Formalising a business partnership: is it necessary at the seed stage?

“Let’s get the product out there and worry about the business structure later”.

Why fret over organisational details at the seed stage? Especially where a new business is created by a close-knit handful of individuals, raising the possibility of a partnership agreement might be regarded as akin to producing a pre-nup agreement on the day before the wedding: unnecessary, slightly heavy-handed and more likely to create mistrust rather than eliminate it.

In fact, formalising the arrangement is desirable on multiple levels. You and your collaborators will each be bringing something to the table – whether in terms of expertise, market contacts and/or capital. You may be clear at this stage on how this is going to be reflected in the allocation of profits – but what happens when circumstances change and those roles are re-defined? What happens if one of the group has to exit the arrangement unexpectedly – or when newcomers arrive? Having a formal arrangement in place is also important when it comes to demonstrating to third parties – e.g. institutional investors, suppliers and customers that you are running a tight ship.

Partnership v incorporation: are you on the right track?

Especially in the early days of a business, the partnership model offers a relatively simple structure. It is where two or more individuals are jointly involved in managing and operating a business. Unlike a limited company, a partnership does not have a distinct legal identity; meaning that the partners as individuals share not just the profits – but also the liabilities of the business.

But if it is desirable to formalise your existing partnership arrangement, why not go one step further and set up a limited company? Bear in mind the following:

• Setting up a company is relatively straightforward. The operating costs can be higher than those associated with partnerships though – not least because of the requirement to file annual company accounts with Companies House.
• Taxation: Partners are taxed on their share of the profits. With a company, you and your fellow directors will draw your income from the company itself. For profits left in the company, there is an extra level of taxation: Corporation Tax. This is not necessarily a negative: the upper level of Corporation Tax is considerably lower than the upper Income Tax rate.
• Directors enjoy ‘limited liability’. In reality, to access company finance, personal guarantees are likely to be required (especially where the company itself is relatively asset-poor). In practical terms, your exposure as a director could be almost identical to the position you would be in as a partner.
• Image counts for a lot. Consider your customer base and industry niche. Do customers tend to look for that ‘Ltd’ assignation as an indicator that they are dealing with a “solid” entity? Alternatively, will a partnership structure help you project a less ‘cold and corporate’ feel?
• Are outsiders likely to be brought on board? If equity investment is going to be required, how will those investors going to seek to protect their interests? A company structure may offer more leeway here to work out a solution to suit all parties concerned (e.g. through a directorship with tightly defined voting rights or through the issuing of shares).

Defining the inter-party relationship

Whether you go down the company or partnership route depends on a whole range of factors including the expected level of revenue, the presence of non-executive stakeholders, likely drawings and the norms in your particular niche. Advice from a small business legal specialist covered by professional indemnity insurance for solicitors should help you onto the right path. This input should also help you define the following key aspects of your business relationship:

• The precise roles of each party
• Ownership of assets
• Drawings, profit sharing and distribution of capital interest
• The introduction of new parties and the exit of existing ones
• The procedure on dissolution or sale of the business
• The preferred method for dealing with disputes should they arise

Getting all of this formally defined will prevent you and your partners getting more – or less than they bargained for as your business grows.