“Ask the Business Attorney” – What’s Wrong with a Partnership?

by Scott Edward Walker on June 30th, 2010

Introduction

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs); it is part 3 of 3 of my posts on choice of entity.  Two weeks ago (in part 1), I discussed what’s wrong with an LLC.  Last week (in part 2), I discussed what’s wrong with a sole proprietorship; and this week I’ll address what’s wrong with a partnership.  Please shoot me any questions you may have in the comments section.  Many thanks, Scott

Question

I’m a student at Stanford, and my classmate and I are launching a new web venture.  We agreed to split the ownership 50-50, and I found a good partnership agreement template on the web to reflect that.  I was wondering if there are problems with us just being partners for now, and then perhaps incorporating down the road.

Answer

Yes, unfortunately there are a number of big potential problems with respect to you and your co-founder forming a partnership (referred to in legal parlance as a “general partnership” as opposed to a “limited partnership”).

First, there is a significant issue from a personal liability perspective.  Indeed, a partnership is like a sole proprietorship on steroids – meaning that not only will you have unlimited personal liability for all of the business’s activities (like a sole proprietorship), including its debts and liabilities, but also you will have unlimited personal liability for the acts of your co-partner within the ordinary course of partnership business.

For example, if your co-partner executes a consulting agreement on behalf of the partnership with a developer, and the partnership breaches that agreement for whatever reason, the developer could sue the partnership and you personally.  (This would not be the case if you formed a corporation or a limited liability company.)

In addition, you also would generally be personally liable for any tortious acts of your co-partner committed within the ordinary course of partnership business.  And the same problem arises if you hire an employee: any related liability could flow through to you personally.

Second, as I have previously discussed, it is imperative that the equity of your co-founder vest over time (usually for four years and sometimes with a one-year “cliff”) to avoid a situation where he or she exits the venture early (e.g., after a few months), but still maintains ownership of half the company.  It is highly unlikely that your template addresses this issue.

Third, each partner has a fiduciary obligation to the other partner with respect to all matters affecting the business – which is an extremely high legal standard requiring undivided loyalty, good faith and fair dealing.  This standard has led to quite a bit of litigation between/among partners, including allegations of conflicts of interest and self-dealing.

Fourth, if there has been and/or will be any intellectual property (IP) created by your partner, there are some tricky issues with respect ensuring that the IP is assigned to the company.  Again, it is highly unlikely that your template addresses this issue, and this could cause significant problems and complications in the event of your partner’s departure (similar to the vesting issue).

Finally, angels and other sophisticated investors will never invest in a partnership (due to the potential personal liability and other issues) and will generally require you to convert the partnership to a corporation.  Such a conversion, however, can be complicated and costly and can create significant tax problems (this issue is discussed in my post on LLC’s – which are also governed by complex tax partnership rules).

Conclusion

The bottom line is that a general partnership has limited utility for entrepreneurs and should be avoided due to the unlimited personal liability of the owners and the other issues discussed above.  For those of you who are interested, a couple of months ago I wrote a lengthy post on the choice of entity for entrepreneurs, which summarizes most of the information in this three-part series.

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