When do you need a partnership agreement?

Toby Pryce

If you are in partnership (or are looking to enter into partnership) and you do not have a partnership agreement in place, then there are default rules which will apply to you and your partner(s) and the management of the partnership business. The default “rules” are found in a relatively old piece of legislation (The Partnership Act 1890) and, despite some modernisation of the legislation over the years, many find the default rules it imposes on partnerships to be outdated and not suitable for the partners and their business.

Examples of the default rules include:

  • Partners are entitled to equal shares in profits and losses of the partnership – this may be appropriate in some circumstances, but often partners wish to have unequal shares (e.g. to reflect differing workloads or differing capital contributions made between them).
  • Partners receive no interest on capital that they contribute to the partnership.
  • Partners receive 5% interest on loans that they make to the partnership.
  • All partners are entitled to fully participate in the management of the partnership – this may be appropriate when every partner wants to fully participate in the management of the partnership and have equal say. However, what happens where you want a detailed decision making procedure that is inconsistent with the default rules? Similarly, what happens where some (but not all) partners wish to make a capital contribution and receive a share of the profits, but not be concerned with the management of the partnership? The answer to both of these questions is that you need a partnership agreement to accurately reflect how the responsibility for the management of the partnership is to be divided between the partners. Having clear and accurate procedures in place can also help to avoid disputes.
  • Partners are not entitled to a salary – clearly, if any one or more of the partners are entitled to a salary, then this will need to be set out in the partnership agreement. The concept of salaried partners is common with professional services partnerships (e.g. accountants, lawyers, surveyors).

Let’s examine certain of the default rules and how they might apply to a partnership, in more detail below.

Making decisions without a Partnership Agreement

Under the default rules, most decisions in a partnership will have to be made by a majority of votes of the partners. However, the default rules also say that the unanimous agreement of all partners is needed to make changes to the partnership, e.g. such as admitting a new partner.

So, the default rules provide a potential stumbling block to partners’ decision making by requiring unanimity on certain issues. This could hold back the progression of the partnership and its business, e.g. where the majority or partners wishes to admit a new incoming partner, but one partner (or a minority or partners) disagree. A Partnership Agreement can be drafted to ensure that the majority (whether that “majority” be set at more than 50% or at 75% for example) prevails.

Accountability for profits

The default rules provide that a partner has a duty to account to his other partners for profits made from any competing business. However, the default rules do not contain any provisions which say that a partner has to work full time in the partnership, and (related to that point) nor do the default rules contain any provisions which deal with how a partner is to account for any profits the partner makes from a non-competing business. A carefully drafted partnership agreement is needed to make it clear whether or not a partner has to work full time within the partnership and also to make it clear whether or not a partner must account to the partnership for profits made from a competing or non-competing business (as appropriate).

Dealing with disputes without a Partnership Agreement

The default rules do not provide any clear procedures to deal with or resolve a dispute between the partners of a partnership. Clearly, this is not an ideal position to be in when running a business, which itself can be a stressful and emotive endeavour that can lead to disagreement between partners!

In light of this, it is recommended to have in place a partnership agreement which sets out (amongst other matters): –

  • what happens if there is a dispute between the partners
  • a mechanism for expulsion of a rogue partner
  • a mechanism for valuing an outgoing partner’s interest in the partnership and how that is to be paid to the outgoing partner
  • obligations / restrictions that are to be placed on an outgoing partner (e.g. restrictive covenants preventing an outgoing partner from setting up or being involved in a competing business)

If you do not have a Partnership Agreement including provisions dealing with the points above, then it is much more likely that the partnership will be dissolved following a dispute, resulting in the goodwill in the business (potentially its most valuable asset) being lost.

Removing a partner

The default rules say that, in order to expel a partner from the partnership, the decision has to be agreed by a unanimous vote of all the partners including the partner that is to be expelled. Experience tells us that the partner to be expelled is unlikely to agree to his own expulsion! So, it is often prudent to include appropriate provisions within the Partnership Agreement dealing with (and setting out the mechanism for) the expulsion of a partner (e.g. by a majority vote).

Next steps

If you are considering setting up a business with others in partnership, or if you are already running a business as a partnership without any written partnership agreement, it is recommended that you put in place a partnership agreement to protect you (and your fellow partners).

At Bray & Bray our Business and Corporate Law experts can prepare and tailor partnership agreements to meet your needs and in doing so, provide a business model for you and your partners to run a successful and long-term partnership. For specialist information and advice about Partnership Agreements you can contact the Corporate Law team on 0116 254 8871 or you can email me directly at tbpreston@braybray.co.uk