Partnership deadlock — the death of a business

As a solicitor with more than 30 years’ experience in commercial litigation, I’ve spent the greatest part of my professional life dealing with disputes between business owners. Some of the most frequently recurring problems that I have seen relate to businesses which are owned and run by friends and family.

Many smaller or owner managed businesses, perhaps even most, are founded by friends and family. Brothers, sisters, parents, school or college friends with a bright idea and the desire to make money on their own terms, as the masters of their own business. It is an exciting prospect, but the seeds of future disputes are often sown right at the outset, and that’s not because of anything the parties do at this stage — quite the opposite. It’s what the parties don’t do at this stage, in the excitement of building a new business together, that’s the problem. All too often essential formalities are ignored because it seems unthinkable that those involved could ever fall out.

Wind forward a couple of years in this scenario and friendships and family bonds sometimes become stretched to breaking point. So, what happens when disputes proliferate and where familiarity between those who used to have some affection for each other has become contempt?

In our scenario the business has done well and its value has increased, but the owners can no longer get along. It is now essential to understand who owns what, who has control of the business, and what might happen if relationships needs to be ended.

In the heat of the moment, when everyone is pressing forward to organise, market, and drive the new business to succeed, people often shy away from (or, more likely, do not even appreciate the need to) regulating how the relationship will work in the future. Everyone is far too busy focusing on the positives to ever consider the negatives. That is fertile ground for a dispute in the future.

It is usually at this stage that those concerned have an unpleasant shock when discovering what the position actually is, with regard to the rules governing their relationship with their business partners, and what can be done to change that and/or separate everyone’s respective interests.

Typically, the relationship will be governed by a default regime, the terms of which are dictated by the kind of business vehicle which the participants have been operating.

So, the question is, “What are the default regimes which apply when those in business together forget to, or choose to defer, setting the rules for how the business should be run”?

In this article I am going to look at what happens in partnerships — a very common business vehicle which can form spontaneously, sometimes without the partners even knowing…

Partnerships

Where two or more individuals start a business with a view to making a profit they automatically form a partnership for the purposes of the Partnership Act 1890 (“the Act”). In fact, that is the very definition of partnership in section 1 of the Act.

What are the consequences of forming a partnership in this way? The Act provides a set of default provisions establishing the rights and liabilities of the partners. A lot of the detail can be found at section 24 of the Act. All of this simply happens — unless you take steps to change the default position a whole set of statutory rules are implied into the relationship. To summarise some key provisions:

1. 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;
2. 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 only 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 that you have not agreed to, or the business folds and your partner disappears, you can find yourself in the unenviable position of having full and unlimited liability for the debts of the business;
3. Some of the other features of the partnership default regime worth mentioning: 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’s 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’s the case, an entitlement to interest is not something that you might want to feature in your partnership arrangements — unless that was what you intended;
4. Each partner also has the right to take part in the management of the partnership with most decisions being made by majority decisions. Decisions outside the scope of day-to-day matters require unanimity;
5. Note that it’s not possible to admit new partners without the unanimous agreement of all those currently in the partnership; and
6. Equally, it is not possible for one partner to expel another unless there is some effective mechanism which permits this — there needs to be express agreement on that point and it had better be recorded in writing. So, in the event that any dispute between the parties reaches breaking point, and the parties simply can’t remain in business together, if 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. Typically, this is because one of the partners wishes to bring the business to an end and the other does not.

If one of the partners does decide that “enough is enough” they can, unilaterally, dissolve the partnership. In theory, notice of dissolution does not even need to be given in writing, although, for evidential purposes, it usually always 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.

If there is a failure to comply with the notice of dissolution, the court can get involved (but only at the request of one of the parties — it won’t 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 discharged 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 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.

Death of a partner

Another problem is that a partnership comes to an end on the death of a partner. It is not uncommon for parents and children to go into business together and the consequences of, say, a parent dying 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 and the means to support themselves.

All of this is the worst-case scenario, of course. What the Act says is that it is possible, (and, in reality, it’s quite commonplace), for an agreement to be reached between partners as to which obligations under the Act will and won’t apply.

In summary, the situations which give rise to disputes that I see most often include the following:

• partners wishing to split the business but being unable to agree terms;
• one partner wishing to buy out the other but not being in a position to do so and therefore being ‘locked in’ with someone with whom they can no longer bear to be in business;
• partners trying to bring in new partners (perhaps spouses, other friends or investors) where this cannot be agreed;
• partners taking very different views about how the business should be conducted or developed, with the consequence that there is just no way forward. Often this comes into focus when one partners wants to sell out but the other does not.
• a perennial point, “profit share”; who deserves more — has one partner worked harder than the other?

It follows from what I have said above that fundamental problems in a situation where a business is jointly owned by friends and family can be summed up in one word: ‘deadlock’.

That is what happens where the owners of a business find that neither, or none, of them has the power to force their will onto the others. Indeed, you might think that that’s a good thing in a business comprising, say, just a couple of people because it means that one party can’t be abused by the other. However, it can also mean paralysis for a new business. If a stage has been reached and the business is doing well and has increased in value and it is time to take the next step and that involves making important decisions about how the business should be conducted the business can hit a brick wall, with the consequence that it begins to stagnate or fail. That’s pretty much the point at which many disputes arise.

Is there ever a happy ending?

Is there ever a happy ending in business ownership disputes and in particular partnership disputes? Well, the general answer, depressingly, is “not often”. However, the scope for festering hostility and long-term legal action is significantly reduced where parties take the step of preparing some kind of documentation to regulate their relationship.

Prevention is better than cure…

So, to summarise; the very start of any business is the best time to put in place suitable arrangements in case things go wrong. This is something that should be undertaken without antagonism and before the greed that is often engendered when a business has proven to be successful has come into existence. If there is ever an opportunity for parties to agree terms it is when they are friends and are getting along well. They certainly will not do so after that time has passed and the asset in front of them, calling out for division, is significant.