For purposes of this article, a sample partnership agreement taken from a large Northeastern law firm has been selected as an illustration. The following language is copied directly from that agreement:
3.02 Additional Contributions to Capital: In addition to the amounts referred to in Section 3.01, hereof, the Partners shall contribute such sums of money as and when the same shall be required to meet the costs and expenses of all business activities with respect to the Partnership and to pay for property to be purchased or leased by the Partnership and when the purchase price or rental therefore shall be due and payable, and to pay all other costs and expenses incurred by the Partnership in connection with the other activities of the Partnership. Such contributions shall be made by each Partner in the same proportion as their respective required capital accounts in the Partnership, as set forth on Schedule 2 annexed hereto, bear each to the other. The Management Committee of the Partnership shall determine from time to time the capital requirements of the Partnership.
3.03 Withdrawals: The Partners may, from time to time, withdraw their capital contributions, in whole or in part, only with the express consent of the Management Committee of the Partnership.
3.04 Capital Accounts: An individual capital account shall be maintained for each Partner.
3.05 Extraordinary Losses: Uninsured losses of the Partnership arising from fire, theft, malpractice, third party claims or judgments against the Partnership or otherwise, which by their size or nature would be deemed extraordinary, will be borrowed by the Partnership from a lending institution (to the extent such loan or loans are available) and be charged against the annual profits of the Partnership as and when such loans are repaid. In the event and to the extent that such loan or loans are not so available, such amounts will be charged directly against the capital accounts of each Partner in the same proportion their respective required capital accounts in the Partnership, as set forth on Schedule 2, bear to the other.
Some few firms still require new partners to contribute capital which is calculated by a complicated formula and then used to "buy- out" existing partners. The new funds do not add anything to general working capital, which is the only reason for requiring capital from the initial founding partners. This archaic practice usually is found only in the very small firm or one where modern management practices are virtually nonexistent.
For many well managed firms, an initial capital contribution from the new partner(s) is not required. Working capital requirements are met from normal cash flow and periodic use of an open line of credit. Major purchases of equipment, facilities repair/renovation and expenses of a relocation are funded by a separately negotiated long term loan.
When arbitrary amounts are used, members of the partnership use their own self-generated criteria to decide how much a new partner will be required to contribute. The simplistic concept basically is "that a new partner is being allowed to have access to a profit generating entity and that there is a cost associated to that access, almost like buying a ticket to a closed party". Therefore, the present partners can justify charging any amount as a capital contribution from the newly admitted partner(s). The amount so determined has no relationship to anything other than perhaps to be relevant to previous year's decisions and the current economic state of the firm.
Some clarifying language should be added in this Section to indicate that the initial capital contribution referred to as Schedule 2 will be the minimum capital that must be maintained as long as the partner remains with the firm in an active status. In no event will an active partner be allowed to withdraw capital at any time that will reduce his respective capital account below this initial minimum.
A "capital call" for additional funds should have a more definitive date for timing of the contribution. For example, the wording should include "within 90 days" or "will be taken from the Partner's draw for the ensuing 90 days" under what is generally known as the "haircut" method of collecting the required amounts.
If, for some extraordinary reason, the partnership believes that capital accounts can be reduced, then there should be a pro-rata distribution to each partner in the same proportion as their respective capital accounts have to the total capital account. One of the first signs of potential internal dissension occurs when selective partners are allowed to withdraw their capital forcing the firm to operate solely with operating revenues and/or borrowings from the credit line to meet cash flow requirements. This becomes a prelude to financial disaster when these short term borrowings are used exclusively to fund partner draws/distributions.
Payment of interest on capital accounts has both pro and con arguments. Basically, the reason for payment of interest at a competitive rate is to compensate each partner for an investment in the firm when the funds theoretically could be invested alternatively.
Section 3.02 appears to be unduly cumbersome in language. The applicable portion of Section 3.01 should be added to this Section for clarity. Comments made above relating to the issue of additional capital requirements in Section 3.01 should be removed to this Section.
Maintenance of accurate capital accounts is paramount to building and maintaining trust among partners. The key to harmony among partners regarding this critical issue is to have concise language in the partnership agreement; to maintain accurate and timely records; and to ensure that every partner is treated fairly and equitably with respect to additions and withdrawals with no exceptions.
Consistent treatment in the handling of partnership capital accounts is vital to maintaining good partner relations. Nothing can cause internal fractions quicker than perceived favoritism relating to the admission or departure of a partner and the handling of that partner's financial agreement. The solution is consistency and fairness with strict adherence to the terms of the partnership documents with no exceptions.