Key Takeaways

  • An equity partnership gives partners ownership and entitles them to a share of the business's profits.
  • Equity partners typically invest capital and share in both the profits and liabilities of the firm.
  • A written equity partnership agreement should clearly define roles, equity distribution, profit sharing, and decision-making protocols.
  • There are different partnership systems such as lockstep and eat-what-you-kill, each affecting income and partner responsibilities differently.
  • Sweat equity allows partners to contribute work or expertise instead of capital in exchange for ownership interest.
  • Key issues such as exit strategy, dispute resolution, voting rights, and capital calls should be addressed in the partnership agreement.

Partnership

A partnership is a legal arrangement where two or more individuals agree to pool their financial and human resources for a business venture. Each partner is given a portion of the profits and losses of the business.

An equity partnership agreement is a legally binding agreement between the partners of a partnership that sets forth the rights and obligations of the partners and the proportion of their equity in the business. An equity partner owns part of the company and is entitled to a percentage of the partnership's profits. An equity partnership agreement should spell out the rights and obligations of all the partners in the partnership, including the equity partners.

Understanding Equity vs. Non-Equity Partnerships

In many professional services firms, equity partners differ significantly from non-equity partners. While equity partners contribute capital and share in profits and losses, non-equity partners typically receive a fixed salary and may not have voting rights or ownership interest.

Non-equity partners may still hold leadership roles or participate in decision-making, but they do not carry the same financial risk or long-term benefits. This distinction is important in firms with tiered partnership models, where non-equity status often serves as a stepping stone to equity partnership.

Types of Partnership Agreements

Partnership agreements are of two types, including:

  • General partnership: Here, each partner has personal and collective liability. In general partnerships, each partner is responsible for his liabilities and the liabilities of other partners in the business.
  • Limited Liability Partnership: In this type of partnership, each partner's liability is restricted to the proportion of his or her investment in the company. Also, partners do not share the responsibilities of other partners.

A partnership agreement sets forth the status of the company as either a general or limited liability partnership.

Key Clauses in Equity Partnership Agreements

A well-drafted equity partnership agreement should include several essential clauses to protect all parties and ensure smooth operations:

  • Capital Contributions: Details the amount and type of investment each partner makes, whether monetary or sweat equity.
  • Profit and Loss Allocation: Explains how profits and losses are distributed among equity partners.
  • Voting Rights: Outlines how decisions are made and what weight each partner’s vote carries.
  • Withdrawal and Buyout Provisions: Specifies what happens if a partner exits or retires, including valuation methods and payout terms.
  • Admission of New Partners: Details the process and approval required to admit new equity partners.
  • Dispute Resolution: Provides mechanisms for resolving internal disagreements without litigation, such as mediation or arbitration.
  • Capital Calls: Allows the partnership to request additional funds from equity partners when needed.

These provisions help ensure transparency and stability in the partnership.

Lockstep Partnership System

A lockstep partnership is a type of equity partnership where senior partners who have spent more years with the business receive a more substantial proportion of the business profits compared to new equity partners. However, the business community no longer favors the lockstep partnership system.

Critics of the system note that it discourages partners who are eager to earn more and lacks accountability. However, advocates of the system argue that it shields partners from loss of earnings and reduces internal competition.

Eat-What-You-Kill Partnership System

The Eat-What-You-Kill Partnership System is the second form of equity partnership. In this system, each partner gets a certain proportion of the company's profits, and individuals also receive compensation for their efforts towards running the business.

Supporters of the Eat-What-You-Kill Partnership System argue that it allows partners to have more control over their earnings and customers and enables them to have a clear understanding of what they must do to achieve their target income.

The downside of this system is that it can lead to a lack of management because it gives no recognition to non-billable time partners spend managing the partnership. Additionally, the system also discourages the training of new or junior employees.

Basics of the Written Equity Partnership Agreement

An equity partnership agreement should list the rights, responsibilities, and obligations of each partner. The contract should also address the proportion of the company's profits that each partner will receive. Partnership agreements should also allocate losses to future partners.

Furthermore, the partnership agreement should address how the business will make important decisions for running its operations. In addition to these, the partnership agreement should discuss how the dissolution of the company will be handled in the event of a partner's exit from the partnership or death.

Tax Considerations for Equity Partners

Equity partners are generally treated as self-employed individuals for tax purposes. This means:

  • They are responsible for paying self-employment taxes on their share of the profits.
  • They receive a Schedule K-1 form, which reports their share of the partnership’s income, deductions, and credits.
  • They must make quarterly estimated tax payments to avoid penalties.
  • Health benefits and retirement contributions may not be taxed the same way as for employees.

Because tax treatment can be complex, equity partners should consult with a tax advisor or legal professional to ensure compliance.

Joint and Several Liability

Only the general partners of a limited partnership are personally liable for the debts and obligations of the company. If the company goes bankrupt, the general partner's assets can be used to settle the debts of the partnership. However, all partners in a general partnership have joint and several liability. If one of the partners is involved in a lawsuit, all the partners can be sued along with that partner.

Equity Ownership

The equity partnership agreement should state each partner's equity ownership in the business. The equity owned does not have to be equal to the investment of each partner because equity ownership can also be based on non-monetary contributions such as the connections partners bring to the company or real-life professional and managerial skills.

Path to Becoming an Equity Partner

The path to equity partnership varies by firm but typically includes the following stages:

  1. Associate or Junior Role: New professionals often begin in non-partner roles to gain experience.
  2. Non-Equity Partner (optional): Some firms promote individuals to non-equity status as a transitional step.
  3. Promotion to Equity Partner: Candidates are evaluated on performance metrics such as billable hours, business development, client retention, and cultural fit.
  4. Capital Buy-In: Upon promotion, a new equity partner may be required to invest capital into the firm, which may be funded personally or via firm financing.

This pathway reflects a commitment not only to the firm’s success but also to long-term financial investment and risk.

Sweat Equity

Sweat equity is an investment of work and effort in a business, enterprise, or project. It is one of the ways of adding equity to a business. Sweat equity can serve as equity for partners who have no money to invest in a partnership. A Sweat Equity Agreement has no monetary value on its own. However, it provides value-adding actions and effort to the business.

Risks and Responsibilities of Equity Partners

While equity partnerships offer profit-sharing and control, they also involve significant responsibilities and risks:

  • Liability Exposure: In general partnerships, equity partners may be personally liable for the firm’s debts and obligations.
  • Financial Commitment: Capital contributions and potential future capital calls can create financial strain.
  • Time Commitment: Equity partners are expected to contribute time to firm management, client acquisition, and mentoring junior staff.
  • Reputational Risk: Equity partners share responsibility for the firm’s conduct, which can impact personal and professional reputations.

Understanding these risks is essential before entering an equity partnership.

Frequently Asked Questions

What is the difference between equity and non-equity partners? Equity partners have ownership interest and share in profits and losses, while non-equity partners typically receive a salary without ownership or full voting rights.

How is profit shared among equity partners? Profit sharing is defined in the partnership agreement and can be based on seniority, performance, or a fixed percentage.

Do equity partners have to invest money upfront? Yes, most equity partners are required to make a capital contribution when joining the partnership.

Can sweat equity count toward ownership? Yes, firms may grant equity in exchange for labor or expertise, particularly in startups or early-stage firms.

Are equity partners employees? Generally, no. Equity partners are treated as self-employed individuals and taxed accordingly.

If you need more information about equity partnership agreement, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.