This article discusses the exit strategy behind, and the steps involved in, dissolving a general partnership. It touches on the type of agreement that might be used to document clear arrangements on the dissolution of a partnership and emphasises the importance of setting out in detail the allocation of responsibilities and assets at a time that could be rife with sensitivities on both personal and business levels.
- Things to consider when entering into a business partnership
- Equity in a business partnership
- Do you need a business partnership exit strategy?
- What is an effective exit clause in a partnership agreement?
- Common problems facing partnerships in business
- What is a dissolution agreement?
- How to leave a business partnership
- How to divide a business partnership
- Dissolving a business partnership without a partnership agreement
Things to consider when entering into a business partnership
Entering into a business partnership raises a number of considerations for the potential partners to think about. A lot will depend on the facts and circumstances surrounding the business and the purpose of the partnership. Even if partners want broadly the same end result, each partner will have their own interests and reasons for joining the partnership.
When things are going well it is easy to fall into the trap of thinking that a partnership agreement is unnecessary but putting in place a legally binding document that sets out each party’s rights and obligations can save time, cost and unnecessary partnership disputes in the future, for example, if the parties need clarification on matters such as how the partnership should operate, how profit is allocated, how much each partner should contribute to the business as well as how decisions are made.
One of the key considerations a partnership should decide on at an early stage is what happens when a partner wants to leave or if it is decided that the partnership should end.
Deciding on the legal structure of your business partnership is a crucial decision that will affect how easily your business partnership is able to be dissolved. This article discusses business partnerships that adopt a legal partnership structure – this is a form of partnership that has to comply with the Partnership Act 1890 (PA 1890).
The PA 1890 describes a partnership as ‘the relation which subsists between persons carrying on a business in common with a view of profit’. It is not a separate legal entity and will usually be governed by a partnership agreement between the participants.
There may be certain tax advantages for being recognised as a legal partnership and the parties should investigate this further. The potential risks of using a partnership structure include the fact that partners could be jointly liable for the other partners’ actions on behalf of the partnership without any limit on that liability. Assets that are contributed or transferred to the partnership will be committed to the partnership but are often dealt with in accordance with the partnership agreement and so it is advisable to take legal guidance on the drafting of the partnership agreement to ensure that your interests are protected.
Equity in a business partnership
Certain types of partnership will allow for partners to become ‘equity partners’, meaning that they own a share of the business in exchange for contributing an amount of capital to the business.
For businesses set up as a company, this means that the business partners will own shares in the company and will be entitled to dividends. For non-company partnerships, an equity partnership agreement can be drawn up setting out the proportion of each partner’s interest in the business and their entitlement to a percentage of the partnership’s profits. The agreement should also state how much capital each partner is required to contribute. Usually equity partners will each be given a capital account for their capital.
Equity partnership has tax implications as equity partners will be treated as being self-employed rather than as employees of a partnership. This means that on taking equity, a partner’s current employment status will end and so it is important for partners considering taking an interest in the business to seek professional advice on the personal consequences of doing so.
To be personally protected as an equity partner, there is an incentive to request that a formal agreement be put in place setting out how capital and assets will be treated on an equity partner leaving or if the partnership as a whole is dissolved.
Do you need a business partnership exit strategy?
To avoid unnecessary costs and disputes between partners, it is advisable to plan in advance what happens if the partnership is considered to be no longer needed or desired by most of the partners. As a partner you do not want to be ‘trapped’ in a partnership that you do not want to be in, nor do you want to have to carry a partner that no longer wants to be involved in the business or has become detrimental to its success.
A day may come where the business is no longer viable and becomes insolvent and again, it is advisable to have an exit strategy for what will happen in advance of the event occurring to make sure that the process runs smoothly.
If you do not include a comprehensive exit clause in your partnership agreement then the terms of the PA 1890 can apply to the dissolution of your partnership. There are many reasons why this may not be suitable for your business, particularly if your business is well established or contains an uneven contribution of assets (as then the partners will no doubt want some control over how the partnership ends and how assets are distributed).
