What’s better for startups: partnerships or incorporation?

Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. He submitted this column to VentureBeat.)

A reader asks:  I’m a student at Stanford, and my classmate and I are launching a new web venture.  We agreed to split the ownership 50-50, and I found a good partnership agreement template on the web to reflect that.  I was wondering if there are problems with us just being partners for now, and then perhaps incorporating down the road.

Answer:  Unfortunately, there are a number of significant potential problems with this strategy.

The most notable is from a personal liability perspective.  A partnership is like a sole proprietorship on steroids – meaning that not only will you have unlimited personal liability for all of the business’s activities (including its debts and liabilities), but you will also have unlimited personal liability for the business acts of your partner.

For example, if your partner executes a consulting agreement on behalf of the company with a developer, and that agreement is breached for whatever reason, the developer could sue both the company and you personally.  (This would not be the case if you formed a corporation or a limited liability company.)

You are also generally personally liable for any tortious acts of your partner (thinks like libel or slander) committed within the ordinary course of business.  You’re also personally liable if problems arise with hired employees.

Also, as I have previously discussed, it is imperative that the equity of your co-founder vest over time (usually for four years and sometimes with a one-year “cliff”) to avoid a situation where he or she exits the venture early (say, after a few months), but still maintains ownership of half the company.  It is highly unlikely that the template you mentioned addresses this issue.

Remember, every partner has a fiduciary obligation to the other(s) with respect to all matters affecting the business. That’s a high legal standard requiring undivided loyalty, good faith and fair dealing.  It’s also one that has led to quite a bit of litigation between/among partners, including allegations of conflicts of interest and self-dealing.

If there has been and/or will be any intellectual property (IP) created by your partner, you could also face some hurdles ensuring it’s assigned to the company.  If you don’t address this, it could cause significant problems and complications if that person decides to leave the venture.

Finally, angels and other sophisticated investors will almost never invest in a partnership (due to the potential personal liability and other issues). Instead, they’ll generally require you to convert the partnership to a corporation.  That sort of conversion, however, can be complicated and costly, not to mention create significant tax problems.

The bottom line is: A general partnership has limited utility for entrepreneurs. In general, it’s best to avoid.

Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.