Avoiding Partnership Pitfalls

Anyone who has run a landed estate or a farming, equine or similar family business knows that it is far from easy - and certainly not a job for one person. Such businesses are frequently operated across different generations of the same family. They can include those who join in the business as life-partners of the original owners/operators. Sometimes these businesses are run by friends. However they are constituted, where those concerned simply work together, without setting up a limited company or other business structure, a partnership may be formed, wholly inadvertently. That can have serious (and unwanted) consequences.

How are partnerships formed?

“Partnership” is defined at section 1. of the Partnership Act 1890 (“the Act”) as “the relationship which subsists between persons carrying on a business in common with a view of profit”. That means that whenever two or more individuals run a business together they may become partners - automatically, by operation of the Act. There are other factors that the courts will consider in deciding whether a partnership has arisen, but, essentially, it can be as simple as that.

What are the consequences of forming a partnership in this way? The Act provides a set of default rules which establish the rights and liabilities of the partners. Much of the detail can be found at section 24 of the Act. To summarise some key provisions:

• subject to any agreement to the contrary, all partners are entitled to share equally in the profits of the business. They also have the privilege to contribute equally towards its losses, whether those are of a capital or income nature;
• all partners have unlimited liability for all debts of the partnership — that’s joint and several liability, which means that each partner is responsible for not just some of the debts of the partnership, but all of them. So, if you have a partner who suddenly goes off the rails or incurs expenses or costs to which you have not agreed, and the business folds, you can find yourself in the unenviable position of having full and unlimited liability for all of the debts of the business;
• where a partner has lent money to the business (and that’s quite common) that partner has an entitlement to interest on the sums loaned. That is worth mentioning because the “deal” in some partnerships is that one party provides the money and the other provides the talent or the skills. If that is the case, an entitlement to interest is not something that you might want to feature in your partnership arrangements;
• each partner has the right to take part in the management of the partnership with most decisions being made by majority decision. Decisions outside the scope of day-to-day matters require unanimity – which can be hard to come by;
• it is not possible to admit new partners without the unanimous agreement of all those currently in the partnership; and
• equally, it is not possible for a partner to be expelled unless there is some effective mechanism which permits this. There needs to be express agreement on that point, and it should be recorded in writing. So, in the event that a dispute between the parties reaches breaking point, and the parties simply can’t remain in business together, but they can’t agree a way to wind up their partnership or separate their business interests, then the likelihood is that the court will have to become involved.

Dissolution

If one of the partners does decide that “enough is enough” they can, immediately and unilaterally, dissolve the partnership. In theory, notice of dissolution does not even need to be given in writing, although, for evidential purposes, it usually is. The threat of dissolution, wielded by one of the partners, can be a very powerful weapon in negotiations between warring partners because the effect of a dissolution is that the business is forced to come to a stop and years of hard work can be lost as a consequence. This is very much the nuclear option.

If there is a failure to comply with the notice of dissolution, the court may become involved (but only at the request of one of the parties — it will not take any action on its own). It can order that the partnership be wound up, at which stage the assets and liabilities need to be collected and disposed of by the former partners, with any surplus being distributed between them equally or, alternatively, any excess liabilities borne by them — in the latter case, a pretty unhappy prospect.

It is also worth mentioning that sometimes in this situation the court will order one partner or group of partners to “buy out” another partner. The old partnership comes to an end and a new one (in which the outgoing partner ceases to be involved) takes over the business, paying the outgoing partner for their share of the business. As you can imagine, that can bring into play all manner of questions regarding the correct value to be received for their share. This is most typical where one of the parties is excluded from the partnership by the others. That can lead to months or years of legal arguments.

Death of a partner

Another problem, particularly in generationally operated partnerships, is that, under the default regime, a partnership comes to an end on the death of a partner. Farms are commonly run by parents and their adult children. The consequences of, say, the death of a partner can be that the partnership has to be brought to an end unless agreement can be reached with those inheriting the benefit of the deceased’s share of the partnership. Quite commonly, arrangements made by way of personal wills, etc., can become out of date, with the consequence that the deceased’s partners find themselves in a terrible position, perhaps forced to work with their former partner’s beneficiaries or face the dissolution of their business, thereby losing the means to support themselves.

Ensuring that your partnership is not governed by the default regime

Fortunately, the Act provides that it is possible, (and, in reality, it’s entirely commonplace), for an agreement to be reached between partners as to which obligations under the Act will and won’t apply – and setting out bespoke terms by which the partnership will be bound.

A sensibly drafted, signed, partnership agreement can set out clear rules as to how the business should be operated including:

• How decisions are to be made – and providing a mechanism to avoid deadlock where interests would otherwise be balanced, leading to a (disastrous) deadlock.
• How profits are to be shared.
• What each partner is required to contribute to the business.
• Whether a partner may be expelled or made to retire and the financial consequences that flow from that.
• What happens to a partner’s share when they die.
• How and when the partnership should come to an end.

All of this will significantly reduce the scope for disagreement between the partners.

A word of warning...

Another common problem is worth mentioning; what can happen when a new partner joins the business but does not sign up to or agree the existing bespoke arrangement that are already in place. This can result in a new partnership being formed – with the agreed terms falling away. The default regime then reestablishes itself. This happens more often than you might think…

Case study exemplifying why you should not permit your business to be operated as a partnership under the default regime provided for under the Act

Hamish and Elizabeth owned and ran a farm in Gloucestershire. They had two children, Louise and Tom. Elizabeth passed away in her fifties and Lousie and Tom, who had worked on the farm from a young age, became full-time farmers, starting to working together with their father in their early twenties. This continued for about 15 years.

When Hamish died, he left everything to his children equally. They continued to operate the farm together. Louise married and had two children. Her husband started working at the farm full time. He took an equal share of profits with Louise and Tom.

Tensions began to emerge regarding who should occupy the farmhouse. Louise’s husband stopped speaking to Tom and the relationship between Louise and her brother also broke down.

After he was excluded from the farmhouse, Tom told Louise that the partnership was terminated and that he wanted the farm and farmhouse sold and the proceeds split between him and his sister. Louise’s husband claimed to be entitled to a third of the partnership assets. Louise did not want to sell the farm and unsuccessfully attempted to negotiate Tom’s departure on the basis that he would receive a modest payment, which would be financed by a mortgage.

After two years and a hearing, the Court ordered that the farm and farmhouse be sold. Due to the circumstances, a low price was obtained from a third party. Louise’s husband was awarded a proportion of the value of the sale proceeds, despite not having contributed any capital to the business. Total legal costs exceeded £350,000.

All of this could have been avoided if a bespoke partnership agreement had been put in place, setting out who was entitled to what and how the business should be wound-up, in an orderly manner, when cracks began to appear in the relationship. The agreement could have been amended at the point at which Louise’s husband joined the business, to prevent them, as husband and wife, from ganging up on Tom, which was one of the problems that emerged.

Conclusion

Those engaged in any farming, equine estate or family business need to understand whether they are operating as a partnership. If so, they need to consider, carefully, how they wish to operate that business and enter into a well drafted partnership agreement to protect their interests and ensure that the business can avoid future disputes. The alternative is not worth considering. The effort and expense involved in getting a proper agreement in place are likely to be dwarfed by the costs involved in a dispute arising under the default provisions of the Act. Equally, proper consideration should be given to whether other structures might be appropriate for the business and to ensure that the wills of those involved are up to date.