Why is a partnership a bad structure for your business?

Setting up a partnership is really easy. In fact, a lot of people do it without even knowing that’s what they’ve done.

When you start to carry on a business activity with one or more other people – BANG! – you’re in a partnership! If you and your parents start to carry on a farming operation together, you’re in a partnership. If you and your mate start to develop an online app together, you’re in partnership. If you share some of your consulting income with your spouse, you’re in partnership.

So what, you may be saying? Well, there are a lot of legal consequences that flow from this – and most of them are not good news.

Let’s step through a few…

All of your assets are now exposed

Running your business through a partnership might seem all well and good while things are going well, but as soon as somebody makes a mistake or things go sour, you and your partners are jointly and severally ‘up a creek without a paddle’! What do we mean by this?

You and your partners get to share the profits in proportion to your share of the business. The other side of this coin is that you are also responsible for the partnership’s losses and liabilities in those same proportions. But the fun doesn’t stop there…

If your partners do not have sufficient funds to meet their share of the loss or liability, then you must make up the difference. So, you may have a small 5% interest in the partnership, but end up responsible for 100% of its debts. If you are the richest of the partners, then chances are you will end up bearing the largest portion of the loss or liabilities, irrespective of how much of the upside you were entitled to.

This means that if you hit a bump and the partnership has losses and liabilities that need to be met, you dip into your own pocket – even if you weren’t responsible for the loss or it wasn’t your idea to raise the debt. In fact, you may not have even known about the debt before the creditor came knocking.

It’s important to understand that a partnership is not a separate legal entity from its partners. You don’t get the benefit of ‘limited liability’, as you would if the business was run in a more protective structure, such as a company. (Interested in setting up a company? Read more here. If you’re not sure about trusts? Read more here).

In summary, if you run your business in a partnership, when creditors come knocking, it’s your door they will be knocking on.

The exposure to personal and unlimited liability alone should be enough to convince you to switch to a company. But if not, read on.

Partnership are simple and easy – really?

Partnerships are really easy to set up. But that’s where the easy bit stops.

To begin with, every time someone comes or goes as a partner, a new ‘partnership’ is created. For more information on how this occurs, read this article. All the existing partners need to agree, and all need to transfer a ‘portion’ of their interest in the partnership assets to the incoming partner (or from an outgoing partner). If the partnership owns a lot of assets, or has contracts with a lot of parties, then this can get complicated, expensive – and in practice, seldom gets done properly.

Most partnerships don’t get around to putting in place an adequate Partnership Agreement. Without a partnership agreement everyone needs to agree on all of the business decisions, including the terms on which people come and go. It is hard enough to get two people to agree on things like price and terms, but this gets exponentially harder with three, four, five, or more partners….

But even for those partnerships that do have a Partnership Agreement, most are ‘simple’ documents that do not adequately cover the key issues of contributions, management and exits. If you are curious, we have prepared a Checklist of ‘exit issues’ to consider for partnerships, which is available at this link.

When it comes times to sell the partnership’s ‘business’, there can be an enormous amount of work to ensure that all partners’ interests are treated fairly, particularly in terms of revisiting each partner’s contributions, debts, client relationships and how confidential information and know-how is to be treated, and restraints of trade. The bigger a partnership gets, the messier the structure generally becomes. The internal ‘sale negotiations’ between the partners can often overtake the sale negotiations with the third party buyer.

As noted above, when it comes to decision-making, in the absence of a more detailed agreement, each partner has an equal right to participate in all decisions. The reality is that effective decisions need to be made by the people with the appropriate experience and knowledge – not by a committee of equals. This is a key source of internal disputes that then leads to paralysis and ultimately a dissolution of the partnership.

Other structures (such as a company) offer a cleaner way for people to come and go, and more flexibility in managing the decision-making rights for the various categories of people involved in the business.

When it goes bad, it goes really bad

We have seen a spike in partnership disputes over the last 18 months. A big part of this is has been because the partners have never stopped to put in a comprehensive agreement governing their partnership – including the key issues of contributions, decision making and exits. As noted above, even those who did have an agreement found that it was too basic to cover the circumstances in which they found themselves. Everyone wants a simple agreement until they actually want to rely on it – then you need the gritty details. To put this in context, our Partnership Agreement runs to over 100 pages.

Things that commonly go wrong in partnerships are:

  • Problematic partners failing to turn up and contribute their fair share to the business;
  • Disputes about profit sharing – which have arisen from disputes about unfair contributions;
  • Disagreements about control and business decisions – with rogue partners making decisions without appropriate consultation and authority;
  • Partners dealing with themselves or related parties on favourable terms; and
  • Arguments about the terms on which one person is to leave the partnership – especially about what value they are going to get and on what payment terms.

By the time you have a disagreement, things between partners are usually quite nasty and it’s often too late to get everyone around the table to talk things through constructively.

Other business structures offer a more comprehensive way of dealing with these issues (particularly around profit and liability sharing) because of the inherent nature of the structure. It’s worth reviewing your partnership structure now to avoid heartache (and a date with the Court) in the future.

Planning for the ‘afterlife’

When you are ready to sit back and enjoy the fruits of your labour in retirement, you might get a rude awakening. Most partnerships require a partner to continue to work in the partnership to maintain their interest. Chances are that the younger partners will have a different view as to the value of your interest when it comes time for your retirement.

The same issues arise if you die unexpectedly. There is nothing requiring your fellow partners to continue in business with your surviving spouse or heirs. There is also usually nothing requiring them to deal fairly with your surviving spouse or heirs, i.e. to buy them out at market value.

Where there are only two partners, when the first of you dies, the partnership will automatically come to an end unless you have an agreement that states otherwise, and the deceased partner’s interest in the partnership becomes an asset of their estate. This is not ideal when the surviving partner wants to carry on the business. It is even less ideal when the surviving partner needs to get into a messy dispute with the deceased’s estate to try to control the partnership assets.

Other structures, such as companies or trusts can make passing on the baton to the next generation a much simpler and predictable process.

It’s easy to move to a better structure

If you’re currently in a partnership and want to move to a better structure, then there is good news. There are different tax rollovers that can be accessed when restructuring out of a partnership and into a company. This means you can transfer the partnership assets to a new structure without triggering a tax liability. This gives you the opportunity to take advantage of a more suitable business structure with minimal disruption to your day-to-day operations and without incurring a tax liability. Win/win!

You’ve convinced me! Now what?

You should regularly review your business structure and make sure it is still working for you. If you are currently in a partnership then we strongly recommend you consider moving to a structure involving a company, and potentially also a trust. Call us, and we can talk you through these options.

The sort of things you need to take into consideration include:

  • What kind of business do you run? Where is the value or any ‘goodwill’?
  • How many people are involved in the business? Do you see the management structure changing in the future?
  • Who brought what into the business? Have you contributed equally? Are there more contributions to come?
  • What’s your long term plan? Is this the kind of business you expect to endure for generations? Or would you like to build it up and sell in the next few years?

Call and speak with one of our experienced lawyers about how to ensure you have the best structure for your business, both now and into the future. You can reach us on 1300 654 590.

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