The Importance of Going Through a Thorough Partnership Agreement Process

For the purposes of this article, the term partnership agreement can mean an agreement between partners in a true “legal” partnership, operating agreement among members in a LLC, or shareholders in a corporation. These concepts apply to any closely held business (regardless of the entity’s actual form) where more than one person is involved.

The Importance of Going Through a Thorough Partnership Agreement Process

One of the biggest mistakes business partners can make is to not invest in a solid partnership agreement at the outset. Of course those partnerships that go without a partnership are fine, until they are not. Every business will inevitably run into some sort of conflict that can’t be easily resolved—and when things do go wrong, they can go very wrong. Without a effective and thorough partnership agreement in place, business partners don’t have the proper guidelines to follow when things get uncomfortable and, unfortunately, disputes can turn out to be disastrous, even resulting in the business going under.

We’ve found that in 1 out of 15 cases, one or both parties will drop out of the partnership when everything is laid out in detail. The truth is that it’s better to know now than later, when there’s more risk, more value, or potential transactions on the horizon. A properly done partnership agreement is just as important than any other investment or asset in the business.

One Size Doesn’t Fit All

A close second in big mistakes business partners can make is thinking that all partnerships are the same and that partnership agreements are a “one-size fits all” solution. That is just simply not the case. There are many online services that offer these types of documents and many entrepreneurs try to save money by not hiring a lawyer by using a pre-existing template. We have seen some disastrous outcomes as a result of using off-the-shelf partnership agreements, including a situation described further below. In that case, the use of an online solution in that case was truly “penny wise and pound foolish”.

In actuality, every partnership is unique and should be treated as such. While there may be some standard structures to implement within a partnership, every partnership has partners with widely varying circumstances, interests, opinions, and goals. So, if you care about the company/venture in which you are about to embark upon, you should give some careful consideration to how the partnership will function.

Failing to Ask the Hard Questions

Even when partners try to customize their own business agreement, they all too often fail to cover difficult situations. You have to ask the tough questions NOW and get it all out on the table from the get go because, in our opinion, it’s better to see the flaws in the partnership and reveal the underbelly of the agreement sooner rather than later. Likewise, having tough discussions now will help your partners know each other’s boundaries and limits. Often when partners know these boundaries and the reasons for them, they will stay clear away from crossing any lines. Failing to have these discussions can be fatal to the business and the partnership.

For example, here some of the challenging questions partners must ask:

– What are the expectations of one another (now and going forward) that are needed for one to
earn/keep their interest in the company?
– How are the parties going to handle an unforeseen and unplanned event like death, bankruptcy,
divorce of a partner, incapacity, disability, etc.?
– How are decisions going to be made and who has the authority to make those decisions?
– Are there decisions that require a heightened level of approval? A different process?
– How will money be split?
– Are certain partners entitled to compensation for their efforts?

An Example of How Not Having an Agreement Can Be Costly

Of course, it seems obvious that there are significant risks to not having an agreement. An example includes 2 partners who worked cordially together for 20+ years without a partnership agreement. But, then, the two partners, who had different life circumstances, had different visions for the company. One wanted to sell and the other didn’t. They even had valuations showing more than $10M in value. After a number of arguments between the partners, one of the partners (wrongfully) expelled the other partner. Litigation ensued and lawyer bills racked up. In the end, the parties settled by conducting a buyout by one of the other. But, in the process (which took nearly 2 years), they destroyed approximately 60% of the value they had created. And the buyout took place at about 40 cents on the dollar (not including legal fees).

An Example On How Thoughtless Agreements Can Be Fatal

Here’s an example on the dangers of a poorly executed partnership agreement or not having one in place at all. A business owner entered into a partnership agreement where he owned 97% of the company, with the remaining 3% going to a key employee in the company. In order to save money, the owner obtained an operating agreement from an online solution that provided a boilerplate operating agreement. After a few years, the parties had a falling out and the key employee left the company, but retained his 3% interest. Years later, the majority owner wanted to sell the business and found a buyer willing to pay a multi-million dollar price. During the due diligence process, the buyer saw that there was another partner in the business and began to scrutinize the documents. Lo and behold, the off-the-shelf operating agreement provided that selling the company required the unanimous consent of the partners. First off, the business owner didn’t even have contact information for the former key employee. So, he had to undertake tremendous efforts just to find the employee. Ultimately, the passage of time caused the buyer to lose interest in the deal and the transaction never closed.

Get the Help You Need

Make sure your partnership agreement is executed thoroughly and thoughtfully so that you’ll have the necessary protections and a solid foundation for the future. In addition, it’s important to know how your own company and partnership is going to function. Going through a thorough and thoughtful process is going to help you understand how it works and make sure that it works for you.

Doida Law Group will work with you and your partner to deliberately and intentionally have the uncomfortable but necessary conversations and go through a thoughtful process to document the unique agreements between you and your partners. Call us at 720.306.1001 today.

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