New Law Journal – 16 October 2020

George Sim looks at the financial aspects of partners falling out

In Brief

  • Types of disputes which may arise.
  • Identifying the issues to address.

A Statistical Release issued by the Department for Business, Energy and Industrial Strategy in October 2019 notes that there were approximately 405,000 partnerships in the UK at the start of 2019. Partnerships are easy to set up and combine ownership with control. Another advantage is that there are no statutory administrative requirements for most partnerships: unless they are limited liability partnerships, they do not have to provide information to Companies House about their ownership, management or financial position or comply with the other requirements of the Companies Acts.

The extent to which partnerships document the relations between partners varies: some have complex partnership deeds whereas others work less formally. Disputes between partners may arise in any partnership, however, and a partnership deed may not address the cause. Although disputes may arise for reasons such as the direction of the business, financial considerations will often be a cause of disputes.

Financial aspects of partnership disputes may concern:

  • assets used by the partnership but owned by one or more partners individually;
  • the division of profits and losses between the partners;
  • changes in the composition of partnerships; and
  • valuations of partnerships.

General Considerations

Although it is often convenient for the partnership’s accountants to advise on the financial aspects of disputes, this may not be practicable if the accountants have a close working relationship with any of the individual partners involved.

A dispute which cannot be resolved quickly and amicably may divert time and attention from the business and may lead to the departure of one or more partners or even the dissolution of the partnership. It is essential to identify exactly the issues between the partners and the information which advisers will need to form a view.

Partners’ decisions may not be documented adequately and parties to disputes may therefore put forward differing versions of events. In such circumstances, advisers must make the best use of the available information and may need to take into account the extent to which precedent has affected the operation of the partnership and/or construct alternative scenarios based on differing assumptions.

Assets Provided by the Partners Individually

Property

Partners need to provide the assets required to carry on the partnership’s business. Contributions such as furniture may be insignificant, but if an individual partner or group of partners provides the property which the partnership occupies, disputes may arise over the rent and service charges to be charged to the partnership and whether these are fair. In such cases it may be necessary to obtain expert evidence of market rents, to ascertain ‘normal’ levels of service charges payable to third-party landlords and to seek advice on the extent to which costs such as refurbishment and property insurance should be divided between the landlords and the tenants.

Loans from Partners

Advice may be needed on the interest and/or repayment terms of loans provided to the partnership by individual partners. Alternatively, if contributions of funds by partners are added to their capital accounts, an issue may arise as to whether interest should be payable on capital account balances if the partnership agreement does not provide for this. Advisers may need to consider whether interest has been paid in previous periods and whether all partners are paid interest.

Partners’ Capital and Current Accounts

The provision and the use of assets, e.g. by way of ‘one-off’ cash drawings, should normally be reflected in the partners’ current and capital accounts. It is often therefore necessary to assess whether these accounts have been computed on an accurate and consistent basis.

Division of Profits and Losses Between the Partners

In addition to an element of interest on capital, arrangements between partners may provide for:

  • profit shares at pre-determined levels for some partners, which are common where there are ‘salaried’ partners and in partnerships operating ‘lockstep’ arrangements in which seniority is rewarded; or
  • fixed profit-sharing percentages; or
  • variable percentages linked solely to turnover; or
  • variable percentages based on individual or divisional turnover less attributable expenses; or
  • variable percentages based on a combination of criteria.

Disputes may arise if there is pressure to change the profit-sharing arrangements, whether resulting from the prolonged absence of a partner or a view that there is a mismatch between contribution and earnings.

Advisers will need to determine whether income and expense items have been treated consistently in the partnership’s accounting records from year to year and between the partners. Examples of issues to be considered include:

  1. the overall profits to be allocated between the partners, particularly if some partners charge certain expenses, e.g. motor expenses, to the partnership whereas others fund such expenses personally;
  2. changes in fixed profit-sharing ratios and the allocation of profit between periods e.g. work in progress (WIP) not being recorded accurately in one period with the result that profit is effectively carried forward to the next period when the WIP is billed;
  3. the recognition for the purposes of computing profit share of turnover on an ‘as billed’ basis as opposed to a basis which includes WIP;
  4. under-billing on specific assignments to create more work for the partnership from a specific client;
  5. the effect of bad debts on the turnover of the partnership as a whole and on that attributable to individual partners;
  6. if relevant, the extent to which the recharging of attributable expenses is an accurate reflection of the use that individual partners make of the partnership’s resources, e.g. staff time sheets may show that costs recharged to an individual partner do not adequately reflect the ‘borrowing’ of staff from other partners’ divisions; and
  7. some partners may make greater use than others of ‘general’ overheads, e.g. the marketing budget, and it may be necessary to consider such expenses.

Disputes over sharing profits and losses may therefore require a detailed review of the partnership’s accounting records. The financial implications for each partner of any change in the arrangements at differing levels of overall profitability may need to be determined by the use of financial models. Such computations may also need to take account of the tax implications of the options.

Changes in the Composition of Partnerships

When partners leave a partnership, the existing partners and any new partners who are appointed may be required to buy the outgoing partners’ share of the partnership’s goodwill, on the basis that the remaining partners will benefit from the goodwill built up by the leavers. This practice is not universal, however: it may be based on precedent or be required by the partnership deed.

The valuation of goodwill which a partnership estimates that it has generated for itself will be subjective unless there is a prescribed methodology to consider. There is therefore scope for disputes. If turnover and/or profit over recent years are the basis for computing goodwill, it may be necessary to exclude significant ‘one-off’ items of income or expenditure from the calculations or at least for the partners to agree on how these should be treated, in addition to ensuring that the financial statements have been prepared on a consistent basis.

In any event, the departure of one or more partners may result in disputes if leavers wish to withdraw significant amounts of capital. In such circumstances the remaining partners may need advice on financing options.

The considerations discussed so far assume that outgoing partners are leaving voluntarily. If it is discovered that a partner has been diverting work, he or she may be expelled and the partnership may take action to recover lost profits. In such circumstances, lost profits are likely to comprise the diverted turnover, less the costs of producing that output, which are likely to be principally staff costs.

Disputes between partners or groups of partners may reach a point at which the only solution is to dissolve the partnership. If a partnership does not own property, its main assets on dissolution may comprise WIP and debtors. One way of accounting for these assets is for the partners who take them to pay for them on dissolution, or when WIP is billed and cash received from the debtors by the departing partners in their new partnerships.

Valuations of Partnerships

Partnerships may be valued as part of the computation of goodwill when partners leave, or when the partnership as a whole is to be sold. In the latter case, advice may be needed on whether an offer which has been received is reasonable. This computation may be complex if, for example, most partners in a partnership wish to sell out but others wish to set up on their own or join other partnerships. Factors to be taken into account include:

  1. how the value arrived at may be divided between the partners;
  2. whether there are valuation ‘norms’ specific to the relevant industry sector, e.g. professional practices are often valued on the basis of a multiple of turnover;
  3. whether it is proposed that any of the consideration be deferred;
  4. available valuations of comparable businesses; and
  5. the possibility that an offer received may over-emphasise one-off adverse factors affecting past profitability.

Conclusion

If a dispute is not to take on a life of its own, it is essential to identify the real issues as exactly as possible and to consider independent advice to help those involved to resolve the situation.

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This article was first published by New Law Journal on 16/10/20, and is reproduced by kind permission.

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