A few weeks ago I wrote a blog post on corporate entities, including General Partnerships and Limited Partnerships. Here’s what I said about General Partnerships, which I’m going to expand on in this post:
The first thing I should point out is that if you start working with other people, and don’t pick a legal entity, in many cases, the state will pick one for you. And to quote my colleague @indiegamelawyer, it will usually pick the worst possible one. Namely, a general partnership.
A general partnership is the oldest form of legal entity. Once two or more people start engaging in a common business enterprise they can form a general partnership without even realizing it – it happens by operation of law in many jurisdictions. (Alternately, you can formally create one by entering into a partnership agreement.) Basically, everyone participating is a general partner, usually able to contract on behalf of the partnership, usually having an equal right to manage the partnership, and usually liable for all debts incurred by the partnership. The takeaway here is that if you’re going to go into business with someone, you need to form an entity deliberately or you may very well enter into a general partnership without even knowing it and without any control over the form of the partnership.
NOTE: Formally created General Partnerships are usually identified by the word “Partners” or “Partnership” in their names. They are governed either by the law of the state where they form, or by their Partnership Agreements. They are owned and operated by Partners.
Now, what I want to call your attention to in particular is the text in bold in the above quote. “By operation of law” means that the law says when the conditions are met, the partnership forms, will ye, nil ye. You can’t stop it, and you don’t have to do anything other than meet the conditions. What those conditions are will vary by jurisdiction, but in many US states it’s either a part of the common law or the principle has been transferred into a statute (a law passed by a legislature) which works pretty much the same way.
We’ll use Illinois (where I’m a licensed attorney though this is NOT LEGAL ADVICE) as an example. Illinois, a large commercial state, has created what is called the Uniform Partnership Act, which codifies the previous common law of general partnerships. Its code section is 805 ILCS 206, if you’d like to see it for yourself. Here is what it says about the formation of partnerships:
(805 ILCS 206/202)
Sec. 202. Formation of partnership.
(a) Except as otherwise provided in subsection (b), the association of 2 or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership.
Again, check the bold. Intent to form a partnership is not required. Only the carrying-on of a business for profit (“Business” is defined in 805 ILCS 206/101(a): “‘Business’ includes every trade, occupation, and profession.”) as co-owners is required and BOOM, partnership exists.
This is why my colleague Sam Castree is fond of saying, “If you don’t pick a corporate form, the state will pick one for you, and it is usually the worst possible one.” Why are general partnerships the worst possible form? Because in legal terms, all of the partners are principals of the partnership and their actions bind the partnership including all the partners. And here’s the kicker: the general partners of a partnership are individually liable for the debts of the partnership. You get all the hassles of sharing ownership and control of a business with someone, and none of the protection from personal liability literally any other form of entity might provide you.
And this is why I call general partnerships “the creeping doom.”
Suppose you and your friend enjoy working on small computer game projects together. You finish a game – both contributing a reasonably equal amount of labor, though that is not necessarily relevant – and show it to a few people, who love it. You go through the process of setting up an account on a platform’s application store (Google Play, Apple’s App Store, whatever.) You set up a promotional web page, with both your names as the creators of the game. You publish the game and sell it, and split the money.
You have arguably just established a legal entity, a general partnership, with both you and your friend as general partners. Congrats!
Now suppose your friend believes that this game will form the basis of a vast new gaming company. Look out, Electronic Arts, we’re coming for you! He calls Dell and orders fifty thousand dollars worth of server equipment on credit, to be delivered to the office space he just leased for two years without telling you. Sadly, his optimism is misplaced, and Electronic Arts retains its position in the industry. (Which is not sad for Electronic Arts, at least.) The business does not generate enough revenue to pay for all this optimism, and legal action regarding collections is imminent. Boy, your overly-optimistic friend is in a heap of trouble, isn’t he?
Yes, he is. But he’s not the only one.
You see, 805 ILCS 206/306(a) provides in relevant part:
(a) […] all partners are liable jointly and severally for all obligations of the partnership unless otherwise agreed by the claimant or provided by law.
Now, that […] is critical, because it provides for times when this does not apply. But the default rule is that the partners are liable jointly and severally for the obligations of the partnership. Your friend has a cheap laptop and a ’97 Corolla to his name. You have a nice house and a 401(k). Guess who the creditors are going to come after for their money? That’s right. And unless you can come up with a reason the default rule should not apply, they’re going to have a shot at everything you own.
“But wait,” I hear you cry (you still haven’t disabled that microphone, have you?) “I didn’t sign for any of that stuff! He did that without my permission. So he wasn’t authorized to do it, right?”
Wrong.
Back to the statute. 805 ILCS 206/201 (1) provides:
(1) Each partner is an agent of the partnership for the purpose of its business. An act of a partner, including the execution of an instrument in the partnership name, for apparently carrying on in the ordinary course the partnership business or business of the kind carried on by the partnership binds the partnership, unless the partner had no authority to act for the partnership in the particular matter and the person with whom the partner was dealing knew or had received a notification that the partner lacked authority.
In other words, the default rule is that every partner speaks for the partnership and can bind it legally. It’s not their job to prove your friend was authorized, it’s your job to prove he wasn’t and that they knew he wasn’t. And if you can’t, bye-bye 401(k.)
Now, have I simplified this and left out a lot of exceptions? You’re darn tootin’ I have. I could make several arguments, if I were your lawyer, as to why there was no partnership in the first place and if there was it shouldn’t be bound by your friend’s acts and if it is you still shouldn’t be personally liable for the debts. But we are playing defense and a lot of burdens of proof are on us which would normally be on them. This is not a good place to be, legal-wise.
Bottom line, if you work with others on a project which has the potential to generate money (and nobody is anybody’s employee or contractor) you are at risk of forming a partnership, which puts your personal assets at risk. If that doesn’t scare you, it should. So you should at least consult with a friendly attorney, licensed in your jurisdiction, and ask them if a corporate entity is a good idea for you, and if so could they help you select one and set it up. Because if you don’t, your state might just go ahead and do it for you.
This is a very short introduction to a very complex topic: If you have them, comments and questions are welcome. As always, thanks for reading!
M
