The Ins and Outs of Partnership Ownership
When it comes to business partnerships, ownership rights are an important piece of the puzzle. In the simplest of terms, this means that, in exchange for their investment in the company, each partner involved has a say in how that company is run, as well as the profits generated from its operations.
In modern business law, these ownership rights are more nuanced than they used to be, with the introduction of the limited liability company (LLC) — but they’re still present and very important for owners of partnerships.
Ownership rights determine how business is run
The most basic form a joint venture or partnership agreement takes is that every partner in the business gets an equal say in how the business is operated. They’ll weigh in on big decisions affecting the future of the company, such as leadership changes, acquisition destinations or financing opportunities. Each partner has a voice in how the company’s assets are used.
Consider the opposite scenario, involving a solitary business operation. It’s understood that the owner has complete control over how the company is run and how its assets are allocated. As the sole stakeholder, all matters are in their hands. But in a partnership , the presence of other owners means shared interests in the goals pursued by the business.
Partnership agreements delineate each owner’s interest
The backbone of any proper partnership should be a partnership agreement. This document serves to define ownership interests in the company, as well as to separate assets and determine how to handle company matters. Unfortunately, many partners enter into agreements with minimal documentation, opting to "go with the flow" on business matters. However, this hands-off approach can be problematic, especially when it comes to dissolving the partnership or determining who gets certain business interests.
Partnerships are governed by state law, which details how business assets can and cannot be divided among partners. Typically, if a business does not have a partnership agreement or it’s not sufficiently detailed in its explanation of the ownership interests within the business, then legal statutes will apply to determine how everything is divided.
Protect your business with a partnership agreement
It’s a good practice to invest the time and money in a partnership agreement that can clearly state the stakes for each partner in the business. In the event the partnership needs to be dissolved, the business assets should be clearly defined and documented. This alleviates stress down the road for a partnership when a business needs to split up assets or go their respective ways.
How the Partnership Agreement Affects Ownership
When considering whether the sale of a partnership interest is permitted without consent, one must first look at the specific terms of an effective partnership agreement. The terms guiding the transfer of ownership always govern—assuming the partnership agreement is valid and enforceable. The provisions governing the transfer of ownership interests in a valid partnership agreement will dictate the rules.
Key provisions and clauses that typically control these transfers are buy-sell provisions and/or drag-along rights in the partnership agreement. Depending on the partner or parties to the agreement, one type of clause may be more favorable than another. An interested party should analyze the terms of its current agreement for those clauses related to ownership transfers. In the absence of an appropriate partnership agreement, the relevant statute will control and state law typically supports a partner’s ability to sell its interest.
A partnership agreement with provisions allowing the current partners to approve or disapprove of ownership interest transfers before they occur in order to prevent unwanted or undesirable partners cannot be taken lightly. Of course, all partners are likely to agree these provisions are not intended to permit preventing a partner from transferring its interest, only to preserve control over the type of incoming partner. And to hold onto such rights in a subsequent business transaction, the parties will require that right be maintained after the transaction closes.
When an agreement includes both the right of first refusal to other partners and drag-along rights including the right to redeem the partnership interest, it may seem like a conflict, but an applicable state statute may allow both the partnership and the partners to redeem the interest before the remaining partners have a chance to accept the offer. Allowing the purchase of the interest through drag-along rights, the remaining partners will receive the same amount as if they were buying the interest themselves and redeeming it.
The Legal Limitations on Selling Without Consent
A partner cannot just turn around and sell his or her ownership interest to a competitor, an outside third party or even to another partner without the consent of the other partners. In fact, there may be such restrictions in the operating agreement or the bylaws. For instance, many agreements contain restrictions on who a partner may transfer his or her interest to. Depending on the type of entity (e.g., whether a corporation, limited liability company or partnership) certain statutory filings may be required before selling or assigning ownership. In fact, if an ownership interest is sold without authorization, not only can the other partners sue to set aside the transaction, but the selling partner could wind up with no return on the investment.
Once the new partner goes through the process of obtaining approval, a new operating agreement may need to be executed to reflect the new ownership. A buyout may be able to take place without going through a sale if the operating agreement has an appropriate buy sell provision. A buy sell provision provides the mechanism for a partner’s exit. These provisions are usually binding on the remaining partners as well as the new partner. Thus, even if approval is not needed, the buy sell can include a requirement that the new partner is bound by that agreement.
State Regulations Affecting Business Partner Sales
Some state laws can affect a business partner’s ability to sell. If you’re in a state that has adopted the Uniform Partnership Act, there may be restrictions on how much the partner can sell their interest. Some states limit the ability of a business partner to transfer his or her interest to a spouse or other family member. There may be state laws that require a buyout agreement to be followed even if that agreement was not written in accordance with the state’s laws. In some other states a partnership agreement that is not written following the law cannot be enforced at all.
The Uniform Partnership Act, adopted by 38 states, makes the concept of a partner having a "freeable transferable interest" a bit more complicated. In the Uniform Partnership Act, a business partner can freely sell his or her interest to an outsider. If the sale is to someone that the other partners are able and willing to accept then the buy-out agreement will work to protect the company from being sold to a competitor. If the buy-out agreement is not followed the state law will provide an alternative.
