Partnership Agreements: Best Practices and Red Flags
Starting a business is a great way to generate a new income stream. And bringing in partners with the skills and subject matter expertise to navigate business challenges will increase a venture's likelihood of success. Partners may be willing to forgo a salary in exchange for equity in the business or may be a silent partner, who does not actively participate in the business, but provides the necessary capital to grow the business. Generally, having an equity stake makes partners more committed to the business' long-term success. A partnership agreement is the tool for outlining each member's involvement and ownership interest in the business.
Create an Agreement Before Earning Revenue
Partnership agreements can evolve over time, but timing is critical. It is wise to have something in writing before the business earns its first dollar. Once revenue is earned people’s memory may become hazy about what was promised or what each partner contributed to make the business a success. A written agreement from the beginning provides the necessary transparency and prevents confusion.
All ventures should use a partnership agreement regardless of how small they are or if the partners consist of friends or family members. Unfortunately, once a business proves profitable some partners can succumb to greed. Other lessons learned in entrepreneurship as well as business best practices are covered in chapters 18 and 22 of Become Loaded for Life.
Roles, Responsibilities, Equity and Exits
At a minimum a partnership agreement should include the roles and responsibilities of each partner and their ownership percentage in the business. It should also explain the process for partners to exit the business and, if necessary, to be fairly forced out. Documenting these terms ensures a clear understanding of how active each partner will be in the business and the commitment that is required. For example, partners need to know if the venture will be on an aggressive growth trajectory requiring 80 hours weeks or a passive growth plan requiring only five to ten hours each week.
Have Experts Review the Documents
It is a best practice to have an experienced attorney draw up these agreements to ensure they comply with local laws and address any legal implications the partners may not have considered. And never contribute money to a business without having a written agreement in advance that specifies the terms and conditions of the capital contributed. You want to be certain that the money invested will fuel future growth not pay off prior debts or expenses.
Not Ready Yet for an Formal Agreement
If the business products or services are still being defined and the partners are not ready yet to sign a formal partnership agreement it can be valuable to capture what is agreed upon in a memorandum of understanding. This document serves as a written record and precursor for a future partnership agreement. In addition, the discussion about the terms of the agreement is a valuable litmus test in assessing partners. For example, these talks may reveal that one partner has unrealistic expectations regarding their share of equity or wants to act as a sole decision maker on key business decisions. These may be conditions that other partners won't accept. It is best to recognize these issues before any capital or more time is invested.
Defining compensation is a critical component of the partnership agreement. Compensation can include being paid a salary like an employee, being paid for a specific set of hours, or receiving a share of profits based on the amount of equity owned. It may also include a mix of these options. The details of compensation are critical, as having 10% of equity does not necessarily mean receiving 10% of profits. The partnership agreement may call for only sharing a limited portion of the profits among equity holders. So make sure you understand what you are signing.
Compensation Red Flags: Avoid the Free Labor Trap
Determining compensation at the outset of a venture also helps avoid the free labor trap. This occurs when a business owner promises potential partners equity in exchange for labor, but then reneges on the promise. There are many unscrupulous entrepreneurs who use this strategy to gain free labor to create profitable businesses. Some people have worked undercompensated for months or even years only to be cheated out of their rightful share of the business.
The first red flag is a partner or business owner who seeks to delay signing a memorandum of agreement or partnership agreement. The free labor trap is based on trust, so ignore all assurances about how much they appreciate your work or praise they offer about how valuable you are to the business. Delaying tactics may include excuses such as “we just need to get through the next quarter” or “once we finish this big project, we can sign an agreement.” These are stalling tactics to get more free labor.
It is wise to keep a record of every email and text related to your contributions to the business and any discussions about equity and compensation. Keep these messages on a computer outside of the business as they will prove very valuable when you litigate for any compensation owed.
Financial Red Flags
A second set of red flags relates to business finances. This includes a partner not regularly sharing financial reports with other partners or taking money out of the business without consulting other partners. In addition, watch for a partner that only pays their expenses out of business funds. This can include legitimate business expenses such as paying for vehicles, insurance or fuel, or paying for training or travel. The cause for concern is when only one partner is benefiting from reimbursed expenses but the other partners are not.
In this situation the partner is paying themselves off the top, reducing what is left in the bank before funds are shared with the other partners. All legitimate expenses incurred by partners should be reimbursed in an equitable manner. Implementing financial controls at the outset can help mitigate this risk.
Decision Making Red Flags
A third red flag is unilateral decision making by one partner without consulting the other partners. A proper partnership agreement should specify how major business decisions are handled. If the process is not clearly written it will be difficult to enforce. Unilateral decision making by one partner erodes trust among the other partners and may put the business in jeopardy. This may include accepting new projects not yet vetted by the other partners, approving major expenses, or reducing a client’s invoice for completed work which robs the business of revenue and in turn the other partners of income.
Most of the red flags above can be avoided through a proper partnership agreement or making amendments to an agreement over time. If the mistakes cannot be reconciled, it may be wise to exit the venture. These types of issues tend to only get worse over time and they can expose partners to financial and legal risks.