Why partnerships are a bad idea (for a small business)

I meet a lot of SCORE clients who formed small business partnerships with friends, relatives, acquaintances, and have no idea of the risks they’ve taken on.  They come to SCORE for help because something’s gone wrong, and it’s often too late to fix.  So, I’ve started preaching in my workshops about the dangers of general partnerships for the average small business owner.  Here’s an example I frequently use:

Let’s say you and your best friend Rose decide to form a catering business.  Rose has been out of work for months and has no assets or savings, but she’s a great cook and willing to work hard.  You have a house, a car, and about $20,000 in savings you’re willing to put into the business.  You form a 50-50% general partnership thinking you’ll just decide everything together because you’re such good friends.  You don’t have much money for ads, but you know how to use Twitter and Facebook, and through word-of-mouth you start to get some customers.

On the very first day of business, Rose is driving to a catering event in the company van.  She’s late, she’s rushing, she’s distracted by a text message telling her she forgot to take the shrimp out of the cooler and in her distracted state she runs a stop sign, causing a terrible accident with an oncoming car.  Rose is fine, but the driver of the other vehicle is badly injured.  The good news is, you have auto liability insurance, but the bad news is it has a limit of $1 million.  The other driver sues for $2 million and wins.  Who pays the judgment, and how much does she pay?

Or, suppose that Rose has the brilliant idea, for an upcoming St. Patrick’s Day event, to dye all the food green, including all of the corned beef and cabbage.  You think this is a terrible idea and tell her so.  But she’s convinced this is genius, so, without telling you, she goes ahead and orders several cases of a special, “organic” green food coloring and a bunch of green paper-goods and utensils at a cost of $10,000.  She dyes all the food for the event a brilliant shade of emerald green, and drives safely to the event, but when she arrives, the customer takes one look and says “That’s gross” and rejects the entire order.  So  now the partnership owes $10,000 for the supplies, has no revenue from the event and not enough working capital to cover the extra cost.  Who pays the vendors?

The answer:  You do.  All of it.

That’s because, with respect to third parties, the partners are each 100% liable for the debts of the general partnership.  This is true regardless of the deal they made with each other.  Yes, theoretically, Rose is liable for her 50% share — and maybe you could even argue she should be liable for 100% of the cost of the disgusting dyed food — but she has no money and no assets.  Even if the creditors were willing to pursue her for her 50%, she couldn’t pay.  And legally, they don’t have to pursue her.  They can just sue you.  Then it’s up to you to recover from your partner.  Which could well be the end of a beautiful friendship — not to mention the end of a business.

So, what form of entity do I recommend for small business “partners?”  Generally, either an S-Corp or an LLC.  And, for a bunch of reasons, I tend to favor the S-Corp.  More on that in  How to Choose a Business Entity.