The PA 1890 provides a number of ways to dissolve a partnership and includes rights of dissolution on a unilateral basis. This will not always work for business partnerships that require certainty of their existence – most partnerships will not want the risk that one partner acting individually can technically dissolve the partnership, as this will have consequences for, among other things, the business, its employees, its customers and any financing that it may have.
What is an effective exit clause in a partnership agreement?
An effective exit clause in a partnership agreement will deal with the situations where the whole partnership is to be dissolved and eventually wound up. There usually will be a separate clause dealing with what happens when a partner leaves the partnership.
An effective exit clause should acknowledge the provisions of the PA 1890 governing the dissolution of a partnership but can also modify or disapply them to the extent necessary to ensure that the exit strategy of the partnership reflects what has been agreed between the business partners.
A typical exit clause will:
- Disapply the PA 1890 provision that a ‘partnership at will’ (this being a partnership that does not have a fixed expiry date for the duration of the business partnership) can be terminated on the notice of one of the partners. The reason for doing this is to avoid a dissolution by one partner without the agreement of the rest of the partnership and to avoid the uncertainty of the partnership being able to be terminated without the consent of a majority or all of the partnership. If a partnership has a fixed term then it will automatically dissolve on the expiry of that term (be it a specified date or at the end of a particular project), unless the partnership agrees otherwise and documents it in the partnership agreement.
- Disapply the PA 1890 provision that a partnership can be dissolved automatically on the date that one partner dies, becomes bankrupt or if a partner allows a charge to be put over its share of the business. The dissolution will take place on a partner’s death, even if the partnership is for a fixed term that still has time to run. Again, this prevents one partner causing the partnership to end without the agreement of the other partners and most modern partnerships exclude this provision but may include it as a reason for expulsion of a partner.
- If the partnership is ending, deal with how the partnership should be wound up and assets divided up – either by bespoke provisions agreed by the partnership or by relying on the provisions of the PA 1890, and if there is no bespoke provision for a particular subject deciding whether the terms of the PA 1890 should apply as a default position.
The partnership agreement might also include a provision to permit a majority of the partners to be able to force a partner to leave the partnership. This is called an ‘expulsion’ clause. Reasons for expelling a partner from the partnership must generally be objective and could include breaching the partnership agreement, the expelled partner’s bankruptcy or insolvency, or their negligence, misconduct, or incapacity to act.
Alternatively, the partnership agreement could be drafted so that the partners have the option to suspend the partner instead of expelling them straight away. This has the advantage of ensuring business continuity.
Common problems facing partnerships in business
A common problem facing business partnerships is lack of foresight and planning for the future. If the business is particularly new, or commercially sensitive, it might seem unnecessary to set up a rigid structure or put in place a legally binding agreement at a time when the partnership’s assets and liabilities are small or the project is secret. The problem is that issues usually arise quickly and in an unanticipated manner and it is better to be thoroughly prepared so that when these events arise, the business has a roadmap as to how to deal with disputes or uncertainties in strategy or management.
Another problem can occur where there is uncertainty over the allocation of profit share or even the division of ownership of the business. In a partnership this should be well documented and agreed between the partners as it can have repercussions when things go wrong, for example if emergency funding for the business is needed, the partners need to know who should contribute and in what percentages. One way to do this would be that partners contribute in the percentage of their ‘share’ in the business. If it is not clear who owns what, then requiring some partners to contribute more than other partners could be difficult.
Another problem could come when the partnership incurs a liability. In a partnership, the partner assets are committed to the partnership and so one partner’s wrongdoing or debt could end up being the responsibility of an uninvolved partner. Working out how best to limit partner liability or to be compensated for any wrongdoing of another partner may be something worth exploring at the start of the business.
