Possible Legal Issues with a Former Partner and How to Avoid Them

The present realities are that many entrepreneurs work on the projects with other parties without officially forming a business entity. The reasons may be different. The prevailing ones are to save costs and/or to wait until they are confident in the viability of the business.  It is important to know how such business relationships are viewed according to the law and what provisions the law imposes on the participating individuals. When there is no formal agreement in writing, the law establishes certain default rules for governing such partnership. Those default rules often do not reflect the best interests of the partners but legally bind them when they have not established their own. Let’s review the main rules and some equitable defenses that help to prevent a total windfall to one party if it contradicts with the initial understanding of the parties.

 

A general partnership is the default business form when more than one person operating a business. In other words, if two or more people run a business without taking the steps to incorporate, the law automatically views them as general partners. The legal test for determining if a partnership has been formed asks whether two or more persons associate as co-owners of a business for profit.  This definition means that a partnership can come into existence simply based on the parties’ acting as partners even without a contract.

 

In addition to the paramount consideration of limiting your liability by the formation of an LLC or corporation, it is important to understand how the law views the relationship between you and your cofounders and what provisions the law imposes on that relationship, especially if you have not yet agreed among yourselves what your relationship is and how it is governed.

 

Just as the law views a general partnership as a default category, the law establishes certain default rules for governing a partnership when it exists without a partnership agreement. For example, the partners in a general partnership share equally in the profits and surplus remaining after all liabilities. This law means that even if one partner does ninety percent of the work and invests ninety percent of the capital in the venture, the profits of the company still must be divided on a fifty/fifty basis absent an agreement to the contrary.

 

Once this default partnership has been formed, however, the possibility remains that a partner will decide to leave the project, whether due to disagreement over how to manage the business or simply because she no longer can or wants to be part of the project. Such a scenario ends the partnership and triggers three technical procedures that law requires be observed.

 

First, either an event or agreement triggers the dissolution of the partnership. For example, an event triggering dissolution of the partnership might simply be that a partner had too many other obligations or moved and said, “Sorry, I cannot continue working on this project with you. Bye.” at which time the partnership would be legally dissolved. Or an agreement provision might be that the partnership would last only until a certain milestone in the project was reached, and having reached that milestone, the partnership automatically dissolved. A partnership can even be dissolved when the partners simply no longer associate as partners.

 

The reasoning for such an easily triggered dissolution is based on the “aggregate” legal theory followed by New York and many other states. Any time a partner leaves a partnership, the partnership technically dissolves and becomes a new partnership. Thus, dissolution is not a question of whether the business continues to operate or not but whether the identity of the partnership—based on the aggregate of partners—has changed.

 

When a partnership has been dissolved, the business cannot simply be stopped immediately; it remains to go through the winding up stage. One reason for the winding up stage, at least in an instance where not only the partnership but also the business itself will cease to operate, is to allow for an efficient closing of the business (for example, a store doesn’t typically close its doors the same day its owners decide to end the business but first tries to sell off most of its inventory, perhaps finish its lease term, etc.). But legally, the most important part of winding up is the accounting—the calculation and allocation of the assets of the partnership to the partners, either in equal shares, if they have no other agreement, or according to their partnership agreement. In fact, the law states that a partnership cannot be wound up without an accounting.

 

Finally, after the dissolution and the winding up are completed, the partnership ends upon termination, but remember the business can live on in a new partnership or other form. For our purposes tonight, we will assume that no argument occurred or remains over which partner keeps the business and which one leaves.

 

Having looked at the proper procedure for the departure of a partner, we ought to now see what risks arise from not following these procedures. You may wonder why anyone would not follow the three steps, but the informality and transient nature of startups plus the cost of professional legal and accounting advice often leaves such new businesses in a state of legal limbo. For example, if partners part ways without an accounting, especially if one continues the business on her own or with a new partner, what could happen if the former partner reappeared and claimed part of the business? To begin, a former partner can sue for an accounting of the dissolved partnership up to six years from the time she left the partnership.

 

A former partner only has a right to an accounting of the partnership property based on its state on the dissolution date, that is, when she left the business. However, although an accounting would be based on the value of the partnership on the dissolution date, the former partner has the right to demand either interest on her share of value remaining in the business or the profits derived from her share of value the business continued to deploy to its profit after the dissolution. If the former partner sued for those profits, the court would calculate them by determining what percentage of the partnership’s equity belonged to the partner at the time of dissolution—perhaps even fifty percent—and award her that same percentage of the profits earned since the dissolution date.

 

Were a business to become profitable or valuable in the future while a supposed former partner legally remained a partner, that former colleague could have a claim on profits or assets far beyond her level of contribution to the business, hence the importance of establishing that no partnership remain between former partners. There may be some equitable defenses to prevent a total windfall, however, such as laches[1], or substantive defenses challenging the plaintiff’s status as a former partner. But remember, even a victory in court by the current partnership can prove ruinously expensive.

 

The most efficient and effective ways to prevent such a debacle are to simply have an accounting or, in the case of a very small startup, simply sign an agreement between a partner and a former partner that they waive their rights to an accounting. One incentive the current partner can offer is to indemnify the former partner against any liabilities arising from her time as a partner.

 

In addition, there remain some residual tasks to cover other bases for liability. Notify any third parties, especially creditors, with whom the former partner may have been used to deal on behalf of the business that she no longer has the authority to bind the business in any form of transaction. And seek the advice of an accountant to make sure whether you must file any documents or owe any taxes in connection with the changes to the business structure.

 

Finally, many new entrepreneurs fear the theft of their business idea in a scenario like the famous legal dispute between the Winklevoss brothers and Mark Zuckerberg over the rights to Facebook. The concern raises the question whether a former partner can sue the ongoing business for having stolen her idea. However, ideas without a particular protection of law cannot establish a legal claim.

 

Under New York State law only contracts, such as non-disclosure agreements, to protect concrete, novel ideas can protect a business idea. Federal intellectual property registrations—trademarks, copyrights, and patents—protect particular forms of other ideas. In the absence of such agreements or IP rights, the current business faces little risk of litigation over a business idea from a former partner.

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