Partnership agreements – planning for profits and losses

When setting up a business as a partnership, or revisiting your partnership agreement for any reason, it is important to consider the core topic of how profits and losses will be shared. Your partnership agreement needs to accurately reflect your true intentions as regards these matters, and it must provide sufficient detail to resolve any disagreements that may arise at the time of profit distribution.

If your partnership agreement is out of date, or poorly worded, and does not provide sufficient clarity about distribution of profits and losses, then there is a risk that the Partnership Act 1890 will apply instead. This would not be in your interests, as it would apply a crude and rudimentary approach to sharing profits and losses, in that they are simply apportioned equally between the partners, which may be far from your intentions.

‘There are various options for sharing profits and losses, so it is paramount that you sit down with your co-partners to discuss these options and seek advice from a solicitor to determine the best approach for your business,’ says Selina Lau, a solicitor in the corporate and commercial team with Ingram Winter Green. ‘The topic of profits and losses is at the heart of your partnership agreement, so it is very important to get it right.’

Selina discusses some of the options for calculating the distribution of partnership profits and losses, and she highlights some of the pros and cons for each option.

Common models for sharing profits and losses

There are a variety of models which you can choose between, or you can come up with an entirely novel and bespoke approach of your own, depending on your objectives. Some of the more common options include:

Equal sharing

The most simplistic of all the models, and one that mirrors the basic provisions of the Partnership Act 1890, is ‘equal sharing’. This simply means that all profits and losses are shared equally amongst the partners, irrespective of any other circumstances. The simplicity of this approach may appeal to you, and it can be an efficient model for a smaller business or a family business, where members think such an approach helps support and foster a culture of trust, cooperation, and fairness.

Similarly, equal sharing can be an effective model if you have broadly equal capital commitments and levels of responsibility across the partners. It is straightforward to calculate at the time of financial year end.

The main downside of equal sharing is that it is a rigid and inflexible model. Furthermore, this style of approach can create resentment between partners if one or more are not deemed to be ‘pulling their weight’ or hitting their targets.

Proportionate sharing

This model is where each partner’s share of profits and losses simply mirrors their capital contributions to the partnership. It is in many respects a fair and equitable model, as the distribution reflects the degree of financial risk assumed by each partner.

However, it is a relatively blunt instrument in that it fails to take into account any other factors, such as an individual partner’s role in the business, expertise or seniority.

Pot A and Pot B sharing

In this distribution structure, you have two different ‘pots’ at the end of each financial year, Pot A and Pot B. You can state the proportionate sizes of each pot in your partnership agreement – the two pots could be equal or different sizes. The idea is that all the partnership profits are paid into those pots in the proportions agreed. Pot A is then shared, usually equally, amongst all the partners. Pot B is shared, again usually equally, only among those partners who have hit their target for that financial year.

As you will expect, the intent behind this structure is to strongly encourage partners to hit their own financial targets, whether that be in billing (e.g. in professional services firms) or in sales. The difference between hitting target, or failing to do so, could lead to a significant impact on an individual partner’s annual remuneration. As such, this strategy tends to work best for growth-focussed firms, and those firms for which individual partner efforts (as opposed to wider team efforts) are fundamental to overall business revenues.

The potentially negative side to pot sharing is that it can lead to a silo mentality at partnership level, with partners keen to protect their own client or customer base at all costs in order to meet their personal targets. This can lead to a reluctance to share information and contacts among colleagues and reduced cross-selling, which in turn limits overall business success.

Fixed drawings plus points-based accumulation

In this approach, the partners each draw a fixed amount each month in a similar way to a salary, and each partner also accumulates points depending on various factors. At the end of each financial year, after payment of the fixed drawings, the remaining profits (or losses) are then split between the partners depending on their total points.

For example, points may be awarded for seniority or length of service, capital contributions, hitting targets, or carrying out specialist roles and responsibilities for the partnership, such as managing partner or finance partner. This can be a great model to reward individual partners for their dynamism and loyalty in helping grow the business.

You may prefer to keep the same fixed drawings (salary) element consistent across all partners for reasons of equality and fairness. Alternatively, you could decide to have a negotiable salary element for each partner, which can be helpful in recruiting new partner talent and is attractive to those with limited desire to make large capital contributions. Your decision will largely depend on the make-up of your partnership and your future business objectives.

Fixed drawings plus points accumulation can be an excellent structure for larger, more complex partnerships with many partners, tiered management roles, and varying degrees of responsibility.

One key downside to this approach is that it can prove more difficult to manage owing to its relative complexity. In turn, this can increase the likelihood of partner disputes, especially if points allocation is not unanimously agreed amongst the entire firm on a partner-by-partner basis, but by a smaller group of partners in the style of a remuneration committee, where individual motivations may be at play.

How we can help

Our solicitors will be able to advise you on all these options, and others, and will be able to take your plans and turn them into legally binding clauses for insertion in your partnership agreement.

If you are looking for advice regarding profits and losses distribution among your partners or require legal support with regards to your partnership business more generally, then our lawyers will be pleased to help.

For an informal conversation, please contact Selina Lau in the corporate and commercial team on 020 7845 7400 or email  Ingram Winter Green has offices in London.