Which Terms Should Be Included in a Partnership Agreement?

Reviewed by Margaret JamesFact checked by Yarilet PerezReviewed by Margaret JamesFact checked by Yarilet Perez

Partnerships can be complex depending on the scope of business operations and the number of partners involved. To reduce the potential for complexities or conflicts among partners within this type of business structure, the creation of a partnership agreement is a necessity. A partnership agreement is a legal document that dictates the way a business is run and details the relationship between each partner.

Although each partnership agreement differs based on business objectives, certain terms should be detailed in the document, including the percentage of ownership, division of profit and loss, length of the partnership, decision-making and resolving disputes, partner authority, and withdrawal or death of a partner.

Key Takeaways

• Many small businesses are organized as partnerships, which require formal documentation before being established.
• The partnership agreement spells out who owns what portion of the firm, how profits and losses will be split, and the assignment of roles and duties.
• The partnership agreement will also typically spell out how disputes are to be adjudicated and what happens if one of the partners dies prematurely.

Percentage of Ownership

Within the partnership agreement, individuals commit to what each partner is going to contribute to the business. Partners may agree to pay capital into the company as a cash contribution to help cover startup costs or contributions of equipment, and services or property may be pledged within the partnership agreement. Typically these contributions dictate the percentage of ownership each partner has in the business, and as such are important terms within the partnership agreement.

Division of Profit and Loss

Partners can agree to share in profits and losses in line with their percentage of ownership, or this division can be allocated to each partner equally regardless of ownership stake. It is necessary these terms be detailed clearly in the partnership agreement in an effort to avoid conflicts throughout the life of the business. The partnership agreement should also dictate when profit can be withdrawn from the business.

Length of the Partnership

It is common for partnerships to continue operations for an unspecified amount of time, but there are instances where a business is designed to dissolve or end after reaching a specific milestone or a certain number of years. A partnership agreement should include this information, even when the time frame is unspecified.

Decision-Making and Resolving Disputes

The most common conflicts in a partnership arise due to challenges with decision-making and disputes between partners. Within the partnership agreement, terms are laid out regarding the decision-making process that may include a voting system or another method to enforce checks and balances among partners.

In addition to decision-making procedures, a partnership agreement should include instructions on how to resolve disputes among partners. This is typically achieved through a mediation clause in the agreement meant to provide a means to resolve disagreements among partners without the need for court intervention.

Authority

Partner authority, also known as binding power, should also be defined within the agreement. Binding the business to a debt or other contractual agreement can expose the company to an unmanageable level of risk. To avoid this potentially costly situation, the partnership agreement should include terms relating to which partners hold the authority to bind the company and the process taken in those cases.

Withdrawal or Death

The rules for handling the departure of a partner due to death or withdrawal from the business should also be included in the agreement. These terms could include a buy and sell agreement detailing the valuation process or may require each partner to maintain a life insurance policy designating the other partners as the beneficiaries.

How Is Ownership Percentage Determined in a Partnership Agreement?

Ownership percentage typically reflects each partner’s financial or asset contribution to the business, though it can also include other factors, like expertise or time commitment. Some partnerships allocate ownership equally regardless of financial input, while others align it strictly with initial contributions.

What Happens to a Partnership if One Partner Wants to Leave?

A well-crafted partnership agreement will include exit strategies for when a partner decides to leave, covering options like selling their stake to existing partners or a third party. Many agreements also contain a buy-sell clause, which details how the departing partner’s share is valued and purchased, ensuring a fair and manageable transition. Without such terms, the departure could disrupt operations and lead to legal or financial challenges for remaining partners.

Why Is a Partnership Agreement Necessary if Partners Trust Each Other?

Even if partners trust each other, a written agreement is critical to prevent misunderstandings and ensure clarity on critical business issues. Verbal agreements or informal arrangements may work initially, but as the business grows or changes, having clearly defined roles, decision-making processes, and profit-sharing expectations in writing protects both the business and the relationship between the partners. A partnership agreement also provides a legal framework to handle disputes or unforeseen events, such as a partner’s withdrawal, more smoothly.

The Bottom Line

A partnership agreement is an essential document for business partners, laying out the structure, roles, and guidelines for running a business. It defines each partner’s ownership percentage, profit and loss allocation, and contributions, and outlines the process for decision-making, dispute resolution, and handling the departure or death of a partner.

Clear terms in these areas help prevent conflicts and ensure smooth operations. Overall, a well-crafted partnership agreement acts as a safeguard, setting a firm foundation for long-term business stability and cooperation.

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