Like any relationship, partnerships are fraught with opportunities for disagreement and misunderstanding. Without clear guidelines as to how the business will operate (and how profits, assets, and liabilities will be shared), you could be exposing yourself to more liability than you realize because partners are typically jointly and severally liable for partnership obligations. This means that you could be personally liable for the actions of your partners—even if you are unaware of their actions.

Why You Need a Partnership Agreement

Using a written agreement to formalize your partnership saves personal grief down the road because it allows you and your partners to anticipate and plan for particular situations before they arise. It should make the day-to-day operation of your partnership smooth and prevent problems from escalating into full-blown crises. Don’t think you don’t need a partnership agreement because your proposed partner is your good friend; many partnerships between friends break up because the partners assumed that they knew how their friend would run a business and that they were on the same page.  While such splits could be contentious, a partnership agreement helps to keep the separation a bit neater by laying out the groundwork as to how partners separate. It also provides a legal remedy to a wronged partner, as a partnership agreement is an enforceable contract (to the extent that it does not violate any state laws with respect to what partners can agree upon). A partnership agreement can set out boundaries, which could help you avoid actions that will open you up to unwanted liability. It can also provide guidance as to how you can leave the partnership if your partners breach the agreement.

Questions your Partnership Agreement Should Ask

A good partnership agreement should provide answers to these questions:

What Is the Financial Contribution of Each Partner? 

Memory is fluid and unreliable. You want to ensure that the financial contribution that each partner brings to the partnership is written down in your partnership agreement in case there’s a disagreement later.  It may be that some partners can contribute more startup capital to the venture than others. In this case, the others may be able to make their contribution in the form of “sweat equity,” which should be valued and specified in the agreement.

What Is the Division of Work Between the Partners?

It’s critical to get this sorted out before you start operating as a partnership because this is the most common way that partners step on each other’s toes. What will each partner do? How will they do it day to day? Who’s responsible for what decisions? 

What Constitutes Income in the Partnership? 

You hope that your partnership makes a profit. But how will partners draw income from those profits? If it’s agreed that partners will draw salaries, how much and how often? What percentage of the profits will be reinvested back into the business?  Without an agreement that speaks directly to this, under some state laws, partners are entitled to equally share profits, despite their initial investments.

What Property Is Included in the Partnership and How Is It Defined?

Partners may bring property to the partnership that is less tangible than a piece of land or a building. Client lists, computer applications, goodwill, process designs—whatever personal or intellectual property an individual brings to a partnership needs to be itemized and described in your partnership agreement.  If a partner is bringing tangible property to the partnership, have that written down and described, too.  Doing this will enable partners to distribute partnership property more fairly upon dissolution of a partnership.

How Will/Can Partnership Property Be Used by Individual Partners?

Sometimes property use is obvious. If two people decide to partner to open a restaurant, and one partner brings a property that she owns with a building suitable for restaurant use to the partnership, presumably, the business should use that.  But sometimes property ownership and use is not this obvious. For example, does the creator of the website, social media account, or app want to allow the other partners to modify it? Will the hairdresser share her clients? Get it sorted out ahead of time to avoid future disputes.

How Will Bank Accounts Be Set Up and How Will Accounting and Tax Matters Be Handled? 

Your partnership will need a business bank account. But how will signing privileges be set up? Will your business use a line of credit? Can purchases be made without the consent of other partners? Will your partnership use a bookkeeper and/or accountant or will one of the partners take on this role?

It’s idyllic to say, “We’ll sit down and resolve whatever issue comes up.” And you and your partners may well do that. But that doesn’t mean that you’ll agree.  Whatever way you choose, make sure that you have it written into your partnership agreement. Absent an agreement, state laws can assist in dissolving some disputes.  For example, in New York, a dispute on an “ordinary matter of business” may be resolved by a majority of the partners, but this may not be what you and your partners want. And if there are only two partners, this state law does not necessarily help you resolve your issue. For these reasons, it’s smart to determine ahead of time how you will work through disputes with your partners.

What Happens If One Partner Dies or Becomes Disabled or Incapacitated?

If one partner becomes incapacitated or dies, how will the others carry on the business? Making arrangements ahead of time can mean the difference between being able to continue doing business and business collapse.  A power of attorney can designate another partner (or someone of your choosing outside the partnership) to make decisions on your behalf in the event of your incapacity.  Your partnership agreement should speak directly to who may be designated by power of attorney. Additionally, a buyout agreement can specify what happens to the ownership of the business if something happens to one of the partners. A buyout agreement can be an entirely separate document or may exist within your partnership agreement.

What Happens If One Partner Wants to Leave the Partnership?

If a partner wants to leave or sell their share of the partnership, your agreement should lay out a roadmap as to how they can do that. It should cover specifics, such as whether or not a departing partner has to be bought out, what price will be paid and how, who can buy the departing partner’s share of the business, or if there is a right of first refusal that must be offered to existing partners.

How Will the Sale of the Business Be Handled?

Any small business should have its exit strategy planned from the get-go, but it’s even more important with a partnership. If selling the business is the eventual plan, partners need to agree in advance on acceptable processes and numbers.  Two prime areas of future disagreement are business valuation and profit sharing. Commonly one partner feels they put more into the partnership or worked harder, so they’re due to a bigger share. Having all the details discussed ahead of time and delineated in writing will provide an easier sale when the time comes.

Partnership Agreements Are Essential

Planning ahead avoids disputes and costly court battles later. No matter how close of a friend your potential partner is, you should never enter a business partnership with him or her without a formally drawn up partnership agreement. Also, as partnership is a complex issue, it is always recommended to have a partnership agreement drawn up by an attorney experienced in this area of practice.  A professional can guide you so that all your bases are covered and you can run your partnership with peace of mind.  Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!