Other common problems that partners in partnerships encounter include not being clear on the right tax arrangements for the partnership or not complying with any regulatory or legal obligations required to operate the partnership. These pitfalls can be avoided by seeking professional advice at the right time (plenty of time before any relevant deadline).
What is a dissolution agreement?
There are several ways to dissolve a partnership under the PA 1890. When partners all decide that the partnership should come to an end, irrespective of what is written in their partnership agreement, the PA 1890 states that they can all agree to dissolve the partnership and a dissolution agreement can be put in place.
Usually all of the partners are required to agree unless the partnership agreement states otherwise and allows that a certain majority of partners have the right to dissolve the partnership. It is better for the partners to all agree in writing that the partnership is ending but there has been case law to suggest that in some circumstances conduct (such as arguing between the partners, the final accounts being created or the creation of new partnerships by the partners) may be enough for a court to conclude that a partnership has ended. If the partnership has been established for a fixed term then the dissolution agreement can also dissolve the partnership before the end of the term.
In summary, if the partnership agreement does not specify the details of dissolution of the partnership then a dissolution agreement can be put in place and signed by all (or if allowed, a majority) of the partners. It should state that it has been agreed to terminate the partnership and set out how the division of assets and responsibilities in respect of the business and the ending of the partnership will be allocated between the partners.
Key terms can include what happens to liability for any debts of the partnership, what happens to the business name, clients and unfinished projects, how intellectual property, real estate and other assets should be divided, who prepares the final tax payments and accounts, and what happens to any records or documentation of the partnership. The partners may also want to think about how insurance arrangements and compliance with industry bodies or other regulatory authorities are dealt with following dissolution of the partnership.
How to leave a business partnership
If a business partnership is governed by a partnership agreement, the terms of the agreement should govern how and when a partner can leave the partnership. The partners may have agreed to a ‘lock in’ period in which partners may not be allowed to leave the partnership (usually this is while the business is becoming established to ensure continuity and secure a status quo for the business).
Under the PA 1890, unless the partners have agreed otherwise, a partnership established for an undefined term can be dissolved by any partner giving notice to the other partners of their intention to dissolve the partnership. Notice that a partner wants to leave has to be given to all of the partners in the partnership and it is best practice to give such notice in writing. The effect of a partner leaving in this manner (unless the partnership agreement says otherwise) is that the partnership will be dissolved from the date stated in the notice. As stated above, it is usual for a partnership agreement to exclude this right due to the business uncertainty it could cause.
A partnership agreement will usually contain provisions that govern what happens if a partner leaves such as stating whether the exiting partner will have any right to receive any profit or interest created by the assets or the business of the partnership after they have left. This is important, otherwise under the PA 1890, the partner may be entitled to either a court allocated share of the profits made since the dissolution or to annual interest of 5% on the amount of their share of the partnership assets. Leaving accounts will often be drawn up by accountants and the assets valued at market value. The exiting partner will then usually be paid a sum made up of any capital credited to their account, any undrawn profit share, and any other sums such as loans or interest due to them.
The partnership agreement may also include some restrictive covenants over what can and can’t be done by an exiting partner after they have left. These should be appropriate and reasonable based on the facts and circumstances surrounding the partnership and it is worth seeking legal advice on the enforceability of these provisions to make sure that they are not too aggressive and anti-competitive.
Including a time limit on these restrictions is a good idea so that the outgoing partners are not stopped from doing certain acts forever. Alternatively, you might qualify the restrictions by saying they apply unless the partnership agrees otherwise. Examples of these covenants include trying to solicit customer business away from the partnership, working for a current customer of the business, creating an identical or similar business that competes with the business, or trying to solicit employees away from the partnership.
Other provisions that a partnership agreement may contain for leaving partners include requiring the exiting partner to return any know how or confidential records or information to the partnership and requiring that the exiting partner provides reasonable assistance to the partnership to ensure that assets are recoverable by or transferred to the remaining members of the partnership once the exiting partner leaves.
