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Five Critical Issues to Address in your Partnership or LLP Agreement to Weather an Economic Downturn

Like all businesses up and down the country, professional services firms will be urgently reviewing their business, operations, workforce and finances, and implementing contingency measures to safeguard business continuity as well as to ensure financial resilience in the face of the unique and unprecedented challenges presented by the COVID-19 pandemic and the consequent economic slump.

As part of this review, it is important for firms to also consider whether their partnership or LLP agreement offers adequate protections for the business and provides senior management with the powers necessary to swiftly deal with challenges such as working capital management, preventing  the departure of high-performing partners and teams, as well as dealing with partner performance and misconduct issues.

Managing these concerns are always challenging but particularly so in the current environment. Firms that do not have effective protections and powers in place are vulnerable to unnecessary disputes, financial loss and potential damage to their brand and reputation (all of which can make it more difficult to bounce back when the economy eventually turns a corner). The impact of these issues can be lessened (or prevented all together) if your firm is proactive in addressing the following five matters in its partnership or LLP agreement.

1.    Cash is no longer “King”…it’s “God Emperor”*

For professional services firms with significant overheads there is always a delicate balance between the cash coming into the business and the cash going out. In these difficult times, many firms will experience a “perfect storm” of a simultaneous decline in new business along with existing clients taking much longer to pay or even being unable to pay their bills; which can lead to a cash crunch for firms. As a result, firms will be looking to conserve cash in the business so that they are able to weather the economic headwinds and pay their fixed overheads (such as rent, PII premiums and wage costs). Many firms will be considering a reduction in partners’ monthly drawings, deferring the payment of any undistributed profits and possibly reducing partners’ fixed profit shares. Senior management can only take such actions if the firm’s partnership or LLP agreement gives them the power to do so, otherwise, it is likely that such decisions will require partners’ approval, which can slow down or limit the firm’s ability to react quickly to a fast moving and exceptional situation.

Firms should consider what approvals are required under the partnership or LLP agreement to raise capital for the business – whether that’s additional partner capital or external financing. Delegating to senior management the power to raise funding (up to certain limits) can avoid having to undergo the partner approval process.

Another significant cash call on the business is when a partner leaves the firm, triggering the firm’s obligation to repay their capital and other amounts held by the firm, such as their tax reserves and undistributed profits. Many partnership or LLP agreements require the firm to pay these amounts soon after a partner leaves, which can put the firm in a difficult financial position, particularly where a number of partners depart in a short space of time. Allowing the firm to defer these payments under the partnership or LLP agreement can mitigate the impact of partner departures on its cashflow.

It is vital for firms to ensure that their partnership or LLP agreement delegates powers appropriately to senior management so that they have the flexibility to react quickly to raise funds or reduce the haemorrhage of cash from the business at a critical time.

2.    Minimise risks of partner exodus

At times such as these, firms cannot afford to lose their highest performing partners. Whilst no partner can be forced to stay at a firm, if the right provisions are included in your partnership or LLP agreement, partner departures and the consequent loss of clients and revenue can be decelerated. The key provisions to include are:

  • An appropriate notice period – notice periods for voluntary retirement in professional services firms typically range between three to 12 months. Firms should consider whether their current notice period is sufficient to protect the business in difficult times.
  • Waiting lounge – multiple and simultaneous partner departures can seriously de-stabilise a firm and result in a significant capital outflow (as noted above). A “waiting lounge” provision is designed to tackle this issue by preventing more than a certain number or percentage of partners from retiring in a given period.
  • Restrictive covenants – the key to safeguarding a firm’s goodwill following a partner’s departure is ensuring that any restrictive covenants applicable to the partner are enforceable. Firm’s should review their restrictive covenants periodically to ensure they can stand up to scrutiny. Firms should also consider including specific covenants to safeguard against team moves.
  • Garden leave – robust garden leave provisions will enable the firm to lock a partner out of the business during their notice period whilst allowing the firm the space and time to consolidate and transition client relationships.
  • Good/bad leaver – such provisions can encourage good behaviour by departing partners (e.g. compliance with restrictive covenants) and penalise those who breach their obligations to the firm by enabling the firm to defer any amounts due to a bad leaver over a longer period or set-off any damages suffered by the firm against the bad leaver’s capital and other balances.

