Succession planning in partnerships and limited liability partnerships (LLP) is crucial to ensure the smooth management of a current partner leaving and/or a new partner joining. When drafting a partnership or LLP agreement, it is worth dedicating some careful consideration to plan for succession.
A good partnership agreement should contain provisions to deal with the retirement of a partner, addressing issues such as notice of retirement and payments.. Business continuity will often be an issue in small partnerships, and the partners may wish to include a provision that no notice to retire can be served whilst another notice is pending. This will prevent multiple partners retiring at the same time.
Admitting a new partner
Admitting a new partner can be an effective way of growing the partnership or replacing an outgoing partner. There are a number of considerations that will stand you in good stead for smooth, well-executed succession including:
- Are any partner consents required?
- What level of majority consent from the existing partners is required?
- What are the admission arrangements? For example, you may need to consider the new partner’s capital contribution, voting rights and entitlement to profits and (in the case of a partnership) liability for losses and debts
- How does the admission fit with your accounting year?
- If the partnership’s name comprises the names of the current partners, will it need to be changed if someone new joins? Similarly, if someone leaves?
The cash question
A key inhibitor to effective succession planning is the financial issue during and post-exit.
Where a successful business has undergone a period of sustained growth, such that its fair market value (including the goodwill) is significantly higher than the seed capital contributed by a founder member, the founder members may prefer to wait until the business is sold to crystalise that value, rather than retire on a traditional ‘capital in=capital out’ basis.
On the other hand, the new generation of partners may prefer to continue on the firm’s current independent trajectory, rather than be acquired by another business or an external investor. Indeed, to aggravate the issue, the younger partners are often disenfranchised under the firm’s management structure, thus frustrating their ambitions for the business.
Balancing the preferences between generations of partners, in order to facilitate effective succession without damaging the business’ potential, is invariably a sensitive and bespoke negotiation.
Broadly, there are two useful tools here:
- An exit payment on retirement – a synthetic goodwill payment – typically paid out in several annual instalments depending upon the cashflow in the business. This staged payment mechanism is important in order to shield the business and partners from making a large capital payment.
- Anti-embarrassment provisions are becoming increasingly prevalent in a well-drafted partnership or LLP agreement. These clauses allow a retired partner to receive a share of the sale proceeds, if it happens after retirement. These are often calculated on a sliding scale over perhaps three years, to recognise the input of the continuing partners post retirement.
The above outlines how to draft a partnership agreement to effectively manage succession and it is clear that a well-drafted, comprehensive partnership agreement is absolutely vital for effective succession planning. But what happens when an unforeseen event triggers succession? For instance, where a partner dies suddenly or unexpectedly becomes incapacitated?
Death of a partner
Under the Partnership Act 1890 (“the Act”), the default position is that the death of a partner will trigger the dissolution of the partnership. It is, therefore, commonplace for the partnership agreement to specifically exclude the default provisions under the Act, and either allow the deceased partner’s personal representatives (PRs) to become partners or provide for the deceased partner’s capital and profit share (including any exit payment) to be paid to his or her executors.
Provided at least two partners remain, this will allow the partnership to continue even after a partner has died. It is not unusual for partnerships comprising two partners to also have a corporate member, thus ensuring continuity on the death of one of the partners.
Incapacitation of a partner
Particularly sensitive issues arise in relation to the incapacity of a partner or member, and it is a good idea to provide for this in the partnership or LLP agreement.
The partnership relationship is at its core fiduciary, and generally personal. This may leave the partners with a seemingly difficult choice between supporting the incapacitated partner, and carrying on a sustainable business in the absence of one of the partners.
The Act states that the dissolution of a partnership can take place where “a partner, other than the partner suing, becomes in any other way permanently incapable” of performing his or her obligations under the partnership agreement. Evidently this is likely to be wholly inappropriate and must be excluded.
Typically, partnership and LLP agreements will provide for varying levels of support to be provided to the incapacitated partner, depending on the length of absence and type of illness. This is a discussion to be had with all the partners to balance the need to protect both the incapacitated partner, and the business itself.
Many LLP and partnership agreements fail to address these often nuanced and sensitive provisions. Whilst they often seem unnecessary at the time of drafting, many years of experience have proved to me that all too often partners only address these issues at the time of need. Invariably, by that late stage, they will find the process stressful and unfortunately acrimonious.
Succession planning in a partnership is naturally a time of great change and potentially upheaval for a partnership. The issues we have highlighted above should all be considered in the drafting of a partnership agreement to ensure that any succession is as seamless and efficient as possible.