INTRODUCTION
Starting a business is an exciting and challenging endeavor, and often requires collaboration and shared responsibilities. If you’re planning to launch a business with one or more partners, it’s essential to have a partnership agreement in place to avoid misunderstandings, conflicts, and legal problems down the road.
So, are you ready to boost your business’ success with a Comprehensive Partnership Agreement? Here is a small guide from team YLCC for budding Entrepreneurs and young lawyers learning to draft a Partnership Agreement.
Many Indian startups are opting for strategic partnerships with other companies, rather than traditional equity investments or mergers and acquisitions (M&A). This trend is driven by the need for faster growth, access to new markets, and complementary expertise or resources. According to a report (see here) by Bain & Company, several Indian startups had formed strategic partnerships by 2020.
Furthermore, in India, there is an increasing emphasis on partnerships that aim to create positive social and environmental impacts by engaging businesses with non-profit organizations, government agencies, and other stakeholders to address crucial societal issues. Such partnerships typically involve innovative financing models, shared value creation, and long-term sustainability objectives. Therefore, a Partnership Agreement becomes crucial in these scenarios.
In this article, we’ll guide you through the process of drafting a partnership agreement for your business, step by step. We’ll discuss the essential clauses of a partnership agreement, provide step-by-step on how to prepare and review the agreement and highlight common mistakes to avoid. By the end of this article, you’ll have a solid understanding of what a partnership agreement is, why it matters, and how to create one that suits your business needs and goals.
KEY CLAUSES OF A PARTNERSHIP AGREEMENT
While the specific terms of the agreement may vary depending on the nature of the business and the partners’ preferences, there are some key elements that should be included in every partnership agreement. Here are some of the essential clauses of a partnership agreement:
NAME AND PURPOSE OF THE PARTNERSHIP:
The agreement should state the name of the partnership and the purpose or goals of the business. This clause is an important element of a partnership agreement, as it establishes the foundation and goals of the business. This clause should clearly define the name of the partnership and its primary purpose or objectives. The name of the partnership should be distinctive and not infringe upon the trademarks or names of existing businesses. Partners may also want to consider conducting a trademark search to ensure that their proposed name is available and not already registered by another entity. The purpose or objectives of the partnership should be clearly stated to ensure that all partners share a common vision and understanding of the business’s goals. This may include a description of the products or services the partnership will provide, the target market or audience, and any geographic limitations or restrictions. In addition to defining the name and purpose of the partnership, this clause may also include provisions regarding the scope of the partnership’s activities. For example, if the partnership plans to expand into new markets or develop new products or services, this clause can outline the process for approving and implementing such initiatives. Partners may also want to include language that outlines any limitations or restrictions on the partnership’s activities.
For example, the partnership may be restricted from engaging in certain industries or activities that could conflict with the partners’ other business interests. This clause serves as the foundation for the partnership agreement and sets the tone for the business relationship. By clearly defining the name, purpose, and scope of the partnership, partners can establish a shared understanding of their business goals and objectives, which can help prevent misunderstandings and conflicts in the future.
RIGHT OF FIRST REFUSAL:
The Right of First Refusal (hereinafter referred as “ROFR”) clause is a provision in a partnership agreement that gives one or more partners the first opportunity to purchase another partner’s ownership interest in the business before the interest is sold to a third party. The ROFR clause is designed to protect the partnership from unwanted outside influence and to maintain the existing ownership structure of the business.
The ROFR clause typically includes the following elements:
- Notice: The partner who wishes to sell their ownership interest must provide written notice to the other partners outlining the proposed sale and the terms of the transaction.
- Exercise of Right: Once the other partners receive notice of the proposed sale, they have the right to either purchase the interest themselves or decline to exercise their right of first refusal. If they choose to exercise their right of first refusal, they must do so within a specified time period, usually 30 to 60 days.
- Purchase Price: The purchase price for the ownership interest is typically set at fair market value, as determined by a third-party appraiser or based on a predetermined formula.
- Payment Terms: This clause should also outline the payment terms for the purchase of the ownership interest. This may include a lump sum payment, installment payments, or a combination of both.
- Restrictions on Third-Party Sales: This clause may include restrictions on the sale of ownership interests to third parties. For example, partners may be required to obtain approval from the other partners before selling their ownership interest to a third party.