3.    Robustly manage partner performance

Whilst senior management of firms may be firefighting on various fronts, they cannot afford to lose their eye on the ball when it comes to managing partner performance. Firms should review their partner KPIs and performance assessment policies and procedures to ensure these are still appropriate in the current circumstances. As cash management is critical to whether a firm survives or thrives, senior management may want to bear down on partners who are not actively managing their WIP, billing and collections.  Incorporating these financial performance metrics in partner KPIs is therefore crucial, as is holding partners’ feet to fire by way of a rigorous appraisal process.

Firms also need to ensure that they have the ability to penalise under-performing partners under their partnership or LLP agreement; this can include the power to reduce points or fixed profit shares, de-equitisation or compulsory retirement.

4.    Deal effectively with allegations of misconduct

Firms should ensure they have the procedures and constitutional provisions in place to deal appropriate and swiftly with any allegations of partner misconduct. Failing to do so can potentially lead to significant financial liabilities for the firm, as well as reputational damage and regulatory censure. The key things to include are:

•    clear obligations under the firm’s partnership or LLP agreement requiring partners to comply with the firm’s behavioural standards and policies (e.g. anti-harassment and bullying policy) as well as obligations to comply with laws and professional regulations;

•    a clear disciplinary and grievance procedure that is applicable to partners – many firms will have these in place for employees but not necessarily for partners;

•    the ability to suspend a partner under the partnership or LLP agreement so that the firm can investigate any allegations of misconduct; and

•    the ability to take appropriate action against a partner who is found guilty of wrongdoing; this can include a warning, removal from a senior role, reduction in profit share, de-equitisation or, as a last resort, expulsion.

5.    Don’t fall foul of discrimination and whistleblowing legislation

In including and exercising any powers in a partnership and LLP agreement, firms must be mindful of the risk of discrimination. The law relating to discrimination protects both LLP members and partners in a general partnership.

In drafting any powers, there is a risk that some partners who share protected characteristics, e.g. disabled partners, may end up disadvantaged compared to others when those powers are implemented. Key areas to give particular thought are around provisions for pay during periods of absence, such as parental leave or sickness leave.

There is also risk when exercising a power. For example, a firm may have the contractual power to expel a partner if they are unable to work for a certain period due to sickness. If that partner is unable to work because of a disability, whilst the firm may have the contractual ability to expel, the act of expulsion may amount to disability discrimination because the prolonged absence is a consequence of the disability.

Similar protections are in place for those partners who may have blown the whistle on wrongdoing. Whistleblowing protections in the UK protect workers (which includes LLP members, but not partners in a general partnership) from suffering detriment, which would include being forcibly exited from the LLP or having their profit share reduced, because the worker made a protected disclosure. Firms must therefore be very careful not to retaliate against any partner who reports wrongdoing by treating them badly, for example, by removal, reduction of profit share or status. Similar rules apply if someone reports an act of discrimination or harassment, and it will be unlawful to retaliate against that person, even if there is the power to take whatever step is to be taken in the LLP agreement. Such conduct would amount to victimisation.

Adopting thorough and robust processes for decision making, including in particular managing partner performance and conduct, and properly documenting these processes and decisions, is critical to ensure that the firm has a defence to any allegations of discrimination or whistleblowing and that evidence of a genuine and lawful reason for the decisions is available.

If you would like more information about updating your partnership or LLP agreement or the issues addressed above, please contact Zulon Begum (Partner), Sarah Chilton (Partner) or Wendy Chung (Senior Associate). 

*Brian Caulfield,VC investor and entrepreneur – @BrianCVC