When you studied for the SIE exam, you may remember learning how a business becomes a corporation. To incorporate, the business files a corporate charter (also called the articles of incorporation) in the state where it’s headquartered. This document establishes the corporation as a legal entity and discloses key details such as the corporation’s name, business structure, and the authorizes shares that represent ownership of the company.
To form a limited partnership, paperwork must be filed with the state where the limited partnership will primarily operate. This filing typically includes the business name, address, and information about the partners (general and limited partners). After the filing is accepted, the state issues a certificate of limited partnership. Once the limited partnership has this certificate, it’s recognized as a legitimate business.
Each state has unique requirements and protocols for establishing limited partnerships. For a real-world look at what a state may request to legally form a limited partnership, here are the protocols from the state of Colorado.
The general and limited partners must also put their arrangement in writing. This written contract is the agreement of limited partnership. It spells out the rights, duties, and restrictions for each type of partner and explains how revenues and losses will be allocated. If you’d like to see an example, here’s a boilerplate version of an agreement of limited partnership provided by a law firm in California.
It’s important to understand the roles of the general and limited partners.
General partners manage the business and must act in a fiduciary capacity. That means they must act in the best interest of the partnership and can’t compete with it, borrow from it, or otherwise work against it.
Limited partners are often described as “the investors.” They don’t have management authority, but they typically have voting rights similar to common stockholders. For example, they can vote on changes to the partnership’s overall objectives and major financial decisions, and they have access to the partnership’s books and records.
Unlike traditional equity and debt offerings, investors usually must complete several steps to become limited partners. A subscription agreement - essentially an application to invest - helps establish whether the potential investor is suitable for the partnership. General partners often prefer investors who are wealthy and not concerned with liquidity. That preference allows the partnership to raise significant capital without pressure to make payouts, and it can be especially important if there’s a capital call or a need for limited partners to take on recourse notes/debts.
In addition to suitability, the subscription agreement typically requires the investor to state explicitly that they understand the risks involved. Registered representatives (like you) often help clients build the knowledge needed to evaluate the investment. If a registered representative recommends a limited partnership, they should perform a thorough suitability determination by gathering information such as the client’s investment objectives, risk tolerance, tax status, net worth, annual income, personal liabilities, and investment goals. Some subscription agreements also require the registered representative to certify that the client understands the relevant facts and is suitable for the investment.
To solicit interest from potential investors, limited partnerships often use investment banking services. If offered privately, limited partnerships are typically sold through Regulation D private placements, where unlimited numbers of accredited investors can participate. Limited partnerships can also be sold through public offerings. In that case, registration with the SEC is required, and investors must be provided with a prospectus.
A defining characteristic of limited partnerships is their limited lifespan. Unlike corporations, which can exist in perpetuity, limited partnerships are dissolved at some point. Dissolution may be voluntary or required (often due to bankruptcy). Regardless of the reason, liquidation follows the same general process: the partnership pays its debts, liquidates remaining assets, and distributes cash in this order:
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