If a partner is leaving the partnership, notice will usually be given to the London Gazette and any other appropriate newspapers stating that there has been a change in partnership and any third parties that are or have recently been dealing with the partnership need to be notified of the change to the partnership and that the partnership will continue (on the terms of the current partnership agreement).
The partners should then decide how the vacant ‘share’ of the exiting partner should be allocated between the remaining partners. This may need some consideration from a tax perspective and so it is wise to seek professional advice on the allocations.
How to divide a business partnership
Once a solvent partnership has been dissolved, the assets of the business can be wound up and divided amongst the partners. To do this, all of the assets of the partnership will need to be valued, any debts and liabilities of the partnership paid off and then the remaining amounts distributed to the partners.
If a business wants its assets to be distributed in a particular way it should include the details of distribution in its partnership agreement otherwise the PA 1890 provisions will apply (see below) or the division of distributions may be decided by a court order. By law, the partners retain their authority as partners so that they can effectively wind up the assets and affairs of the business and the terms of the partnership agreement will continue to apply (and so this means that they could theoretically finish doing business for the partnership after it has been dissolved if it is required to wind up the affairs of the business). Creditors can also continue to claim against the partnership after its dissolution.
The PA 1890 sets out how the assets of a partnership will be wound up if there are no overriding provisions set out in the business’ partnership agreement.
|1||Losses are paid for out of profits and then out of capital by the (solvent) partners in the proportion in which each partner is entitled to profit share.|
|2||Assets (including the sums, if any, contributed by the partners to make up losses or deficiencies of capital) are to be used in the following order: to pay the partnership’s debts and liabilities owed to non-partners; then to repay to each of the partners any advances (as opposed to capital) made by them to the partnership (advances include loans); and then to pay any capital owed to each partner.|
|3||If, after paying all debts and liabilities, there is not enough to repay all of the partners’ capital, the amount of capital which cannot be repaid will be treated as a loss to be divided between the partners in the proportion of their profit share.|
|4||The ultimate residue, if any, will be divided among the partners in the proportion in which profits are divisible.U.K.|
|5||Sums that may be distributed between the partners could also include any premiums on the capital contributions paid by partners for joining the partnership which can be given back to those partners. It is prudent to make sure that the partnership agreement sets out whether or not such premiums are repayable on early termination or dissolution of the partnership. Under the PA 1890, the premium will not be repaid if the partners agreed to dissolve the partnership.|
|6||Any sums due to exiting or deceased partners will be treated as a debt accruing at the date of dissolution or death, unless agreed otherwise between the partners.|
Dissolving a business partnership without a partnership agreement
If a partnership does not have a partnership agreement in place, it can still be dissolved in a variety of ways, most of which have been described already and that are provided for by the PA 1890.
If a business partnership has been formed for a particular purpose or has a fixed term, the partnership will automatically dissolve at the end of that term or on completion of the project. The issues come when it is not clear on what date the project has ended and so it is important to make sure that the end date is agreed between the partners as early as possible into the business partnership.
If the partners have not agreed otherwise (and there is no evidence of such agreement in a partnership agreement), the partnership can automatically dissolve if a partner dies, becomes bankrupt or if a partner allows a charge to be put over its share of the business. This again highlights the importance of having a partnership agreement in place to ensure that the business partnership has sufficient certainty of its existence. The exclusion of this provision in a partnership agreement can help the business to feel secure to trade without the threat of dissolution by an individual partner.
A court can also dissolve a partnership if the dissolution is requested by a partner or the subject of the dissolution becomes contentious. The court will look for just and equitable grounds for the dissolution (for example deadlock between the partners, the business can only be carried on as a loss making enterprise, or if a partner is incapacitated, or for the misconduct of a partner that causes detriment to the business, or if it is not reasonable to carry on the partnership).
Any court action will be costly, and just confirms the benefits of putting a well drafted partnership agreement in place at the start of the partnership, saving time, money, and unnecessary distress.