When is it good to bring in a partner? A partnership is a type of business structure in which two or more entities (or partners) share the ownership and the profits and losses of the business. Joining forces with someone else can help a businessperson share the costs of starting and running a business as well as the managerial responsibilities and workload associated with it. Having a partner whose skills complement your own can be quite advantageous. For example, if you are great at numbers but hate making sales calls, bringing in a partner who loves to knock on doors would be beneficial for your business.

Another advantage of a partnership relates to time: Because more owners are involved in the business, there is more time available for the owners to increase the firm’s marketing and sales efforts to generate more income. A partner can also help come up with new ideas and projects for the business as well discuss major decisions with you and help you make them. And because partners have a stake in the business, unlike employees, they are more likely to work long hours and go the extra mile.

Are there disadvantages to adding partners? For every advantage a partner can bring, adding the wrong partner can be equally problematic. Obviously, adding partners means sharing profits and control, so if you don’t want to give these up, a partnership may not be the right structure for you. Your partner may also have different work habits and styles than you. If the person’s style does not complement your own, the differences can be challenging. In addition, as the business begins to grow and change, your partner might want to take the business in a different direction than you had envisioned. Like entering into marriage, you want to consider carefully the person(s) with whom you will be sharing your business.

As a business form, how does a partnership compare to a sole proprietorship? Partnerships and sole proprietorships are similar; in fact, the biggest difference between the two is the number of people contributing resources and sharing the profits and the liabilities. It is just as easy to form a partnership as to form a sole proprietorship. The government does not require any special forms or reports, although some local restrictions may apply for licenses and permits. For example, suppose you and your brother-in-law form a small partnership called “All in the Family Electricians.” Before you are able to do business, you might have to apply for a license, but you do not need any special papers to create the partnership itself. Also, like a sole proprietorship, partnerships do not file a separate tax return. All profits and losses of the partnership flow directly through each partner’s individual tax return. Figure 6.3 outlines other characteristics of a partnership.

Figure 6.3

Characteristics of a Partnership

What goes into a partnership agreement? A partnership can begin with a handshake, and many of them do. Although no formal documents are required to form a partnership, it is a good idea to draw up a partnership agreement that formalizes the relationship between partners. Think of a partnership agreement as a prenuptial agreement. It helps settle conflicts when they arise and may prevent small misunderstandings from erupting into larger disagreements. Many points can be included in a partnership agreement; however, the following items should always be included:

• Capital contributions. The amount of capital (money), equipment, supplies, technology, and other tangible things of value each partner contributes to begin the business should be noted in the partnership agreement. In addition, the agreement should also address how additional capital can be added to the business—who will contribute it and whether there will be a limit to a partner’s overall capital contribution.

• Responsibilities of each partner. To avoid the possibility of one partner doing more or less work than others or a conflict arising over one partner assuming a more controlling role than the other partner desires, it is best to outline the responsibilities of each partner from the beginning. Unless otherwise specified, any partner can bind the partnership to any debt or contract without the consent of the other partners. Therefore, it is especially important to spell out the policy regarding who assumes responsibility for entering into key financial or contractual arrangements.

• Decision-making process. How will decisions be made? Knowing whether decisions will be the result of mutual consent of all or several partners or whether just one or two partners will make the key decisions will help the partners avoid disagreements. What constitutes a key decision should also be defined in the agreement. In a partnership of two, where the possibility of a deadlock is likely, some partnerships provide for a trusted associate to act as a third “partner” whose sole responsibility is to be the tiebreaker.

• Shares of profits or losses. The agreement should specify not only how to divide profits and losses between the partners but also how frequently this will be done. For example, it might stipulate that the profits and losses will be proportional to each partner’s initial contribution to the partnership, as reflected in Figure 6.4. Or, the agreement might split the profits evenly, regardless of contribution. It is also important to detail how adjustments to the distributions will be made—if any at all—as the partnership matures and changes.

