Partnerships: It’s All Fun and Games Until Someone Loses an Eye

John Tabita
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In my previous article, I wrote about the pros and cons of partnerships. When we formed ours, there were many things we didn’t plan for in advance, but I was fortunate that we had an amicable split due to changing priorities and goals, not ill-will. Looking back, I can see how under different circumstances, things could have ended badly. So here are some safety tips to consider when forming a partnership—before you shoot your eye out.

(DISCLAIMER: I’m not an attorney, so this should not be construed as professional advice; nor is it intended to replace talking to an actual attorney. Also, since I live in the U.S., the legalities may vary from country to county.)

Identify Yourself!

There are three types of legal entities that apply to partnerships: general partnership, limited liability partnership, and limited liability company. Let’s take a look at each.

General Partnership

As with a sole proprietorship, a general partnership makes no distinction between the individuals and the business. You, your partner, and the business are one and the same, both in terms of taxation and legal liability. Unlimited personal liability is one of the disadvantages of not incorporating. Not only is each partner liable for his own actions, he’s also liable for the actions of his partner(s). That means if you are sued the personal assets of both you and your partner are at risk. For example, if one partner injures someone in a car accident while on company business, all partners would be jointly and severally (i.e., individually) liable.

Tax-wise, all company income passes through to each partner as personal income, on which each are taxed. Conversely, if the business loses money, partners can claim a portion of that as a loss on their personal tax return, based on each one’s percentage of ownership in the partnership.

Limited Liability Partnership or Limited Liability Company

To eliminate the unlimited personal liability aspect of the general partnership, two or more people may form a limited liability partnership (LLP) or limited liability company (LLC). With an LLP or LLC, one partner is not responsible or liable for another partner’s misconduct or negligence. The pass-through taxation aspect, however, is the same as the general partnership. There are some slight differences between the LLP and LLC, so you’ll want to consult with an attorney before deciding which legal entity works best for you.

That’s not in My Job Description

Be sure to clearly define the responsibilities of each partner, including how many hours everyone is expected to commit to the business each week. One partnership I know of involved two roommates. While one of them was busy at his computer each day, building a web app they intended to sell, the other lounged around the pool or sat watching television rather than looking for clients. When his other partners approached him on his lack of effort, it became apparent that, while he was an experienced salesperson, he didn’t know how to prospect for new business, nor had they made it clear that they expected him to do so. Mis-managed expectations like that can make or break a partnership very quickly. Even if your partner is your twin brother or your best friend from third grade, treat it like a business venture.

Plan Your Escape

Having an exit clause is important when forming a partnership. As Steven Covey recommends, begin with the end in mind. This is a good philosophy for every point of partnership formation.

Exit or buyout clauses are generally for corporations where two or more owners have equal shares in the company, and equal investment and involvement. But even with a general partnership, it’s still a good idea to draft one, especially when division of assets might be an issue. If you and your partner go separate ways, yet still intend to conduct business as sole proprietors, who gets your clients? What happens if one partner dies? In the absence of an agreement, you could find yourself in business with a spouse you never intended to have as a partner.

Not every partnership ends badly (mine didn’t), but it’s best to agree beforehand what will happen in the event that one partner wants out. Again, seek legal counsel.

Make a Profit on Yourself

Sometimes, what seems like a disadvantage turns out to be an advantage. As a sole proprietor, you have complete autonomy over your business and the decisions you make. No so with a partnership. This means that when a client pressures you to drop your price—and you’re tempted to do so to win the bid—having a partner becomes your escape valve. It’s not just you; now you’re a company, one with established rates.

So you no longer base your price on how long it takes you. Besides, your time involved is not really the issue. People buy because of real or perceived value, not how long it takes a vendor to produce something (if that were the case, Nike shoes would cost less than $20). Simply put, what is the worth of this site to your client? How much does he stand to make from it over the next year? Your cost ought to be based on that, not on your time involved. But I digress …

My point is, when you’re a partnership you ought to have a standard rate you charge. A business pays both itself (profit) and its employees (wages), so as partners, treat yourselves and the business as separate entities, even if you aren’t so legally. Determine your break-even point by calculating the time necessary to build a basic site, then multiplying that by how much money per hour you want to earn. This becomes the minimum amount the company will pay you per project. Once you know this, treat it like a hard cost, then mark it up appropriately so that the company makes a profit and puts some money in the bank. Once you do this, it’s easier to stand your ground when a prospect begins “negotiating.”

These are just a few of the things to consider when forming a partnership, so plan wisely. The pain of a breakup can be akin to divorce. A good rule-of-thumb is to expect the best but be prepared for the worst.

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  • http://www.viewpoint.pro Dan King

    Great advice! LLCs are good way to go for single-person shops too.

  • Charles R. Perry

    I am a lawyer licensed in California and have helped a number of people form, manage, and dissolve their businesses. The issues Mr. Tabita discusses are important to consider when forming a business, but there are many more that need to be addressed. Legalities also vary not only from country to country, but from state to state within the US as well. California’s state income tax system, for instance, can catch a new business by surprise.

    A good set of documents is essential to minimizing the risk of future problems, especially when substantial amounts of money are involved. When I say “good,” moreover, I mean documents tailored to the business, people, and sums of money involved. I do not mean fill-in-the-blank forms pulled off the Internet, with little consideration of what those documents say or whether they are suitable for the situation at hand. One of the largest pieces of litigation I ever worked on involved an ambiguous three-word phrase in a form contract (though that particular contract was not a partnership agreement).

    I also acknowledge that lawyers are expensive. A competent lawyer that is consulted judiciously during all phases of the business, however, will help the parties identify and address issues and potential problems before they materialize, and can result in the savings of thousands of dollars in legal fees and liability to third parties later on. Think of it as akin to consulting a doctor for various types of medical screening, in the hopes of avoiding a major medical problem in the future.