If the sale is to a person that the company either does not accept or is not able to function well with, there are several things the remaining partners can do. Under some circumstances unilateral withdrawal from the partnership may be available. The business partner who would like to sell most likely will not prefer this type of outcome. Recapture rights of the Capital Accounts may be imposed, but this is usually reserved for clear cases of bad faith conduct by the selling partner. The selling partner may also be forced to sacrifice future profits. This forfeiture will only happen under a few circumstances, such as when the selling partner competes with the business during the 2-year period following the termination.
Different business entity types have additional rules that apply. For example, if the business is a Limited Liability Company ("LLC") that is considered a partnership for tax purposes the member’s interest may not necessarily be freely transferable. The member will have the right to receive their proportionate share of all profits and losses as well as the right to distributions but the member’s right to participate in management of the LLC will remain with the remaining members. In other words, the partner’s freedom to choose from whom they purchase services will be impaired.
An agreement to buy out a member’s interest in an LLC may be more difficult to enforce than a partnership buy-out agreement. It is important to understand the state laws applicable to a business entity because these will help determine the above.
Resolving Issues from a Sale Between Partners
Disputes between partners can happen for a number of reasons. Partners might feel that they can agree on the value of a business today but they may not agree on the price of a business sold five or ten years down the road. It’s common for partners to have disagreements about business loans and debt and over who should be in charge of the day to day management of the company. When these disagreements arise, it’s not uncommon for one partner to want to sell and to do so without the other partner’s consent.
There are a number of methods of dealing with this scenario, including mediation, arbitration and legal action. Mediation is a process by which you and your partner sit down with an independent third party who will facilitate a discussion and hopefully help the two of you reach an agreement. Usually, the mediator will not make a ruling but will instead dig deeper and continue the conversation until a resolution is found.
Arbitration is a method in which the two parties submit to a neutral third party that hears both sides of the story and then makes a decision that the two parties will be bound by, just as if the dispute were settled in court . Unlike mediation, an arbitrator will make a ruling.
Both of these methods are compelling and they can save time and reduce the costs of a lengthy court proceeding. There may also be some discussion on this topic under your partnership agreement; if not, it’s worth the consultation with an attorney to draft an appropriate mediation and/or arbitration clause.
If mediation and/or arbitration does not work, or if you feel that the mediator and/or arbitrator is biased, the court process may have to be initiated.
If no settlement is reached, and the business is to be dissolved entirely, the Court will most likely place it into receivership, and appoint a Receiver to oversee the sale of the business.
If a settlement can’t be reached but you hope to maintain a business relationship, it may be a matter of offering the partner wishing to divest an opportunity to purchase the shares that you would otherwise have sold to someone else.
Ways to Protect Your Business Interests
This begs the question, what can business partners do to protect their respective business interests? First and foremost, partners should deal openly and honestly with one another. Keeping clear lines of communications open and communicating any issues or concerns is critical. Once a major problem arises many partners regret the lack of communications. Consequently, regular meetings to discuss the current business issues and success are also a great way to make sure everyone is on the same page and no surprises will occur down the road.
Second, partners should also take time to regularly review and update all legal documents to ensure that the business is operating in a manner that is consistent with its governing documents. For example, if the partnership agreement, bylaws, or operating agreement permits the partners to sell their interest in the business, a sale may happen without a partner’s knowledge and consent. Further, in some states the failure to adhere to corporate formalities can enable a business to unwind itself and hold the owners personally responsible for all of the business debts. Thus, if personal liability is not what you had in mind when you formed your business, you should make sure that your business is complying with the proper legal formalities. This is especially important when forming a corporation or limited liability company because there are many formalities involved either that must be followed in order to maintain your corporate or limited liability status and protect yourself from personal liability. Formalities may include having a readily identifiable business location, having bank accounts for the business with its name, keeping books and records of the business, conducting annual meetings and recording minutes, securing appropriate licenses, and generally conducting the business as a separate entity apart from the owners.
Third, if one or more owners are bringing in different levels of capital, time, and energy into the business with the intent to share in the profits, it is important to consider a tiered ownership structure to protect those owners bringing in more contributions from losing their interests in the business.
Fourth, a well-drafted buy-sell agreement is an essential safeguard to protecting your business. A buy-sell agreement specifically outlines the rules and processes by which a partner’s interest is sold to another partner or to an outside party. Some buy-sell agreements are structured like traditional life insurance policies, where the business or remaining partners pays the deceased partner’s estate a designated sum to buy out the business interest. Other buy-sell agreements contain clauses that require the business to pay a specified amount for the business interest even if, for example, the business is not doing well. In any event, a properly drafted buy-sell agreement avoids having the business interests being sold to an outsider who the other partners do not approve of. It also protects a partner’s estate from having to manage an unwanted and otherwise uncertain business investment.
Seeking Legal Guidance
As always, the best way to sort through this and any other legal type confusion that may arise in a business arrangement is to consult an attorney with experience in the particular area. A lawyer experienced in this area will help to assess whether or not your partner has the right to sell, the timing of the sale, and what your rights are as the other party to the agreement. Such an attorney will know whether the law of your state allows your partner to sell upon withdrawal from the business or if it legally require a longer time period . In addition, a knowledgeable attorney will be able to aid in determining the value of the business share in question and how that value is to be determined. Finally, this attorney will know whether anything needs to be filed with the state regarding the business sale. With all of these things considered, you will be much farther along to being assertive in asserting your rights under the situation. This article is not a substitute for legal advice and should not be taken as such. Again, contact an attorney for advice in your particular situation.