- Just 30% of firms have a valid partnership agreement in place
- Not having one leaves the firm vulnerable when partners retire, fall ill or die
- Without one, firms are governed by the Partnership Act 1890
- Read on for details of how this can affect your firm
Practices operating without a valid partnership agreement in place are a disaster waiting to happen, explains Nicola Draper of Draper Hinks.
It is estimated that only 30% of accountancy firms have a legally binding partnership agreement – a shocking number when one considers the risks to the firm of not having one.
When a partner announces their intention to retire or leave, the first course of action should be to refer to the partnership agreement. A good partnership agreement will also ensure that other partners have a carefully structured plan to follow if one partner becomes seriously ill or dies. It will secure everyone’s legal positions and ensure the continuity of the firm.
While it’s advisable for accountants to draw up partnership agreements as early on in the partnership as possible, there is no legal obligation to do so. I’ve come across many practices where there’s no written agreement in place and partners operate on trust alone. Naturally trust is a major factor in a partnership and many firms of accountants, architects and other professional services operate perfectly well without a written partnership agreement. However, it’s a risky route that presents many dangers which partners may not be aware of.
If you already have a partnership agreement, it’s worth checking that it’s up to date, as an old agreement may not determine the right terms and conditions for your practice today. In many cases the agreement is not revised to take account of resignations, new appointments, retirements or even deaths, and this can often lead to difficulties both as to validity, enforceability and applicability of the agreement.
It’s also essential to check that all partners have signed the agreement and that it’s not just in draft form – failure on either of these counts will render it legally null and void.
The Partnership Act
In cases where there is no partnership agreement or where the agreement is void, the practice will be governed by the Partnership Act 1890, an archaic piece of legislation that could leave all partners vulnerable.* It’s curious to think that a piece of Victorian statute can determine how 21st century partnerships operate, but if there’s no valid written agreement of partnership terms and conditions in place, this could be the case.
The Partnership Act dictates that unless the partners have a written partnership agreement that states otherwise, any one of them, after ‘an undefined time’ has the right to dissolve the firm. No notice is required, and there are no defined timescales – meaning that in theory a partner could dissolve a firm within the hour if they so wished (although it’s unlikely that many would go down this route as it helps no one and may result in the firm losing most or even all of its value in an instant).
Another thing to note is that the Act offers no restrictive covenant of any kind on a partner who is leaving. Unless there is a partnership agreement, a leaving partner can go immediately to work for the firm’s main competitor. It also states that unless the partners have agreed otherwise, they are all entitled to an equal profit share. This may not be what is wanted and a partnership agreement setting out the details of profit share (or losses) is the only way round this.
Retirement and illness
Without a partnership agreement, if one partner wants to retire or is too ill to return to work, other partners can just take over the client base and make no goodwill payment. They can decide which clients they want and ask the ones they don’t want to go elsewhere. They could buy out the retiring/sick partner, but valuation is likely to cause disputes.
The leaving partner is entitled to sell their share of the client base to an outsider. Without an agreement clarifying the position, the latter is fraught with difficulty and other partners have no say in who it is sold to. However, if an outsider buys the fees and the base practice is still going, clients may migrate back to it and the income multiple paid will be lower. A proper agreement will make the position clear.
There may a dispute as to which clients belong to the departing partner. Some practices operate on the basis that each partner is a sole practitioner and they share office facilities – this is much easier to assess. In other practices, the managing partner might deal with the internal running of the practice and have a few clients of their own, which is far more complicated. For example, I met one accountant who runs the office and wants to retire. None of his partners are willing to pay for his clients or take on his workload. He does not want to sell to an outsider so, despite being over 70 years old, he is still (unhappily) working there.
The Partnership Act also states that partners aren’t entitled to interest on the capital they contributed to the firm, unless the partnership agreement says so. A well-drafted partnership agreement should cover the return of any capital invested and any interest to be paid. You don’t necessarily want a leaving partner to demand immediate withdrawal all the capital they have invested in the firm, so a partnership agreement can specify timescale and terms. It should also cover the situation if a retiring partner owns the office property, for example, which can often be the case with a founding partner. It may be that the firm can lease it from the retiring partner, or even buy them out over a specified period.
Succession and disputes
One provision of the 1890 Act is that no person may be introduced as a partner unless every single existing partner agrees. In this age of big partnerships, there can be dozens of partners. A partnership agreement can let the majority or a certain percentage carry the vote, so the appointment can go ahead even if some disagree. If you are retiring, you may have identified a candidate for succession from either inside or outside the firm. It is worth stating your case quite forcefully, especially if your agreement stipulates any future income for you comes from the success of the firm, or if you are to receive a goodwill payment on retirement and have a clawback clause.
Partnership agreements should cover how often partner meetings are held, drawings, retirement dates, time worked, holiday entitlement, and what would happen in the case of a partner’s ill health or death (particularly with regards to payment structure).
It should also cover how to resolve disputes and in what order, from mediation, arbitration, or the expensive option of the courts. Partnerships without an agreement may be unaware that if one partner dies or is declared bankrupt, the partnership is automatically dissolved. What’s more, if one partner defrauds the practice or clients, quite apart from the financial loss and the damage to the reputation of the practice, other partners can’t expel that partner unless it is expressly agreed that there is a right of expulsion. While there may be other courses of action open to them, such as the fraud squad, it seems it is legally impossible to remove them from the partnership without an expressed agreement.
In the case of a partner’s death, it could be that their estate receives a certain percentage of GRF in a one off fee or in tranches. Purchasing insurance to cover any payments in case the worst happens is sensible, and yet it’s estimated that only 20% of accountancy firms have it. If there is no legal agreement, the firm has no obligation to pay the estate anything.
In cases where the firm is owned by a sole partner, it is advisable to make an arrangement with your solicitor and leave a letter of instruction with a will so that they know to act quickly and sell the practice after your death before its value is reduced or gone altogether. It is advisable to sell within two weeks (maximum), this being the time that most people take as annual leave, but within days is better. The longer a sale is delayed, the lower the value of the firm.
Sole traders should also consider having an alternate in place, preferably in the geographical area of your clients so they can handle clients on your behalf should you fall ill or die. The most important thing is to keep the business, keep clients happy and ensure the work required is completed satisfactorily and within the timescale required, before clients and staff start to leave.
No doubt the lawyers among you will point out my inadequacies in interpreting the law, but I must admit the Partnership Act did shock me. If ever there was a case for instigating a written partnership agreement, this Act is surely it. Without one, it’s a disaster waiting to happen.
Please note this article does not refer to limited partnerships or limited liability partnerships, which are separate entities. There are also regional differences between Scottish and English partnerships.
Article written by Nicola Draper from Draper Hinks.
To contact Nicola Draper please email her on firstname.lastname@example.org