  Figure 6.4

  Share of Profit and Loss in a Partnership

  

  Figure 6.4 Full Alternative Text

• Departure of partners. Eventually, the composition of partners may change as original partners leave and new partners come onboard. The partnership agreement should have rules for a partner’s exit, whether voluntary, involuntary, or as a result of death or divorce. Provisions to remove a partner’s ownership interest are necessary so the business does not need to end (liquidate). The agreement should include how to determine the amount of ownership interest and to whom the departing partner is permitted to transfer his or her interest. It is important to consider whether a partner can transfer his or her ownership solely to the remaining partners or whether individuals outside the existing partnership can buy the departing partner’s share of the business.

• Addition of partners. The partnership agreement should spell out the requirements for new partners entering the partnership. Also included should be how the profits will be allocated once a new partner is taken on and whether there will be a “junior partner” period during which the person must prove himself or herself before obtaining full partner status.

Are there different types of partnerships? There are two common types of partnerships: general partnerships and limited partnerships. The distinction between the two types involves who accepts most or all of the business liability.

What is a general partnership? A general partnership is the default arrangement for a partnership and is, therefore, the simplest of all partnerships to form. For instance, if two friends, Juan and Franklin, set up an ice cream stand at the local park, sell ice cream cones, and split the profits at the end of the day, they have created a general partnership. For Juan and Franklin, this is a logical arrangement because they share the profits equally, and there is little worry about liability. In a general partnership, each partner has unlimited liability for the debts and obligations of the partnership, meaning every partner is liable for his or her own actions as well as the actions of the other partners and the actions of any employees.

What is a limited partnership? Sometimes, a business can bring on additional “limited” partners who mostly provide capital and earn a share in the profits but who are not involved in operating the business. To encourage investors to contribute capital to a business without risking more capital than they have contributed, a limited partnership is created. In a limited partnership, there are two types of partners. General partners are full owners of the business, are responsible for all the day-to-day business decisions, and remain liable for all the debts and obligations of the business. Limited partners are involved as investors and, as such, are personally liable only up to the amount of their investment in the business. They must not actively participate in any decisions of the business. To continue our example, suppose Juan and Franklin don’t have enough money to purchase a new freezer for their business. So, they ask Juan’s brother Carlos to invest enough cash in the business to buy the freezer. Because Carlos is already working full-time and cannot participate in the business’s activities, he becomes a limited partner. Should something go wrong and the partners needed to cover the damages incurred by the business, Carlos will only lose the money he has contributed (the cost of the freezer). Limited partnerships can be much more complex to form than our simple example, so it may be worth exploring other business structures before deciding on this strategy.

Another kind of limited partnership is a master limited partnership (MLP). This business structure combines the tax benefits of a limited partnership, but it is similar to a corporation (which we discuss next) in that it is publicly traded on a securities exchange. MLPs are restricted mostly to certain businesses pertaining to the use of natural resources (such as petroleum or natural gas) and real estate.

Will partnerships work well when liability is a concern? Although forming a general partnership for Juan and Franklin’s ice cream business makes sense for them, it is not right for every business. In some situations, especially if liability is a concern, neither a sole proprietorship nor a partnership will protect the owner(s) from unlimited risk. For instance, if Sarah and Hannah decide to form Personal Training Partners, a personal training and fitness motivation company, they know that each partner is liable—not only for her own business debts and actions but also for each other’s business debts and actions. If a client claims that Sarah mistreated him or her and the client sues the business, not only are the business assets at risk, but both Sarah’s and Hannah’s personal assets are also at risk. Sarah and Hannah would prefer to only be responsible for their own mistakes. In this case, a partnership is not the best business structure because a partnership has unlimited liability. So, neither partner is protected against the losses of their personal property.

Instead, Sarah and Hannah should consider forming a limited liability partnership (LLP). An LLP protects the partners not only from any debt or liability incurred by the business but also from the liability of another partner. A partner in an LLP is personally liable only for his or her own negligence. An LLP would protect Hannah’s assets from being used to pay for claims against Sarah’s negligence. Sarah would be solely responsible for damages caused by her own mistakes. If Sarah and Hannah aren’t concerned about being protected from each other’s possible negligence, then a limited liability company is another option. We’ll discuss this and different types of corporations next.