Four Friends Make Their First HUGE Mistake

THE WISHFUL CONTRACTING PARTNERSHIP

Mike, Olivia, Fred and Carl hung out at Mike’s house one Saturday and decided it was time. They had talked about going into business together for a while. Mike had just finished a major project for a client and had a lot of free time just now. Olivia and Carl had both been laid off when the companies they worked for were sold or closed. Carl’s own handyman business was limping along.

Wishful Contracting was born. The four friends decided to form a simple partnership. They would all be equal owners and share equally in the profits. They had been friends for years without any problem, so they felt that a simple partnership agreement would be fine. They found something online, filled in a few blanks, and they each signed it. Done!

A quick trip to the county got them a fictitious name license and they opened a bank account. All four of them were signers on the account. As they started looking for a place to lease, the plan was that the partnership would sign the lease.

THE DANGER OF PARTNERSHIP

Mike, Olivia, Fred and Carl had made the single most dangerous choice any group of people can make when forming a new business. They decided on a partnership.

Some common dangers you can probably already see. In a partnership, every partner has equal access to everything. If the Four Friends each own the company equally, they have equal access to the money. Any of them can write checks. Any of them can make withdrawals.

Fred Could Take All the Money

A sad truth of partnerships is that many of them end with one partner absconding with all the money. They can do it because any partner on the bank account can go take all the money. It’s the nature of partnerships! At any time, Fred could show up at the bank, withdraw all the money, and disappear.

Mike and Olivia Could Empty the Account

When more than one partner can access accounts, it’s easy to spend the same money twice. If Mike is setting up the website and purchasing marketing supplies and Olivia is buying supplies to organize an office, they could both check the account balance and think they have money to spend.

This part isn’t just a problem of partnership. It’s a problem in any form of business when more then one person can access the same account.

If Olivia sees she has $1,000 to buy supplies and Mike sees he has $1,000 to buy materials, they might both go spend that same money at the same time. This has actually happened to clients and it can create a mess. Overdraft charges on a checking account can add up fast when they have both used a debit card to make the purchases.

One two-person partnership solved the problem simply: Three accounts. The main business account received all the money and only specified bills were ever paid out of that account. Then each partner had an individual account with funds they could spend by their own discretion.

Olivia could order office supplies and know that no one else was touching the account for her department. Meanwhile, Mike could spend his marketing money any way he needed without fear that someone else was spending the marketing budget. This set up allows maximum flexibility and keeps the money under control. No one has to check with anyone else to know what they can spend.

A more common but slightly slower system is to make all the expenses have to go through and be approved by one person. For most small businesses, this system can work, too.

Partnership Profits and Partnership Liabilities

Wishful Contracting had a great first year. They generated plenty of money to pay everyone a healthy income and had $100,000 extra profit at the end of the year.

The Four Friends were equal partners. If they decided to keep the profits, each of them would be entitled to 25%. That would be $25,000 each.

A danger is with liabilities. Any one of them could be held liable for 100% of any outstanding debt.

Suppose they decided to use that money to buy a small commercial location to operate their business. They find a place for $450,000 dollars with seller financing. After some excellent negotiation by their real estate broker, they invest $50,000 as the down payment with the idea that the other $50,000 would be enough to handle build-outs and upgrades. They owe $400,000 on the property.

After a couple of years, suppose Fred and Olivia both move on, basically disappearing. Technically, since the partnership owns the property, each of them are entitled to a quarter of the equity. If Mike and Carl sell the property, they would be required to leave half the money in escrow for Fred and Olivia.

But what if Mike and Carl can’t sell the property? What if they can’t pay for it, either? If the seller comes for his money, Mike and Carl can’t just pay half and explain that Fred and Olivia have disappeared. If Carl then files bankruptcy, the seller only had Mike left to go after ““ and he could be on the hook for 100% of the money all by himself!

That’s one of big dangers of partnerships. It’s call “joint and several liability,” meaning any one of several people could be required to pay up to 100% of whatever it owed.

No Partnership

In short, no lawyer would ever advise a group of friends to form a simple partnership without also having some other legal entity. The Four Friends can still be partners, but they can be partners in an LLC, or equal owners of an S Corporation ““ but not just partners.

Never use a partnership as a form of business.

To be perfectly honest, you might start off that way when you’re just starting to explore the viability of the idea. But once you’re making money or engaging in any behavior that could open you to obligations or liabilities, it’s time for another form for the business.