The ROFR clause is an important provision that helps to ensure that the existing partners retain control over the ownership structure of the partnership. By providing partners with the first opportunity to purchase ownership interests, the partnership can prevent unwanted third-party involvement and maintain the integrity of the business. Additionally, the ROFR clause can provide a level of financial protection for partners, as it helps to prevent undervalued sales of ownership interests to third parties.
VALUATION OF BUSINESS ASSETS
This clause is an essential provision of a Partnership Agreement that outlines how the assets of the partnership will be valued in case of a dispute, liquidation, or any other event that requires a valuation of the business assets. This clause is particularly important for partnerships that have significant assets or intellectual property that need to be valued accurately.
This clause may include several key elements, including:
- Valuation Methodology: This will specify the method of valuation that will be used to determine the value of the business assets. Some common methods of valuation include asset-based valuation, market-based valuation, and income-based valuation. The valuation methodology should be determined based on the type of business assets and the nature of the partnership.
- Valuation Expert: This may specify the qualifications and experience required for the valuation expert who will be responsible for determining the value of the business assets. The valuation expert could be an external third-party or an internal accountant or financial professional who is authorized to make the valuation determination.
- Frequency of Valuation: This clause should specify how often the business assets will be valued. For example, the assets may be valued annually, bi-annually, or only in case of specific events such as a partnership dissolution or the sale of a partner’s interest.
Partners can ensure that the business assets are valued accurately and that their investments are protected. Additionally, this clause can help to prevent disputes and ensure that any disagreements regarding the valuation of business assets are resolved in a fair and timely manner.
PROFIT SHARING RATIO
The Profit Sharing Ratio clause is a critical provision of a Partnership Agreement that outlines how profits and losses will be allocated among the partners. This clause specifies the percentage or ratio of profits and losses that each partner will receive and is typically determined based on the contribution of each partner to the partnership.
This clause should specify how the profit sharing ratio will be determined. This may include the contribution of each partner to the partnership, including capital, labor, and expertise. It may provide for a fixed or variable profit sharing ratio. A fixed ratio is when the profit sharing ratio remains the same over the life of the partnership, while a variable ratio may change over time based on the partners’ contributions.
Apart from the profit sharing, it should also specify how losses will be allocated among the partners. This may be done in the same way as profits, or a different ratio may be specified for losses.
Additionally, this clause will also consider the tax implications of the profit sharing ratio. The profit sharing ratio may affect the tax liability of each partner, and should specify how taxes will be paid on profits and losses.
By specifying the profit sharing ratio, partners can ensure that each partner receives a fair share of the profits based on their contributions to the partnership. Additionally, this clause can help to prevent disputes regarding the allocation of profits and losses and ensure that the partnership operates smoothly.
DEATH OF THE PARTNER:
The Death of the Partner clause is an important provision in a partnership agreement that outlines how the partnership will be affected in the event of the death of one of the partners. This clause helps to ensure that the business can continue to operate smoothly and without interruption, even if one of the partners passes away unexpectedly.
A provision can be created in this clause which may allow the surviving partners to purchase the deceased partner’s interest in the partnership. This can help ensure that the surviving partners retain control over the business and prevent unwanted third-party involvement. This may include a predetermined formula for valuing the partnership, or it may require a third-party valuation to determine the value of the deceased partner’s share.
It should also outline the payment terms for purchasing the deceased partner’s interest in the partnership. This may include a lump sum payment, installment payments, or a combination of both.
Additionally, it may also include transfer restrictions that prevent the deceased partner’s interest in the partnership from being sold or transferred to third parties. This can help maintain the integrity and continuity of the partnership.
Hence, this clause is an important provision that can help protect the partnership in the event of the unexpected death of one of the partners. By including this clause in the partnership agreement, partners can ensure that the business can continue to operate smoothly and that their interests and investments are protected.
STEP BY STEP GUIDE TO DRAFT A PARTNERSHIP AGREEMENT
Drafting a Partnership Agreement requires careful consideration of the specific needs and goals of the partnership. Here are some step-by-step guidelines to help you create a comprehensive Partnership Agreement:
Step 1: Define the Partnership
The first step in drafting a partnership agreement is to define the partnership. This includes identifying the partners involved, the name of the partnership firm, the business purpose, and the location of the firm/business.
Step 2: Outline Contributions
Before drafting a legal agreement, partners should agree on the contributions each partner will make to the partnership, including capital, property, and services.
