What Are Partnership Agreements And How Do They Work?

Starting a business is similar in many ways to a marriage or civil union. A partnership is formed with a legally binding agreement. The contract sets out the terms and conditions for a hopefully long-lasting and healthy relationship.

Only, unlike government-recognized civil partnerships, you have many more options when working together as entrepreneurs. Sure, you can have a verbal agreement or note written on a restaurant napkin that is proof of contract.

But what about when things get difficult? How will each partner be compensated? If you do nothing, then you will be at the mercy of your local state laws.

Rather than be unpleasantly surprised when the unexpected happens, you need to create contracts that cover your bases and offer protection to all parties.

In this article, we will go over what partnership agreements are and how you can use them as the foundation of your business.

What Are Partnership Agreements?

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A partnership agreement is a contract between two or more parties that is the foundation of a business partnership. The agreement outlines the terms and conditions of the partnership. This includes obvious things like the name and purpose of the business entity. It also determines who is liable for business debt obligations, who has voting rights, partner compensation, and many other important details.

Partnership agreements are a kind of executory contract. What is an executory contract? It sets out obligations that are still pending, and may also set out a timescale for their completion.

A partnership agreement can help smooth business operations when the going gets tough e.g. a business dispute or when a partner exits the company. You can add your business to the list of registered partnership entities by creating your own partnership agreement.

Why do I need a Partnership Agreement?

Any time you create a business with one or more partners you enter a partnership. If you do not create your own legal document, then your business will be labeled as a general partnership by default.

A general partnership is a legal entity but will be held to laws and regulations as defined by the state. This means you have no choice when it comes to dealing with problems and issues. All business issues will proceed according to local laws. De facto business partnerships can result in undesired results.

For example, in many states, if one partner passes away, the entire partnership is dissolved. This means it will have to be reformed and can create plenty of problems along the way.

Instead, you and your partners can protect yourselves against foreseeable risks by creating a partnership agreement that is fit for purpose.

Types of Partnership Agreements

Partnership agreements are not a one-size-fits-all solution. There are many options you will want to consider when deciding what type of partnership you want.

General Partnership (GP)

A general partnership is the most basic business union you can create. The main appeal of this type of partnership is that it requires no legwork or filing with the state. Basically, all that is needed is some form of a preserved document signed by all involved partners.

Under this type of partnership, profits and dividends are split equally among all the partners. And as mentioned previously, if one partner dies, the entire partnership is dissolved. Regarding liability, every partner has an equal responsibility for business debt and legal obligations.

Limited Partnership (LP)

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Every limited partnership has at least one “general” partner. These parties will have full liability like with a general partnership. Intuitively, this means “limited” partners will have limited liability for business debts and legal obligations.

Typically, the general partners are involved in running the business, whereas the limited partners are hands-off investors.

Limited Liability Partnership (LLP)

An LLP is similar to a limited partnership. However, in this case, each partner is fully liable for the business. Each partner is not liable for the actions of the other partners. This protects partnerships from things like lawsuits and other legal recourse.

Limited liability partnerships are typically used by professionals in accounting, law, and medicine.

Limited Liability Limited Partnership (LLLP)

A limited liability limited partnership is similar to the LP but the general partner also has limited liability. This type of agreement offers greater protection for every partner but is not recognized in many states. This means of course that entering into an LLLP will limit where you can legally operate and conduct business.

What Are Partnership Agreements Composed of?

There are many diverse elements that may be included as part of a partnership agreement. Which items and clauses you include will depend on your situation and how much protection you desire.

With that being said, here are the main components you need to consider when drafting a partnership agreement:

Business details - choose your business name, add an address/what state the partnership will be registered in (which will also hold governance over the agreement).

Partnership agreement type - this is fairly straightforward but make sure you fully research your options. Changing the partnership will require creating a completely new partnership agreement.

Ownership interests - any agreement needs to state who has ownership of the business. Typically, this is represented by a percentage interest in the business.

Purpose - what are the goals of the partnership? Keep it simple but describe the activities of the business. You can elaborate somewhat on the products or services you will provide but keep it relatively simple.

Duration - how long does the agreement last? This is a standard section of any good legal agreement.

Contributions - define what each partner is expected to contribute. This includes cash, property, services, and other forms of capital.

Decision making - how will decisions be made? This includes outlining the voting process, who has voting rights and how much of a vote each partner receives. Is voting weight based on ownership proportion or equally per person?

Profits and distributions - describe how you will allocate profits and losses. This is where you outline what proportion of profit each partner will receive. You will also define how often and when this happens.

Compensation - you will likely have one or more partners that relieve a salary. In this section, you can also include terms for things like vacation, sick pay, and other benefits.

Death and disability - what to do if a partner either dies or is unfit to continue in their role? Here you can describe who inherits the previous owner’s share of the business. You will probably want to include a buyout clause. This will allow the remaining partners to buy the newcomer out rather than have to accept an unknown partner. 

Withdrawal or addition - what happens if a partner wants out or someone new wants to invest in the business? Here you will define the leaving and adding processes. This includes but is not limited to areas like buyouts, liabilities, and responsibilities within the company.

For example, if an operational partner exits the business, you would want conditions in place that divide their roles and responsibilities amongst the remaining partners.

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Dispute resolution - no matter how smoothly things may start off, one thing is certain, there will be disagreements. Adding a section that outlines the resolution process can save a lot of pain and suffering (as well as time and money) when business disputes arise.

Business dissolution - nothing lasts forever, and at some point one or more partners may wish to dissolve the business. You can be prepared for the worst by clearly describing the dissolution process. This can include contingencies for remaining partners who wish to continue the business.

Acquisitions - as the company grows, there may come a time when you wish to acquire another business. In this section, you can describe the terms of when this option is or isn’t allowed and how to initiate the process.

Acquiring another company can be a messy process so it helps to have preparation. You can get a free letter of intent template online.

Finance - how will the partnership's finances be handled? This section describes how finances and tax reporting will be managed.

How to Write a Partnership Agreement

Writing a partnership can be as simple or complex as you need it to be. An easy place to start is with a free partnership agreement template online.

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But even after reading through this brief article, you may still have questions. In that case, you would be best served by seeking legal advice from a partnership agreement lawyer.

Alternatively, you can refer to online legal services that can help you with drafting a partnership agreement.

Partnership Agreements Protect You and Your Business

When you have a good idea, the last thing you want is to get bogged down in legalese and paperwork. When starting a business or passion project, it can be tempting to quickly sign a piece of paper with your partners and get to work, but that can have many unforeseen consequences.

Rather than expose the partnership to unnecessary risk, it’s best practice to create a partnership for any business you take an interest in. Drafting a partnership agreement will help you smooth uncomfortable transitions, limit liability, and protect the business from unwanted dissolution.

It can also help lay the groundwork for important operational processes like decision-making and dispute resolution. By putting in a bit of extra work at the beginning, your investment will return future dividends by saving both time and money.

And with online partnership agreement templates, you don’t have an excuse anymore. Take advantage of the tools available and start making your own partnership agreements today!