Partnerships – Don’t get set in stone.

As spring approaches, those who have been offered an equity partnership should start thinking about due diligence. The prospective partner is entering into unlimited personal liability and should consider taking steps to inform themselves of the risks and liabilities they are assuming. The prospective partner should ask for a copy of the firm’s up-to-date partnership agreement and review it thoroughly. If there is none, the firm may be dissolved at any time by an aggrieved partner. This is an unacceptable risk; firms have been effectively held to ransom by the threat of dissolution. The current and last year’s management accounts, the budgets for the coming year and a calculation of partners’ drawings and profit shares, should all be requested. Having checked the firm’s performance, the prospective partner can then query serious income shortfalls and significant liabilities. It would be prudent to compare capital contribution with the profitability of the firm to get an idea of the soundness of the proposed investment. What capital contribution is the prospective partner required to provide and are there arrangements with the firm’s bank to help finance it? When can the capital be extracted if he or she leaves the partnership – in a lump sum on departure or in instalments over a period? How is capital valued on retiring as a partner? Is the partners’ drawings policy too reckless or conservative? Does it take account of the firm’s cash flow and its liabilities, and is it flexible enough to take into account changes in cash flow? Is the firm’s billing system efficient: does the firm turnover its work in progress and debtors quickly? Check there is adequate provision for bad debts. Ascertain what tax arrangements are made and whether they are efficient. How will profit share be calculated? A lockstep system provides additional points in the profit share pool for every year the individual is a partner: rewarding longevity rather than individual effort. Some firms share profits on a merit basis, recognising – and giving appropriate weight to – the various functions a partner has to perform. Achieving this can be difficult and every system has its own inherent inequities. A number of firms operate a hybrid arrangement to reward effort and loyalty. Find out if the arrangements are reviewed and changed regularly. Upon becoming a partner, the individual will be personally responsible for the firm’s liabilities and his or her personal assets will be at risk. Are all of the partners’ assets in the names of their spouses? What level of professional indemnity cover is available? Compare it with the type of work the firm does and the level of liability that could result. Will the incoming partner be responsible for negligence claims based on work done prior to their becoming a partner? The prospective partner should check whether the firm requires any contributions to be made by salaried partners or whether a full indemnity is given by the firm. Check what notice a partner would have to give if they were to leave the firm. How could the firm get rid of the partner? Some agreements require a particular percentage of votes by partners, which would depend on whether a departure is with or without cause. Ascertain whether expulsion would be decided by the partnership as a whole. Many large firms are run by a committee authorised to expel a partner without reference to the other partners. Does the partnership agreement provide that the partner could be placed on ‘garden leave’, so excluding him or her from the market for a specific period? Finally, would he or she be subject to any restrictive covenants after departure? In contrast to restrictive covenants in employment contracts, those between partners are far more likely to be enforceable as they are regarded as being part of an arm’s length commercial arrangement. The firm may resist providing the prospective partner with this type of information. A confidentiality undertaking can be offered to the firm to secure them. Without these, the prospective partner is walking into unlimited personal liability with eyes wide shut. – Clare Murray and Kolvin Stone specialise in partnership and employment law at City law firm Fox Williams.

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