Thinking About Bringing Partners Into Your Small Business? This Is Everything You Should KnowBarb Weidner
Personal partnerships and business partnerships have a lot in common. But, unlike a spring fling, a small business partnership is founded on the promise of long-term success.
Once you have your idea solidified and your partner’s on board, together you have the chance to turn your relationship into a money-making venture for years to come. The key, however, is to not get overwhelmed during the honeymoon phase—otherwise, you might get burned like so many partnerships that are rushed into.
To help you navigate the sometimes-messy terrain of a small business partnership, we put together this quick walkthrough to starting a joint venture. From there, we’ll touch on the many common pitfalls we see business partners run into, so you make your venture last.
What to Know Before Starting a Small Business Partnership
Partnerships combine the unique skills of each business partner to create an intellectual synergy that benefits everyone. What one partner lacks, another brings to the table—this way, complementary skillsets can compensate where one’s might be inadequate.
Forming a partnership sounds like an easy decision, right? However, starting a partnership should not be taken lightly. Like marriages, many partnerships end in divorce.
But if you feel confident that you’ve found “the one” for starting a small business partnership with, then you need to first decide on the basic corporate structure of your company.
When we’re asked, “what is a business partnership”, our first response is to throw back another question: what kind of business partnership do you have? Here are the three most common partnership business types:
- General partnership
- Limited partnership
- Limited liability partnership
General partnerships are formed when all partners accept mutual responsibility for the company’s debts and operations. By contrast, limited partnerships involved varying levels of involvement, with some partners taking a more hands-on role in operations while others simply stay on as investors.
Limited liability partnerships are slightly more complex. These arrangements limit each partner’s degree of personal financial responsibility so that they’re only partially responsible for and vulnerable to the debts and legal obligations of the company.
Know Your Roles
If you’re certain that you need a business partner to build a successful company, then you need to know how to be a business partner yourself. To do this, you need to make your respective roles and expectations clear from the start. There should be no assumptions in a partnership. In a general partnership, the division of labor should be specified in the company’s operating agreement.
Dealing With Debt and Liabilities
A partnership in business implies that the debts and liabilities of the company are the mutual responsibility of the involved partners. To prevent downstream conflict, discuss each of your sensitivities to debt—how much debt and risk are acceptable, and how much are you comfortable being liable for?
Partnerships and Taxes
We are often asked “how do business partnerships work” when it comes to taxes. Like sole proprietorships, partnerships do not have to pay small business taxes. Instead, Form 1065 is used to report business expenses and income to the IRS, but only the value of each partner’s share of the company is taxed at the personal level.
Why Form a Partnership?
Starting a business with a partner comes with a variety of advantages over formally incorporating a business entity. For instance, there’s no paperwork that needs to be filed with your state’s Secretary of State. Instead, all you have to do is draw up an operating agreement to start a general partnership.
Better yet, general partnerships as “pass-through” entities, which implies that the individual partners themselves are the ones who are taxed—not the company. This makes filing income taxes more streamlined than it would be under a corporate structure.
One often overlooked benefit of forming a business partnership rather than a corporation is that the prospect of becoming a partner is seen as attractive to many employees. For instance, associate jobs in LLP law firms are highly competitive due to the potential for upward mobility within the organization.
The Drawbacks of a Partnership
General and limited partnerships have their share of setbacks too. For example, each partner is on the hook for the debts and liabilities of the company, which implies that each partner can potentially be sued by a lender or creditor. As such, a partner’s personal assets are always vulnerable to risk under a partnership agreement.
When a partner contributes assets to the company, these too are at risk. Since all assets are owned jointly by the partners, there is no guarantee that you’ll be able to retrieve them if the business folds.
Starting a Partnership the Right Way
Knowing how to start a partnership begins with knowing how to find the right business partner. But, assuming you’ve already narrowed down the right partner to start a venture with (ideally, one who is compromising and who supports your weaknesses), you must decide whether you want a general or limited partnership and how profits will be divided between the shareholders.
With this step out of the way, you need to settle on a business name. Typically, limited liability partnerships have the acronym “LLP” embedded right in the name (i.e., Smith & Johnson LLP). Once the name is decided, register it with your state as a Doing Business As (DBA).
When it comes time to secure funding for your partnership, you will first want to apply for an Employer ID Number (EIN) and ensure that all internal documents are up-to-date and spell out the value of each partner’s share. The valuation and percentage of shares held by each partner will also be stated in the company’s partnership agreement, which should cover all of the contingencies and “what if” scenarios that may arise.
Last, you need to register your partnership with your state tax authority for all sales taxes and with the federal government through the EFTPS Payment System. Depending on your industry, you may need to acquire permits or licenses to operate. Consult with an attorney to help you draft your partnership agreement and become compliant with licensing regulations
Taking it Step-by-Step
To summarize the instructions laid out above, we’ve listed the key takeaways to help you get started with your partnership quickly:
- Decide on your partnership type and business name
- Register with your state
- Get an EIN from the IRS
- Draw up a partnership agreement
- Acquire licenses and permits
- Consider consulting an attorney
Mistakes to Avoid
Even partnerships with plenty of expertise and working capital can fail during the early days of the venture. To ensure that your small business partnership stays afloat for the long haul, consider this list of common pitfalls that throw upstart partnerships to the wayside:
Partnering Instead of Hiring
Small business partnerships are sometimes founded out of a desire to avoid a payroll. That is, the first partner can’t afford to hire the second, so instead they bring the second partner aboard and share expenses and profits.
The catch is that now both partners will work against each other and are now liable for each other’s obligations according to the partnership agreement.
Not Drafting a Partnership Agreement
Every small business partnership needs a signed partnership agreement, period. To be sure, have an attorney draft a comprehensive agreement that expresses each partner’s interests, and have it notarized. If a conflict arises later down the road, defer to the agreement for clarification.
Jumping Into a General Partnership
It’s often assumed that a general partnership, given its lax structuring rules, is the natural default for a small business partnership. Instead, consider forming a limited partnership. This way, limited partners won’t be liable for the obligations of other partners. As the saying goes, fences often make for better neighbors.
Lacking an Exit Plan
Like a prenuptial agreement, an exit agreement sets forth the terms on which you and your partners will walk away from the company in the event of its demise. The exit strategy should be embedded in your partnership agreement and drafted by an attorney, with clauses that allow for partners to buy out other partner’s shares.
Not Having a Boss
Leadership is often sorely lacking in even 50/50 partnerships. This is why we recommend 70/30 or 60/40 partnership agreements, so there’s a clear business leader who can assume accountability for bookkeeping, maintenance, payroll, and strategic direction.
A small business partnership is rarely a union of equals. Instead, there’s often one partner who takes operational control. The imbalance in duties must be reflected in the initial partnership agreement, which should also include provisions for one partner to buy out the other’s shares should one partner want to leave.