delegation.
Set up a system that works for the partners, from requiring them to vote on decisions to having one partner be the final decision maker.
A managing general partner can also be designated. Such a clause can include broad authority as follows:
“the management and operation of the Partnership will be exclusively vested in the Managing General Partner…who may undertake those actions, in its sole discretion, as deemed necessary, advisable or convenient to the discharge of its duties under this Agreement and the management of the operations and affairs of the Partnership.“
How profits and losses are shared between the partners
The goal of any business is to make a profit. It is important to determine how to share profits between the partners. This can be difficult for some people, but it is important to discuss your ideas about money from the beginning.
Distribution of profits outlined in a partnership agreement
The partnership agreement should include details about the receipt, expenditure, and disbursement of partnership income. It should provide information on “when and how” partners become eligible for profits.
The agreement should detail:
- how the partners will divide business profits;
- how much will each partner receive, and
- who will be paid first?
It should also specify the distribution method of profits among different partners. For example, a partner involved only as an investor may receive different profits than a partner who manages the business.
Remuneration of partners
The partners work in the firm like employees. In return, they demand compensation for their work in the firm. These remunerations include bonuses, salaries, and commissions.
The agreement must specify whether each partner receives a salary or not. And, of course, the amount of the salary. By mutual agreement between partners, the salaries of the active partner, the non-active partner, and the sleeping partner must be stated.
Also, the salary clause must specify the date on which the salary will be paid.
Drawings of profits
It is not easy to determine the profit shares of each partner before the close of the financial year. As a result, partners make withdrawals during the year based on expected profits. Thus, the agreement should state when profits can be withdrawn from the business. Partners might draw profits at their discretion if the agreement is silent on this issue.
Share in losses
In a partnership, losses are passed on to the partners as specified in the partnership agreement. If not written, the losses are shared equally among the partners.
The contract should specify the amount of loss sharing. This division can be according to the percentage share in the business. Otherwise, partners may bear losses equally or by other means.
For example, an agreement may provide a partner who is only an investor not liable for future losses. Losses are thus borne only by the partners who manage the company.
How partners can leave the business - the termination clause
A partner may leave the business to pursue other opportunities. There are many reasons why this may happen. For example, you may have found a partner and then find that you are not working well together. Or you may have built a strong partnership, but your partner no longer has time to run the business.
Duration of Partnership
The agreement must specify how long the partnership agreement is to be in effect. It may specify that the agreement is for the duration of the partnership itself. But, the partners may also agree on a shorter period.
Procedure to leave the partnership
The agreement must provide a procedure to dissolve the partnership. For example, it may state the leaving partner to give other partners 30 days’ written notice of his intention to leave.
The agreement must specify when the partnership ends. It may end upon receipt of the notice or provide a specific date.
What a partner will receive or not receive
The agreement should cover what is to be done with the business’s assets (if any). And it should talk about the obligations of each partner in such a case. The agreement should specify what a partner will receive – or not receive – if he no longer wants to be part of the business.
In most cases, the partner is entitled to his share of the value of the business, including the partnership’s assets and profits, less the partnership’s expenses and debts.
Buy out the partner's share
The agreement should include a plan to buy out the partner’s share of the business. This means that the partner who wants to leave the business must offer his shares to the remaining partners.
The other partners have the option not to buy out the share. If all partners do so, the leaving partner can offer the share to a third party.
Restraint of trade and non-compete clauses
When a partner leaves, you don’t want them to open a competing business in the immediate area. The best strategy is to take action to prevent the problem.
Partnership agreements must include a non-compete clause in which the partners agree not to start a competing business or compete directly with each other.
Scope of the non-compete
The agreement should give the partnership firm direction and control over the specific actions of current and former partners. A non-compete clause must state that the partner will not engage in competitive activities.
Prohibited competitive activities include, but are not limited to:
- Working for a competing business or person;
- Starting a business that provides the same services or products;
- Recruiting former colleagues to work with a non-solicitation agreement;
- Working in a specific geographic region in a specific industry;
- Conducting business in a particular market;
- Developing competing products;
- Serving as a manager or director of a competitor.
Duration of the non-compete
A firm cannot require a partner not to compete indefinitely. Non-compete clauses must specify a specific time that will apply after the partner leaves. Typically, it involves one or two years but must not be unduly onerous.
Clauses that are unreasonable may violate public policy and market economy principles.
Simply put, the duration of the agreement should not exceed the period reasonably necessary to protect the legitimate business interests of the other partners. However, what is considered “reasonable” varies from business to business. It requires specific consideration of the facts and circumstances surrounding the non-compete agreement.
Location of non-compete
A non-compete can also specify where a partner may not engage in a competitive business. Often, the partner is not allowed to engage in competitive business within the same state.