Over the past few weeks, I've been asked to review some partnership agreements. On the surface, having a written agreement might sound like a good idea. In fact, it is always better to have any contract or business deal in writing rather than an oral agreement. However, a partnership agreement is not just any contract because when two or more individuals enter into a partnership agreement, they are not just entering into a contractual relationship, they are also forming a business entity, which is usually a general partnership. Unfortunately, there are a lot of problems with partnerships, especially general partnerships, and there are a lot of problems with partnership agreements. Many businesspeople think thuey are solving or preventing problems by entering into a partnership agreement. However, they are in fact creating new and unnecessary problems. So, in today's Freedom Friday blog and email newsletter, I am answering the question, “Why is a partnership agreement a bad idea?”
Before I answer that question, what is a general partnership to begin with? A general partnership is a business structure with two or more people, and they have not together formed a limited liability company or a corporation. Just like the sole proprietorship is the default business entity structure for one person, a general partnership is the default business entity structure for two or more people. Unfortunately, a general partnership has a lot of problems, and even if the partners enter into a partnership agreement, there are still a lot of problems that can be avoided. In today's Freedom Friday blog and email newsletter, I want to share three (3) problems with partnerships, and these are also three (3) reasons why a partnership agreement is a bad idea.
No Liability Protection
The first problem with partnerships and the first reason partnership agreements are a bad idea is that there is no liability protection. In a partnership, regardless of what is provided in the partnership agreement, the personal assets of the partners are subject to liquidation to meet the partnership's financial obligations if the business is sued. Partners are personally liable for any court judgments or business debts. There is no liability protection of the partners individually. If you want that liability protection, then you and your partners should form an LLC instead of a partnership.
The second problem with partnerships and the second reason partnership agreements are a bad idea is that the partners agree to take on additional liabilities. Not only do partners face no liability protection, but a general partnership requires additional duties of the partners which are not found in an LLC. Specifically, partners have fiduciary duties not only to the partnership itself, but to each other. These fiduciary duties include the duty of loyalty, the duties of good faith and fair dealing, and duties of care and disclosure. If something happens in the partnership, not only can a partner sue his fellow partner for breach of contract and dissolution, but also for breach of the fiduciary duties, and if found liable, the breaching partner can face punitive damages beyond any liquidated damages. All of these liabilities and risks can be avoided if the partners choose to form an LLC instead of a partnership.
Instability and Difficulty in Transferring Ownership Interest
The third problem with partnerships and third reason why partnership agreements are a bad idea is that a general partnership is an unstable business entity structure, and it can be very difficult for one partner to transfer his or her ownership interest to a third party. Partnerships are not stable because if something happens to just one partner, such as death, bankruptcy, or some other tragic event, the partnership can suddenly terminate and bring an end to the business. In addition, it can be difficult for one partner to transfer his or her ownership interest to a third party because consent is required from the other partners, and if just one other partner refuses to consent, the partner wanting out can be stuck. Many partnership agreements lack buy-sell provisions which can avoid these problems, and forming an LLC as opposed to a partnership also avoids these problems from happening.
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