Choosing the right business structure is critical for the operation of a business. General and limited partnerships are common business structures for those wanting to enter business together. While both partnerships offer flexibility and a shared approach to business ownership, they differ significantly in terms of control, liability, and financial responsibilities. In this article, we explore the key differences between these types of partnerships, the common pitfalls, and ways to resolve them.
General Partnerships
In a general partnership, two or more individuals come together to operate a business. General partnerships are often used by small businesses where each partner is closely involved in the daily operations and share equal responsibility. These usually include local retail stores, restaurants, and coffee shops.
In a general partnership, all partners share equal responsibility in managing the business, contributing capital, and making decisions. This gives each partner a role in the business’s daily operations. Each partner is personally responsible for covering the business’s debts, and personal assets can be at risk. This is true even if the act was carried out by another partner so long as the copartner was carrying on partnership business in the ordinary course.
Pitfalls and Solutions
- Pitfall #1: Unlimited liability. All partners share in unlimited liability and are personally liable for the business’s debts, which can expose partners’ assets if the business faces lawsuits or financial troubles.
- Solution: Partnerships should obtain comprehensive business insurance that protects personal assets. While partners may agree among themselves to share losses or debts in differing proportions, third parties are usually not bound by such an agreement and can seek equal contribution from each partner.
- Pitfall #2: Conflicts in decision-making. Because each general partner has an equal responsibility in the management of the business, decision-making can become contentious, especially if partners disagree on the approach.
- Solution: Having clearly defined roles and responsibilities in a written partnership agreement can help prevent disputes. Further, partners should consider a dispute resolution clause in place requiring mediation and arbitration.
- Pitfall #3: Unequal distribution of profits. Disputes often arise resulting from the distribution of profits, particularly when there is a sense that one partner contributes more to the business than the other.
- Solution: To avoid this, the partnership agreements should explicitly outline how profits (and losses) will be shared and what factors play a role in the distribution, such as each partner’s contribution, capital investment, and/or role within the business.
Limited Partnerships
A limited partnership consists of at least one general partner and one or more limited partners. Limited partnerships are often used in industries where passive investors want to contribute capital without getting involved in the management of the business. This includes businesses such as real estate investment groups, venture capital funds, and private equity firms. The general partner is usually a special purpose entity incorporated as an LLC or a corporation to shield the general partner from personal liability.
Limited partners share profits. But, unlike general partners that control business management and are liable for partnership debts, limited partners usually take no part in running the business and incur no liability beyond their capital contributions. If the business fails or faces a lawsuit, unless the limited partner participates in the control of the business, the limited partner’s liability is limited to their initial investment.
Pitfalls and Solutions
- Pitfall #1: Return on investment. Limited partners focus on the return on investment as they play no role in the day-to-day management of the business. When limited partners do not see a return on their investment, such as during a down year, this can lead to dissatisfaction and disagreement between the limited and general partners.
- Solution: Open communication is key. General partners should regularly update limited partners on the business, including key initiatives and financial status.
- Pitfall #2: Misunderstanding profit distributions. Profit distributions between general and limited partners are often different and usually dependent upon the proportion of the partner’s contributions. Disproportionate distributions may lead to disputes among the partners.
- Solution: To avoid misunderstandings, the partnership agreement should clearly define how profits and losses are to be shared and detail any preferred returns or priority distributions for limited partners.
- Pitfall #3: Reliance on general partners. General partners have full control and responsibility over the business’s operations, and limited partners do not have the ability to manage the day-to-day business. As a result, if general partners make poor decisions or mismanage the business, limited partners may be without recourse.
- Solution: To mitigate this risk, limited partners should carefully vet general partners before entering the partnership. In addition, depending on the business structure, limited partners may engage in certain actions that can help drive the direction of the business without it constituting “control of the business.” This includes, without limitation, serving on an audit committee, proposing or calling a meeting of the partners, and serving on a committee to approve certain actions of the general partner.
The choice between general and limited partnerships affects every aspect of how a business is run, how profits are distributed and shared, and how liabilities are handled. By understanding the pros and cons of each structure and anticipating the common pitfalls, partners can make informed decisions to minimize conflict and keep the business running smoothly. Careful planning, clear agreements, and open communication are key to ensuring a successful partnership—whether general or limited.
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