Step 3: Determine Profit Sharing
Partners should agree on the percentage of profits each partner will receive based on their contributions before the agreement has been incorporated. This percentage can be based on the amount of capital contributed, the value of services provided, or a combination of both.
Step 4: Outline Decision-Making Procedures
Partners should agree on how decisions will be made in the partnership. This includes how decisions will be made, who has the authority to make decisions, and how disputes will be resolved.
Step 5: Define Roles and Responsibilities
Partners should agree on the roles and responsibilities of each partner. This includes the duties of each partner, how tasks will be delegated, and how decisions will be communicated.
Step 6: Establish a Plan for Disputes
Partners should establish a plan for resolving disputes in the partnership. This includes defining the process for dispute resolution and identifying any alternative dispute resolution methods.
Step 7: Include a Clause for Dissolution
Partners should include a clause in the partnership agreement that outlines how the partnership will be dissolved. This includes identifying the conditions for dissolution and the process for winding down the partnership.
Step 8: Consult with Legal Professionals
Partners should consult with legal professionals to ensure the partnership agreement is legally binding and enforceable. Legal professionals can help identify any areas of the agreement that may require additional attention or detail.
Step 9: Review and Revise the Agreement
Partners should regularly review and revise the partnership agreement as needed. This helps to ensure that the partnership agreement remains relevant and up-to-date as the partnership evolves.
By following these steps, the partners can create a comprehensive partnership agreement that helps to ensure the success of their partnership.
MISTAKES TO AVOID
While drafting a partnership agreement, there are certain common mistakes that partners should avoid which can lead to misunderstandings and disputes. Hence, it is important to avoid them. Here are some common mistakes to avoid:
- Ignoring Legal Requirements: Partners should ensure that the partnership agreement meets all legal requirements for their jurisdiction, including registering the partnership with the appropriate authorities.
- Not Addressing Future Changes: Partners should anticipate future changes, such as the addition or departure of partners, and include provisions in the agreement to address these changes.
- Failing to Define Roles and Responsibilities: Partners should clearly define the roles and responsibilities of each partner to avoid confusion or conflict later.
- Neglecting Dispute Resolution: Partners should establish a clear dispute resolution process to avoid costly legal battles.
- Not Establishing an Exit Strategy: Partners should establish an exit strategy in case of dissolution or departure of a partner to avoid potential legal battles.
- Failing to Update the Agreement: Partners should regularly review and update the partnership agreement to ensure that it remains relevant and up-to-date with the partnership’s changing needs.
SKILLS NEEDED
Drafting a partnership agreement requires a variety of skills and knowledge, including:
- Legal knowledge: A strong understanding of the Indian Partnership Act, 1932, the Indian Contract Act, 1872, and certain business laws is essential to ensure that the partnership agreement is legally binding and enforceable.
- Communication skills: Effective communication skills are crucial to ensure that all partners are on the same page and that their expectations are aligned.
- Analytical skills: Drafting a partnership agreement requires careful analysis and consideration of various factors, including the partners’ roles and responsibilities, profit-sharing arrangements, and dispute-resolution processes.
- Problem-solving skills: Drafting a partnership agreement involves anticipating potential issues and disputes and developing strategies to resolve them.
- Negotiation skills: Partners may have different goals, interests, and priorities, so strong negotiation skills are essential to reach a mutually beneficial agreement.
- Business acumen: A good understanding of the business and industry in which the partnership operates is necessary to develop an effective partnership agreement that reflects the partners’ goals and objectives.
CONCLUSION
When starting a new business, partnerships are a common and attractive option for many entrepreneurs. Partnerships allow individuals to pool their resources, share the workload, and capitalize on each other’s strengths. However, partnerships can also be a recipe for disaster if not structured properly. That’s where a Partnership Agreement comes in!
This document serves as a roadmap for the partnership, outlining expectations, responsibilities, and protocols for decision-making, profit-sharing, and conflict resolution. Without a Partnership Agreement, misunderstandings and disagreements are inevitable, leading to wasted time, money, and even the dissolution of the partnership. A partnership agreement is the foundation of any successful business partnership, providing clarity, security, and peace of mind for all parties involved.
Disclaimer: This article is for information purposes only. You are advised to consult a legal professional for drafting such crucial documents for your business.
This article has been written by Team Your Legal Career Coach (YLCC), for queries, please write to us at: queries.ylcc@gmail.com
